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Thursday, February 3, 2011

Bond portfolio management strategies for a rising interest rate environment (published in January of 2010 in the SB News Press)

I recently wrote about municipal bonds and suggested that California munis could be an attractive option for fixed income investors.  In this week’s column, I would like to expand on the municipal bond investing theme by providing some additional detail on some of the techniques that can be used to manage muni bond portfolios and some of the types of bonds available.

First, let me just say that the information in this article is intended to help investors understand some of the possible investment vehicles and techniques that are available.  It is not intended as a specific recommendation.  Each investor must understand their own unique needs and the appropriate level of risk for their portfolio, etc., before making any investment decisions, and should contact a qualified professional for assistance, if needed.

I expect interest rates to rise over the coming few years, starting in 2010.  With the Fed Funds rate set at a range between zero and ¼ percent, there is really only one direction rates can go, which is up.  One could argue that the Federal Reserve will hold rates steady for a long time, but my opinion is that we are looking at a matter of months and not years before the Fed raises rates.  If I am correct, there are important implications for investors; especially bond investors. 

In general, one strategy that bond investors can use in a rising interest rate environment is to buy a laddered portfolio with shorter maturities.  For example, if you can envision a picture of a ladder with five rungs, each rung would represent a maturity date for a bond or set of bonds.  A simple ladder would look like this:

1 bond with a 1-year maturity
1 bond with a 2-year maturity
1 bond with a 3-year maturity
1 bond with a 4-year maturity
1 bond with a 5-year maturity

If this portfolio were bought today, and then held for one year, the 1-year bond would mature, meaning that the principal for that bond would be returned to the investor.  If rates are rising, the investor would be able to reinvest that principal into a new bond with a 5-year maturity, maintaining the same average maturity for the portfolio.  Since rates would be higher than they were when the portfolio was bought initially, the overall yield of the portfolio would increase each time a bond matured and the principal was reinvested (again, assuming rates are rising).  The investor would want to keep the maturities in the portfolio shorter—for example five years or less—until interest rates peaked, at which time the investor would then want to increase maturities to lock-in the high level of interest rates and maximize current income production from the portfolio.

This type of portfolio management technique can be used with any type of bonds, including municipal bonds.  Although I have used a maximum maturity of five years, each investor must consider their current income needs, and therefore must select maturities that provide the necessary total income from the portfolio.

As an alternative to the simple ladder, bond investors may want to consider a portfolio of “kicker” bonds.  These are bonds that are sold at a premium price—priced above par or 100% of the stated face value of the bond—and are therefore offered at a coupon interest rate above current market rates.  For example, if a 5-year bond is currently yielding 3% and is sold at par ($100), a kicker might be priced at $108 to yield 3.25%.  (Bear with me here because there is a lot of math involved.)  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.  For example, if the bond matures in ten years, but the issuer would like the option to call (buy back) the bond in only five years, they have to offer a higher rate of interest on the bond for the right to call it early.  The reason they might choose to call the bond is that, after five years, rates might be lower, which means they could buy these higher cost bonds back 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 prices “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: If a bond maturing in 2020 has a 5% coupon, is priced at $109, and is callable in 2014 at par ($100), its yield to call (yield to worst) would be 2.8% and its yield to maturity (in 2020) would be 3.9%.  This difference in yield results due to the amount of time over which the investor amortizes the premium paid above par ($109 minus $100).  If that difference is amortized over the shorter time-period, the return for the investor is lower each year, than if the difference is amortized over the period to maturity.

Kickers tend to offer higher coupons and higher yields to investors as compared with similar, non-kicker (non-callable) bonds, for the reasons outlined above.  There are however some risks.  First, in a rising interest rate environment, while it will be less likely that the bonds get called, resulting in the higher yield received by the investor, the bond may become less attractive if rates rise significantly.  Kickers, due to their premium prices and higher coupons are less sensitive to interest rate changes than non-kickers with lower coupons of the same maturity, so this is a positive (they have a shorter duration, which is a measure of price sensitivity to changes in interest rates).  But, their prices can still decline if rates rise, and if they are long maturity bonds, and the price declines, the investor will either be stuck holding them to maturity with a lower than market return, or will have to sell them, possibly at a loss, to reinvest as rates rise.

If rates do not rise, kickers are more likely to get called since their coupons are higher than equivalent, non-kicker bonds.  If they are called, the investor gets the yield to call (yield to worst), which may still be higher than an equivalent non-kicker bond, but they will not enjoy the kick to the higher yield that would otherwise result if the bond was not called.

There are many considerations when building a bond portfolio.  I have outlined two possible strategies—a simple ladder with shorter maturities and a kicker portfolio with longer maturities, and with call features.  Depending on the investor’s expectations, income needs, time horizon and risk tolerance, the strategy chosen could include one or both of these strategies, (or possibly neither).  These concepts can be difficult to understand, so if you are unsure about what to do, contact an expert for assistance.  I hope this information will help you navigate the investing environment to come!

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