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Bond investing for many has never been more difficult, but not for the reason many think.
Central bankers around the globe began aggressive campaigns of monetary interventions following the financial crisis in 2008. These unprecedented measures to stabilize capital markets and induce economic expansion in developed countries have had far reaching effects. We know that with Federal Reserve intervention interest rates have fallen precipitously while asset prices have surged higher. With interest rates now near historic lows the search for yield by investors has been a difficult task. However, it is in that quest for yield that many investors have unwittingly taken on excessive credit risk (the risk of the bond issuer defaulting) by pouring money into “high yield,” a marketing term for “junk bonds.” and emerging market debt. However, the real problem that continues to frustrate most fixed income investors isn’t credit risk but rather interest rate risk.
Investors have enjoyed a 30-year bull market in bonds, and deflation has been the reigning theory since the 2007-2008 financial crisis.
In our opinion the risk profile of traditional bond portfolios has changed. Today, traditional strategies benchmarked against the aggregate fixed income universe are dominated by interest rate risk –not the most desirable risk after decades of falling government bond rates.
When the Federal Reserve’s announcement of QE3, what Ben Bernanke said was interesting. Not that policy was being linked to a 6.5% unemployment rate, but that the Fed would tolerate an inflation rate up to 2.5%. So we have to ask ourselves, assuming the Fed does get what it wants, how can you explain that interest rates across the maturity spectrum up to the 10-year treasury will stay below that inflation expectation that the Fed wants to achieve?
While it’s difficult to predict when rates will rise, investors need to begin thinking about their fixed income strategies, and how their portfolios will provide income while helping to shield them from undesired risks.
With the 10-year treasury currently at 2.6%, despite all the current angst, seems to be in a middle of the range of 2.3 – 2.8%…for now. Investors should begin asking themselves, how should I invest if yields go higher? Most investors think of investing in fixed income with the idea of what has worked for the last 30 years – be long bonds. It’s time for a new strategy.
Most bond funds in a rising interest rate environment are not the place to be. Also, a long duration bond portfolio is less than ideal as well.
For investors who think rates will rise, we can suggest several strategies. While we do not recommend any of these as pure strategies, as a compliment to a fixed income portfolio some of these strategies should be considered.
For example, if an investor had one $20,000 bond that matured in five years and earned 2.5% interest per year, the investor would not have access to that $20,000 for five years. Also, if interest rates increased to 3.5%, he would be stuck earning the lower, 2.5% rate until the bond matured.
On the other hand, if the investor had five bonds worth $4,000 each that were laddered so that one bond matured each year, he only have to wait a few months to start earning a higher interest rate on a portion of his investment if interest rates increased.
At the same time, if interest rates fell from 2.5% to 1.5%, the investor would not be faced with putting $20,000 into a lower-earning investment all at once. Interest rates might go back up by the time the other bonds reached their maturity dates.
We would recommend laddering bonds as an essential risk management strategy within any balanced fixed income portfolio.
As an alternative to the simple bond ladder, bond investors may want to consider Kicker bonds to compliment their portfolio. Kicker Bonds are premium bonds with above market coupons and short-term calls. In this scenario if rates move higher you have locked in a better income producing bond than had you purchased par bonds, and as rates increase, the likelihood of an early call decreases. If rates move lower, you have earned a higher short-term rate than had you purchased a straight bullet maturity.
Before I get into the math, let me explain why the yield is higher and why the issuer (the seller of the bond) would be willing to pay a higher interest rate than the current market rate. First, the issuer is offering the higher yield because they want the opportunity to call the bond at an earlier date than the stated maturity of the bond. The reason that they might want to call the bond early is because rates may move lower, which means they could buy back these higher cost bonds and issue new ones at a lower rate, saving the issuer a lot of money in interest payments.
To have the right to call the bonds, the issuer will have to offer a higher coupon. Because of the higher coupon, the bonds will be priced at a premium (above par). Premium bonds are harder to sell than bonds at par or bonds at a discount (below par), simply because most investors do not like the idea of paying a premium. Because of this, premium bonds will typically be priced so that there is a little extra yield (a cushion), to entice investors to buy the bonds.
Kickers get their name because there is a “kick-up” in yield if and when a call date is passed and the bond is not called. Bonds are priced “yield to worst,” which means that, if there is a call date, the bond will be priced to the first call. This pricing method results in a lower yield for a callable bond than the bond’s yield to maturity—its yield percentage if the bond is not called and is held to maturity.
Example: (Hypothetical) * The example below should not be considered a recommendation to purchase/sell Holly Frontier (HFC) or Kinder Morgan. The information is merely an example of how a “kick-up” structure works.
November, 2015 – 3.85%
November, 2016 – 4.15%
November, 2017 – 4.70%
November, 2018 – 5.00%
Kicker bonds are a nice feature in either scenario. Kinder Morgan (KMI) bullet bonds to the November, 2018 maturity were trading on the same month at a 3.50% YTM (yield to maturity) as compare to the Holly Frontier bonds with a 5% YTM.
Kicker bonds are reviewed by our firm to determine if they are appropriate for our client’s portfolios. Currently, it seems to make sense that these bonds could add a potential hedge against interest rate risk.
Our firm has owned unconstrained bond funds to compliment some of our clients fixed income portfolios, and we have experienced some good results. Just remember not all of these funds are the same, and should be reviewed carefully before purchase and reviewed consistently.
These bonds are known as step-ups because quite literally the coupon “steps up” from one period to another. Consider the following example. *The example below should not be considered a recommendation to purchase General Electric/GE Bonds. The information is merely an example of how a “Step- Bond” structure works.
General Electric (GE) (A1/AA+ credit) offers a step up $100.74 with a semi annual call structure starting in 2014 and maturing in 2032. While these bonds do technically mature in 2032, Bloomberg has the duration on these bonds at 3years. Below is the step up structure.
Etc… to maturity
In contrast, a straight bullet would yield only .36% to maturity in February, 2014 versus a 1.70% yield to maturity in a similar step-up. This would lead to an outperformance of over 130 basis points between the two bonds.
Another important call date is in February, 2017 because, as stated above, it is the last time the bond can be called before coupon payments to the bondholder step up to 5.25%. GE bonds with a straight maturity to 2017 currently yield 1.5%. The YTC (yield to call) to February, 2017 in these GE step up bonds is 4%!
Compared to fixed-rate debt instruments, floaters protect investors against a rise in interest rates. Because interest rates have an inverse relationship with bond prices. In other words, a fixed-rate bond’s market price will drop if interest rates increase and vice versa.
A floater’s interest rate can change as often, or as frequently, as the issuer chooses which could be from once a day to once a year. The “reset period” tells the investor how often the rate can adjust. The issuer may pay interest monthly, quarterly, semiannually or annually as they so choose.
The secondary market for a floater is based on several factors that include:
Each of these factors is dynamic, and can result in higher or lower secondary values. Some things to be aware of are that the market for floating rate bonds is small compared to the broad bond market, and not as liquid. Also, investors in floating rate bonds lack certainty as to the future income stream of their investment. While an owner of a fixed-rate bond can suffer if prevailing interest rates rise; floating rate notes pay higher yields.
The flip side, of course, is that investors in floating rate securities will receive lower income if rates fall because their yield will adjust downward. If interest rates are expected to increase, floating rate bonds may be considered as a small part of a fixed income portfolio.
Regarding credit risk, some investors step out of their comfort zone in search of higher coupons when rates drop and current income is dwindling. Be sure that you understand the additional risks you are contemplating and that your bond advisor has done his homework. There are plenty of good lower and non-rated bonds out there, but they are not for everyone.
In recent years, we have been able to cull out bonds with strong creditworthiness after the bonds lost their previously high ratings based on bond insurance backing. Remember that quality must always be a primary part of an investors fixed income portfolio strategy.
Perhaps it’s time to review the credit risk in your portfolio and diversify.
The argument can be made that within the current economic, political and interest rate environment – fixed income investors need to rethink their strategy. What worked well for the last 30 years may not work as well going forward. A prudent investor may want to consider employing a few or all of these strategies as a part of their overall fixed income portfolio.
STA Wealth Management
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