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Investment Strategies

Give Me a Ginnie Mae Any Day

Riding and Rolling the Yield Curve in Government Securities

Adding Pizzaz to Your Bond Portfolio

Maybe It’s Time to Drop a Few Zeros From Your Retirement Plan?

Why You May Want to Pass on Investing in Bond Funds

Why Would You Sell a Perfectly Good Bond and Reinvest in a Lower-Yield Bond?

Don’t Buy and Forget!

Climbing the Bond Ladder

How Did that Bond Become AAA-Rated?

Should You Sell a Few Stocks to “Stock Up” on Munis?

Bonds that Build the House and Raise the (Yield) Ceiling

How to Get a Bargain by Paying a Premium


Give Me a Ginnie Mae Any Day

They sound complicated and get a bad rap; however, for risk-averse investors who include bonds in their portfolios, this much maligned mortgage-backed security (MBS) can offer generally lower risk, a higher yield, and monthly income.

What are MBS’s?

They are bonds comprised of a pool of mortgages that all share similar features, such as interest rates, scheduled payoff dates, property quality, etc. (i.e., 30-year single-family home mortgages at a similiar fixed interest rate all from the same community).

MBSs are often disregarded by investors because the mortgage-backed security returns a portion of the principal along with each interest payment. This can disturb investors who are not used to being subject to uncertainty in the redemption date of their bond. Owning an MBS is like owning a bond that has monthly calls for a portion of the principal.

Nevertheless, I believe that the following benefits of MBSs far outweigh any drawback.

MBS Advantages

MBSs are available from private insurers, ranging in credit quality from BBB to AAA (as rated by S&P). Those issued by government-sponsored entities, like FNMA (Federal National Mortgage Association, or “Fannie Mae”) and FHLMC (Federal Home Loan Mortgage Corporation, or “Freddie Mac”) carry an implied AAA rating, and as of September 2008, the Federal Housing Finance Agency became the conservator of these mortgage insurance agencies. As such, the U.S. Treasury has committed to provide necessary funding to support the net worth of these agencies. GNMA (Government National Mortgage Association, or “Ginnie Mae”) bonds carry the full faith guarantee of the U.S. Treasury as to prompt payment of principal and interest, just like Treasury bills, notes, and bonds. This guarantee does not remove market risks if sold prior to maturity.

Ginnie Maes, Fannie Maes, and Freddie Macs are actively traded, and there is a long history of their prepayment and return of principal behavior. If you stick with these bonds, you should find them to be lower risk, easy to buy or sell at market value, and relatively easy to understand. Government agency mortgages tend to yield from 0.75 to 1.25 percentage points higher than a comparable term Treasury Note. Concerns about reinvesting principal that is returned from MBSs can be remedied with a little education and organization. Each month, when you receive the principal and interest payment, put the principal into a money market for easy reinvestment. Your broker may be able to set up your account to separate these portions for you automatically.

How Do MBSs Work?

When you have a mortgage on your home, you make monthly payments to the bank until the mortgage is repaid. In the early years, monthly mortgage payments are made up of mostly interest, with just a small amount of principal payment. In later years, those payments are made up of mostly principal, with just a small amount applied to interest. When you own an MBS, you are on the receiving end of those monthly mortgage payments.

Let’s say that ABC Bank gives you and each of your neighbors with the same quality properties a 30-year, fixed-rate, single-family mortgage. ABC Bank then sells these mortgages, totaling $2 million to $3 million, and sells them to Ginnie Mae, and ABC Bank uses this money to reinvest in new mortgages. A second bank, XYZ Bank sells the same types of mortgages from the same neighborhood to GNMA, which then puts them together into a “pool” of $10 million to $12 million of 30-year, same fixed-rate, same quality, single-family mortgages. GNMA then creates a security, backed by this pool of mortgages, that is guaranteed by the U.S. Government as to the timely payment of principal and interest.

For that guarantee, GNMA charges a service fee which reduces the interest that passes through to investors. GNMA then sells this bond to an investment bank, which divides the bond into $1 million increments and resells them to brokerage houses, which divides them and sells them to investors in pieces as small as $25,000.

Now, when you make your mortgage payment to ABC Bank (or XYZ Bank), the bank passes it through to Ginnie Mae, who passes it through to an investment bank, who passes it to a the brokerage firm and, finally, through to the investor. That’s why these are called “pass-through” securities. Therefore, in the early years of an MBS, the investor is going to receive payments primarily comprised of interest with just a small amount of principal, and vice versa in later years.

Important MBS Issues.

An MBS made up of 30-year, single-family home mortgages has an average life of only 10 to 12 years because of various “mobility factors” that affect repayment of mortgages (i.e., death, job changes, relocation), any of which may cause mortgages to be paid off early.

Significant changes in interest also may have an impact on the average life and yield of an MBS. When interest rates drop, people tend to refinance their mortgages. When this happens, investors will receive payments of principal from their MBS earlier than anticipated, thereby shortening maturity and lessening yield. If interest rates rise, the average life of an MBS tends to lengthen and yield tends to rise. In periods of dramatic interest rate moves, investing in MBSs can be a bit tricky. If you anticipate dramatic interest rate swings, buy a bond with a coupon that reflects your interest rate expectation. If rates are climbing, for example, you can buy higher coupon Ginnie Maes. Your financial advisor should explain how MBSs react to different market conditions.

If you are looking for an investment that provides steady income, low credit risk, and offers market liquidity, government-backed MBSs like Ginnie Maes may be a good option.

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Riding and Rolling the Yield Curve in Government Securities

An investment strategy that you may want to consider is Riding and Rolling the Yield Curve. Using $1.5 million, for example, purchase $500,000 each of the 4-year, 3-year, and 2-year Treasury Notes. (Or 12-month, 9-month, and 6-month bills; any term structure of maturities is possible.) Each year as the notes age, the 4-year note will become a 3-year note, the 3-year note will become a 2-year note, and the 2-year note will become a 1-year note.

The Strategy

When the 2-year note becomes a 1-year note, it should be sold and a new 4-year note should be bought. A continual roll out of the current 1-year note and back into a new 4-year note should be maintained year after year, for whatever period of time is appropriate. Because there is an active and huge market in government securities, these notes can be easily liquidated. Because of this convenience, this strategy can be maintained indefinitely and liquidated as needed.

Please look at this illustration of typical (not actual) Treasury Note rates:
4 Yr. Note 3 Yr. Note 2 Yr. Note 1 Yr. Note
1.85% 1.50% 1.00% 0.50%

The average annual yield of the portfolio for the first year would be 1.50%. Each year (in a normal, steepening yield curve environment) the lowest yielding note would be sold and a new highest yielding note would be purchased. Throughout the life of the investment, average annual yield for the portfolio would remain somewhere around the prevailing 3-year note level.

Assume that rates prevailing in the market were to remain constant. Then, when the 4-year note would have aged to become a 1-year note, its price would have appreciated from par (100) to approximately 101.5. This price appreciation will necessarily occur in order for the note to be a comparable investment to the 0.50% yield that would be the current market yield for the 1-year note. For the 4-year note, this appreciation would represent an approximate +2% capital gain over three years. As the 3-year and 2-year note age (roll down the yield curve) to the point of having a 1-year maturity they, too, would have to experience capital appreciation in order to be comparable to the prevailing 1-year note yield. In addition to these capital gains, the portfolio continuously earns income at approximately the 3-year note rate.

Consider

1. If interest rates remain constant, the 1-year note will likely be sold at a gain.

2. If interest rates are declining, the 1-year note will likely be sold at a larger gain.

3. If interest rates are rising, the 1-year note may or may not be sold at a gain, depending upon the magnitude of the interest rate rise. Remember, moving back along the yield curve from a 4-year to a 1-year maturity necessitates pick-up (gain) in the price of the note in order to maintain the appropriate yield spreads between the different maturities. This gain acts as a hedge against the price loss due to rising interest rates.

Importantly, at all times the portfolio is earning an annual interest rate considerably higher than the rate that could be earned on a single, short-term treasury note or bill period. And, if rates rise to the extent that this strategy ceases to be profitable, simply hold the notes until maturity.

Another Option: Use actively traded Government Agency Notes rather than Treasury Notes. This will likely result in a yield pick up for the portfolio with only a slight increase in risk.

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Adding Pizzaz to Your Bond Portfolio

Many first-time and veteran investors are comfortable with the reliability and low risk of high-quality bonds. While they may lack the heart-racing excitement of a hot stock on the rise, for those who can live without the thrill and the volatility, there are alternatives to the straight AAA-rated bond-buying rule.

The alternatives listed below may boost returns on various bond types. Also, varying the terms within your bond portfolio and the makeup of the portfolio may boost overall return. Read On!

Single and Loving It

Even if you are very wary of anything but the highest-grade investments and have a strict policy of “AAA-rated only,” you should be aware that there are many good bonds available with an investment-grade rating but with significantly higher yield than some AAA-rated bonds.

For example, in the municipal bond market, Orlando Aviation bonds, are not likely to default, in my opinion, as long as Disney World remains in business. A bond such as this could increase your tax-free yield by half a percentage point or more over most AAA-rated muni bonds. Also, in the taxable bond markets, there are many A-rated bonds from issuers with good credit histories, and they offer a significant yield advantage over AAA-rated corporate bonds.

Bond Shifting

If you have a portfolio of bonds, you can shift its makeup to boost total yield. Weight your portfolio with a variety of differently rated bonds to boost its overall return without giving up too much creditworthiness. In the segment of the bond portfolio with shorter-term maturities, you may want to consider investing in lower-rated investment-grade bonds, and in the longer-term end of the portfolio maintain the higher-rated investment-grade bonds. In the intermediate-term of the portfolio, mortgage-backed securities, such as GNMAs and FNMAs, which often provide a yield advantage over comparable-term Treasuries, should be considered. However, keep in mind that mortgage-backed securities represent an investment in a pool of mortgage loans; thus, the yield and average life will fluctuate depending on the rate at which mortgage holders prepay the underlying mortgages and changes in interest rates. Your financial advisor should explain how mortgage-backed securites react to different market conditions. In a municipal bond portfolio, total return may be boosted by maintaining the shorter-term bonds in the lower-rated investment-grade municipals and the longer-term bonds in the higher-rated municipals. Also consider housing bonds, a type of municipal bond with a variety of redemption possibilities that generally reward investors with extra return for taking the uncertainty of redemption.

Go Long

You may want to increase your portfolio’s percentage of long-term bonds (15 to 20 years), up to a maximum of 25% of the bond portfolio. This may provide greater portfolio yield, as long-term yields are generally higher than short-term yields. Remember, you don’t have to hold long-term bonds to maturity. Today’s bond markets are so liquid that many bonds can be easily sold before maturity, perhaps when you feel there will be material change in interest rates, since when interest rates rise, bond prices will fall. Of course, the price you receive on a sale prior to maturity may be higher or lower than what you paid for the bonds.

“Cushion” Bonds

Consider including a few “cushion” bonds. These are high-coupon bonds (which are bought at a premium) that have very long maturity dates but which have calls in the 5- to 10-year range. If the bond is called, the yield to call will generally be from 0.5 to 1 percentage point higher than the yield to maturity of a comparably rated bond that matures in the year of the call. Because the coupon on the bond is so much higher than current coupons in the market (which is why you pay a premium), the likelihood of the bond being called is very high.

Up the Ladder

Most investors are familiar with the wisdom of having a laddered structure of maturities for their portfolio. Maturities should range from 3 to 12 or 15 years. Rather than selecting bonds that mature in each of those years, purchase bonds of various maturities, types, and yields based on a portfolio divided into segments: short-term of 3 to 7 years; intermediate, 7 to 12 years; and longer-term, 13 years or longer.

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Maybe It’s Time to Drop a Few Zeros From Your Retirement Plan?

Back in the 1980s and early 1990s, a warm enthusiasm for zero-coupon bonds developed among long-term investors, such as pension and profit-sharing plans. “Zeros” are deeply discounted, non-interest-bearing bonds that accrete in value annually to equal their par or redemption value at maturity.

Zeros had (and still have) much appeal. If you had a relatively new plan with fewer dollars to invest, you could buy a lot of zeros at a very small cost and receive a sizable sum when they mature on a specific date in the future. Since the intention of a retirement investment plan is to grow capital, it was reassuring to know that the initial investment in zeros would remain intact and you could count on the amount of money you would have at retirement.

With zeros, you can match their maturities and amounts to meet known future liabilities, such as payouts to pensioners or specific annual payouts to yourself. Plus, you could ladder zeros at maturities to correspond with specific retirement dates and payout periods. However, you may want to look at the investments in your pension and profit-sharing plans and determine if you have too many zeros, thus unnecessarily dragging down your overall pension and profit-plan earnings. Because you aren’t earning “interest on interest,” you probably aren’t getting the highest yields you could from a variety of other zeros and interest-bearing bonds comparable in risk to your zeros. Let’s compare the non-interest-bearing zeros with other interest-bearing bonds.

When you buy a bond, the issuer is giving you a promissory note to repay a specific amount of principal to the note holder on a certain redemption date (the call date or the maturity date). On an interest-bearing note, the issuer agrees to pay in cash, usually semi-annually, the amount of interest that accrues on the note each year until it is redeemed.

With an interest-bearing bond, the interest can be reinvested, and you can earn “interest on interest.” Meanwhile, the original principal continues to collect interest at its stated yield. With zeros, a fixed accretion (growth) rate is locked in; you can’t enhance the bond’s earnings to anything greater than the accreted principal value. Because zeros pay no interest, you cannot earn “interest on interest.” (However, accreted interest income on these bonds may be subject to annual taxation as ordinary income even though no cash payments are received.)

You can advance yields by taking advantage of cycles in the interest rate market. Both U.S. Treasury strips (zero-coupon Treasuries) and long-term U.S. Treasury bonds (interest-bearing) are very liquid, and there is plenty of time between purchase and maturity for you to “play” the interest rate fluctuations with these easily marketable securities.

If interest rates fall, there is usually a big increase in the value of long-term bonds, and an opportunity to realize a capital gain if you sell. Because strips pay no interest over this long-term period, their price is more volatile than the interest-bearing bonds. If rates drop, strips will outperform bonds during this rate move. Of course, there’s a flip side. When rates move up, strips will greatly under perform interest-bearing bonds, not only because they are more volatile, but because the interest earned on higher interest-bearing bonds can be invested at increasingly higher rates, helping to offset adverse price moves of the original investment. Of course, with both types of bonds, you can simply hold on to the original investment and wait for the next interest rate cycle. During this “holding-on” period, the interest-bearing bond, but not the zero, will pay cash interest to investors while they wait.

We’ve focused primarily on boosting yields in pension and profit-sharing plans, but many individuals buy zeros to cover children’s college or to give them a down payment for their first home. Zeros used for these purposes, too, may be a mistake. Over the long term, historically, no financial instrument has grown more than equities. If you have, say, 10 years to invest, you may profit most by investing in high-grade, well-established blue chip stocks and reinvest the dividends and capital gains. Also, you can probably put away more money for your children in the form of equities than in the form of bonds before you hit the $1,900 mark of annual income that is tax-advantaged for children under 19 (or 24 if full-time student) according to current IRS rules. For instance, if a bond yields 5% annually, you can invest about $38,000 before reaching $1,900 of income. If a stock’s dividend yield is 3% annually, you can invest about $63,000 before reaching $1,900 of income. Remember, once your under-19-year-old investment income exceeds $1,900, taxes are paid on the excess income at the parents’ tax rate. (After the age of 19, or 24 if full-time student, children establish their own tax rate.)

I strongly advise having a significant amount of retirement and pension-plan investments in equities.

Other Options

If you insist on owning zeros, consider those offering higher yields. Several yield a higher rate of return than U.S. strips. For example:

  • Government Trust Certificates

    are guaranteed by the U.S. Defense Department and, like T-strips, carry the full faith and credit guarantee of the U.S. government as to the timely payment of principal and interest. However, these zeros yield 20 basis points more than the comparable term T-strip.

  • Government Agency Securities

    historically have not carried the full faith and credit guarantee of the U.S. government. The agencies have a perceived tie to the federal government as institutions established under federal legislation, and thus have an implied AAA rating, but carry greater credit risk than those guaranteed by the U.S. government. Since September 2008, the Federal Housing Finance Agency became the conservator of the two housing mortgage insurance agencies: FNMA and FHLMC. As such, the U.S. Treasury has committed to provide necessary funding to support the net worth of these agencies. From time to time some agency securities yield more than other “agencies” due to debt issuing schedule or other financial circumstances. Look for and take advantage of these potential opportunities. These may yield 15-25 basis points more than the comparable term Treasury.

  • Corporate Zeros

    are typically issued by quality corporations with high credit ratings. Historically, these have provided a rate advantage over both Treasuries and Agencies and are still very creditworthy.

  • Yankee Zeros

    are zeros issued by foreign governments or corporations but denominated in U.S. dollars. Some sovereign country Yankee Zeros are highly rated, provide more yield than Treasuries or Agencies, and are more creditworthy than corporate zeros. They maintain a higher yield than other comparably rated zeros in order to boost sales, since investors are not very familiar with them. So sit down with your portfolio and consider the merits of zeroing out some of your zeros!

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Why You May Want to Pass on Investing in Bond Funds

While they appear to have some of the same positive characteristics of mutual funds: spreading risk through diversification and professional management, bond funds generally do not offer the key benefits that are characteristic of individual bonds. Most investors are attracted to bonds for two reasons: the preservation of capital if held to redemption, and to lock in a known, steady stream of income. Bond funds provide neither of these.

In My Opinion, here’s why:

A bond is a contract

like any other. It spells out the rights and obligations of the parties involved — in this case — the bond issuer and the bond holder. The issuer contractually promises the return of the principal on a specific date, and an annual stream of interest income at a particular rate. If the issuer defaults, the bond holder can seek recourse through the courts.

Bond fund shares are equities — ownership.

Like all business owners, one risks one’s investment capital for the potential greater return in the future. Equities do not involve contracts or guarantees regarding return of principal or fixed interest rates.

With these essential differences in mind, let’s look at how the two investment types compare when it comes to preservation of capital. When you buy a bond, the value (price) of the bond will fluctuate with the interest rate environment. But, you can ignore that fluctuation because you have the option of holding your bond until redemption (by call or maturity) when you will get back the face value of the bond, unless the bond defaults.

When you buy a bond fund, you are buying into a fund that lives on into perpetuity. There is no known end date when your principal will be returned to you. The fund is in the business of trading and managing an inventory of bonds and cash and possibly other financial derivatives. You are completely dependent upon the trading acumen of the fund’s managers and upon the interest rate environment returning the value of your shares back to their original price or higher. Thus, with bond funds, there is only a potential for preservation of capital.

Now let’s compare owning individual bonds and bond funds when it comes to locking in a known, steady stream of income.

When you buy a bond, the instant you pay for it you know the yield to call and maturity, and the annual current yield of your investment until the bond is redeemed. When you buy shares of a bond fund, there is a prevailing dividend payout rate, but there is no guarantee that this rate will continue. If rates fall in the bond market, it seems inevitable that there will be a cut in the dividend payout rate of your bond fund. As rates continue to fall in the interest rate market, so will the dividend payout rate of your bond fund. You do not lock in a yield to maturity. You do not lock in current yield.

There are additional risks and costs associated with bond funds that do not exist with bonds. For instance, you pick up “trading risk.” The managers of a bond fund are in the business of trading bonds and/or using derivatives strategies in an attempt to increase the total return of the bond fund. Sometimes the trading is not profitable and this poor trading performance is reflected in your share price. You also pick up annual management expenses which come out of the bond fund, and that is reflected in your share price.

Finally, in open-end bond funds, there may be a sudden and large amount of share redemptions such as we typically see following substantial market upheavals (1987, 2004, 2008). The bond fund managers MUST meet those requests for redemptions, and in order to do so, they may have to sell some of their inventory of bonds, very likely at a very disadvantageous time and price. The remaining bond fund holders may see the result of that “forced redemption” reflected in the lowered value of their shares. Closed-end bond funds take away the “forced redemption” risk but they do not take away any of the other risks associated with bond funds.

Am I a proponent of buying individual bond issues? Clearly. If you are seeking preservation of capital and a known income stream, buy bonds. If you are seeking potential growth and a decent dividend payout rate, invest in the stock market. But don’t be misled by thinking that you can get all the advantages of these diverse types of investments by buying bond funds!

One positive note on bond funds: Bond funds have low investor minimums which may help small investors achieve some diversification. However, this may also be accomplished through other investment alternatives. Bond funds also would not be as affected by call risk as individual bonds.

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Why Would You Sell a Perfectly Good Bond and Reinvest in a Lower-Yield Bond?

Perhaps to increase your total return!

I’m going to tell you about a strategy that on first glance doesn’t seem to make sense. But stay with me to learn about a way that you might sell a perfectly good bond and reinvest in a bond with a lower coupon and be right on the money to increase your total return given all other conditions are right.

For example, I encountered an opportunity to sell a bond with a 6.75% coupon and to reinvest in a bond with a 6.35% coupon and improved the total return by more than $20,000.

Here’s how:

The 6.75% bond had become pre-refunded, which means that the issuer had backed the bond with enough U.S. Treasury Securities to cover interest and principal up to the first call date (in 5.5 years) and made a guarantee to call the bond at that time. When a bond becomes pre-refunded, there is a ‘pop-up’ in its price. This is because the bond has become Treasury quality, which increases its creditworthiness and value (price). Also, the fact that it becomes a shorter-term bond because of the certainty of being redeemed at its first call date contributes to an increase in price. Shorter-term bonds usually yield less than longer-term bonds, and now that this bond has become shorter-term, it’s price must rise in order for it to yield less if sold to a new investor.

By selling the bond well before its call date, the investor would have captured the sudden rise in the bond price. Reinvesting in another tax-free bond enabled an investor to continue earning tax-free interest in a vehicle consistent with a low risk investment profile while improving the total return by more than $20,000.

Here are more of the particulars:

In this example, an investor had purchased $250,000 of 6.75% bonds at par (100) a year earlier. Because of the decline in interest rates, the issuer saw that it would be able to call the 6.75% bonds and reissue new bonds at a much lower cost. In order to finance the calling of the bonds, the municipality issued new refunding bonds with lower coupons, for use in purchasing Treasury securities to back the original higher coupon bonds. Thus the bonds become pre-refunded. (These types of bonds are frequently referred to as “pre-res.”)

The bond’s call date was in 5.5 years at a price of 101, which would return to the investor a total of $252,500 if held until call redemption. However, newly backed by U.S. securities and with a shorter term, the bonds became more valuable. Trading at a price of 11.426 points over par, the bonds appeared to be near the peak of their value five and a half years before the call! As early as three years before the call date, the price of the bonds would begin to slide toward the call price of 101, regardless of prevailing interest rates. Selling would realize a net gain of $28,565 ($278,565 less the purchase price of $250,000). A new bond with a 6.35% coupon was available for purchase with the original $250,000 principal. Although over a five and a half year period, the new bond investment would net less interest income, the total return was still $20,000 more than it would have been had the original bond been held to its call date.

I want to emphasize that you aren’t likely to be trading bonds every month in order to use this strategy. However, you could reinvest the same dollars every two or three years in another potential candidate for pre-refunding and earn yet another round of capital gains. Of course, the capital gains would be subject to capital gains tax.

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Don’t Buy and Forget!

Why a Buy-and-Hold Bond Portfolio Strategy May Be Leaving “Total Return” on the Table

In this article, we’re going to discuss the differences between a “buy-and-hold” strategy for the bond portfolio versus a modestly managed bond portfolio.

Under the modestly managed bond portfolio strategy, we are neither actively trading nor passively buying-and-holding bonds, but rather, we are making changes in our bond portfolio as opportunities present themselves in the normal course of a bond’s life or a bond portfolio’s life. Reacting to and taking advantage of these changes is the means by which the individual investor may procure capital gains from a bond trade, in addition to enjoying the interest that accrues in the bond portfolio from holding bonds. As the portfolio is not actively trading bonds with great frequency over a short period of time, say every day, or every week, there’s no apparent trading risk in this strategy. For instance, if the investor can’t get an attractive bid price on a bond, then what had appeared to have been a good opportunity to realize capital gains is indeed not such a good opportunity. The bond in this case can simply continue to be held until another opportunity presents itself or until the bond is redeemed. So, as in an actively managed portfolio, we use capital gains to enhance total return, but unlike an actively managed portfolio, our goal is not the “art of trading,” nor do we pick up those risks.

So you ask, “what do you mean when you say managing a portfolio?” Well, first of all, with any bond portfolio strategy, there should be a laddered structure of maturities. This provides some protection from having to predict with perfect accuracy the direction of interest rates. Also, try to have all the bonds in the portfolio be approximately the same dollar amount (eggs in a basket, etc.) and diversify geographically, by type of security, and by rating.

It is very important to note that I am not interested in owning bonds that are less than 2-3 years to redemption. Adequate funds are almost always to be found in our money market or from interest that is being paid on our existing bond portfolio or that can be made available from other securities that cover the cash equivalent portion of the portfolio. I let these resources substitute for the 0 to 3 year range of the ladder. Let’s consider a maturity ladder that runs from 3 to 15 years.

Having laid the groundwork for a portfolio, let’s talk about how to manage it. First, when a bond is within three to four years to redemption, I look to sell it. “Three years to redemption” means either that the bond is going to be maturing in three years, or because it has a very high coupon relative to the new issue market, it is likely to be called by the issuer within the next three years. In either case, I suggest selling the bond and purchasing a new bond at the longer end of the maturity ladder. Why? Many bonds that were bought several years ago that were, say, 10-year bonds then are 3- to 4-year bonds now and are trading with significant capital gains. This is because the bond has become a short-term bond and its coupon rate, meant for a longer-term bond, is high relative to “now current” short-term bonds (the bond has “moved down the yield curve”). This makes it more valuable, higher priced.

But once a bond is within about three years years to redemption by call or maturity, its price starts to quickly erode toward par because it must be redeemed at the price of par (100 or the call price usually 100 – 102). That’s a contractual obligation. So take advantage of those capital gains before they’ve been reduced as the bond’s price moves toward par value. You can sell the bond at this point and move back out to the long end of the ladder. This is one of those “events” that should be taken advantage of because it may provide the portfolio with an extra bit of gain that will enhance total return over and above the return from a simple buy-and-hold portfolio.

Pre-Refundings

In the course of owning bonds, there may be an occasion when a bond has become pre-refunded. We say that a municipal bond becomes “pre-refunded” and a corporate bond becomes “defeased.” In both cases, this means that the bond has become backed in U.S. Treasury securities so that the issuer can get the debt liability off of its balance sheet. This Treasury backing is usually tagged to the first call date of the bond and, at that date, the bond will be redeemed. The issuer usually issues new bonds at lower rates in order to raise the funds to buy the Treasuries necessary to effect this process.

From the bond owners’ point of view, we now own a bond whose credit quality has risen to U.S. Treasury quality. We also have a bond, in the case of those which have been pegged for redemption to a call date, which is certainly going to experience shorter term than was expected prior to the act of refunding. Those two characteristics — shorter term and higher quality — cause a bond’s price to jump up. Take advantage of that unexpected capital gain opportunity, and consider selling. Look for another bond that fits the portfolio’s investment parameters and which may also be a candidate, a few years from now, for this same kind of refunding. Again, taxes will apply for any capital gains.

Rating Changes

Another event that occurs in a portfolio is that bonds become up-rated or down-rated and, as a result, their value (price) changes. A perfect example is former New York utility company Long Island Lighting Company (LILCO). LILCO was the creditor for both municipal bonds from New York City, as well as for corporate bonds in their own name. They had been experiencing declining credit ratings, and the value of their bonds had experienced declining prices. The State of New York bailed them out with a partial takeover of the corporation and better financial management. All at once LILCO’s bonds jumped from deep discounts, to par prices and higher. Also, because of its improved financial situation, LILCO’s bonds would likely be called through refundings financed with lower coupon bonds. This event caused an unexpected kick-up in the value of the bond. In this type of instance, you should consider selling the bond, taking the capital gain, and finding another bond that meets your investment parameters. These gains would not be realized in a buy-and-hold strategy.

These are just a few of the unexpected events that frequently occur in a bond portfolio. If your bond portfolio is following a buy-and-hold strategy, it will be leaving total return on the table- an earnings boost over simply collecting bond interest. However, if you pursue a moderately managed portfolio strategy, you have the potential to enjoy a much higher return if you recognize and take advantage of these types of opportunities and make strategic changes in response to them. A 1% or 2% increase in the overall return of the portfolio, year after year after year, can become significant.

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Climbing the Bond Ladder

Laddering. It’s not just a way to get things off the top shelf. It’s a top-shelf financial strategy that may give you significant protection from interest rate volatility.

When I talk to clients who are thinking about their children’s futures, they usually think about laddering as a simple technique to ensure that a certain amount of cash becomes available each year of their children’s progress through college. They typically fund this ladder with zero coupon bonds. They use zeros and targeted laddering as a way to make sure that secure assets have been put away to fund a future stream of liabilities.

As security-conscious investors become more involved in managing their bond portfolios, however, they quickly recognize that the larger purpose of laddering a portfolio is to hedge against interest rate risk.

This article will cover various laddering strategies that may help you hedge against interest rate risk, and sometimes boost the return of your bond portfolio.

The Ladder as an Interest Rate Hedge

We may make our best-educated guesses about the direction of interest rates, or we may faithfully follow our favorite economist guru, but in the end, we don’t know with absolute certainty whether rates will remain flat, make a mild move, spike, or plunge. If we knew this, we would invest all of our bond money in the appropriate maturities for that known interest rate move. But we don’t know.

Therefore, the wary investor wants some protection. I prefer that Bond maturities be laddered in a range from 3 to 15 years and perhaps invest 10% of the portfolio with maturities in the 15 to 30 year range.

Why? Let’s say that interest rates go up. We may feel sorry that we have invested in longer-term bonds at rates that could be beaten now, but at least we have short-term bonds regularly maturing that we can reinvest at the prevailing higher rates.

What if interest rates go down. We may regret having invested in shorter-term bonds that will have to be reinvested at these lower prevailing rates, but at least we have locked in higher rates at the long-term end of our ladder. A laddered structure provides a mid-range rate of return and the overall income stream.

Weighting the Ladder

If you are a person who feels confident about making modest predictions about the direction of interest rates, and if you happen to be right, you can boost the yield of your laddered bond portfolio by weighting one end of the ladder, or in certain instances, weighting both ends of your ladder.

Say that you think interest rates will be steady or lower for the next several years. The economy is experiencing modest growth and little inflation and the rest of the world is at peace. In other words, you see a replay of the late ’50s and ’60s. You believe interest rates will be steady, give or take a half a percentage point or so.

With this scenario, you might want to weight your ladder lightly with bonds that would mature during the first five years of the ladder and more heavily in the later years of your ladder. If you believe that interest rates will be going significantly lower, you may want to buy only a few bonds for the short-term years (1-5), one bond every other year for the mid-term years (6-15), and weight the long-term (15-30) more heavily to pick up additional yield. You never completely abandon a presence in each of the segments: short-term, mid-term, or long-term as you could be wrong in your interest rate predictions.

Similarly, if you think inflation is likely to return and “run away” higher, you may want to weight your ladder more heavily at the short end, say during years one through five. That way, as interest rates rise in the next several years, you’ll have more bonds to reinvest at higher rates.

Varying the Ratings Along the Rungs of the Ladder

If you are strictly a treasury buyer, consider taking on a very modest risk and buy government agency bonds to mix with your U.S. treasuries. If you are slightly more risk tolerant, mix in several investment-grade bonds with ratings of BBB, A, or AA This can significantly improve your portfolio’s overall yield.

Consider these scenarios for using this mix in a bond ladder. Remember, short-term is 1- to 5-year maturities, intermediate-term is 6 to 15 years, and long-term is 15 years or longer to maturity.

Buy government or high-rated bonds for the intermediate and long end of the ladder, then use the short end of the ladder, perhaps those maturities from one to seven years, to invest in lower investment-grade bonds or in those bonds that are higher-rated “junk bonds” by Standard & Poor’s and Moody’s, say BB rated.
If you can tolerate a bit more risk, you can alternate every third bond on your ladder with a lower-rated bond.
Remember that mortgage-backed securities, such as Ginnie Maes, Fannie Maes, and Freddie Macs, can be looked at as bonds with a series of monthly and annual calls on them because of the mix of mortgages that are retired at different times. So, for your intermediate-term bonds in the ladder, say, years 7-12, you might want to purchase a larger-sized mortgage-backed bond than the others in your ladder and let it represent several years’ maturities. Ginnie Maes carry the full faith and credit guarantee of the U.S. Treasury as to the timely payment of principal and interest but pay nearly a full percentage more than a 10-year Treasury note. However, keep in mind that mortgage-backed securities represent an investment in a pool of mortgage loans; thus, the yield and average life will fluctuate depending on the rate at which mortgage holders prepay the underlying mortgages and changes in interest rates. Your financial advisor should explain how mortgage-backed securities react to different market conditions.

Taking Two Rungs at Once

If you don’t feel you have enough cash to diversify your bond portfolio into 15 different years, you may want to consider buying smaller bonds of $10 thousand or $15 thousand each, instead of several larger bonds. Or if you do prefer to purchase securities in larger denominations, you can skip every other rung on your ladder. The important point is to have bonds that adequately cover the short-, intermediate-, and long-term ranges of the maturity ladder in an organized manner.

It is better to spread even the most limited bond holdings over a longer maturity range. If interest rates do go much lower, and you don’t have enough of a spread for the term structure of maturities in your portfolio, your ladder won’t be much of a hedge and won’t help you maintain your portfolio yield.

The whole point of laddering your bond portfolio is to keep you from getting “wrung out” by fluctuating interest rates!

Bond laddering does not assure a profit or protect against loss in a declining market. Yields and market values will fluctuate, and if sold prior to maturity, bonds may be worth more or less than the original investment.

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How Did That Bond Become AAA-Rated?

You Ought to Ask

Did you know that all AAA bonds are not the same? Some bonds may have achieved their AAA status through a “credit enhancement”; for example, something like an escrow account backing a bond issue, or collateral, such as a Government National Mortgage Association (GNMA or “Ginnie Mae) bond, or a bank-issued certificate of deposit (CD). The AAA rating of a bond may not be based on the creditworthiness of the issuing municipality. What does this mean to an investor? If you are an investor who seeks the very safest of investments, it’s important to know how a bond achieved its AAA rating and the creditworthiness of the “payor of last resort,” that is, what entity provided the final principal backing. Also, if you are confused about why one AAA-rated bond offers a higher yield than another, you may find that the reason is tied to how the AAA was achieved.

The Safest Credit Enhancement

The safest municipal bonds are those that are Escrowed to Maturity (ETM) or Pre-refunded. These bonds are backed dollar-for-dollar by U.S. Treasury securities for both principal and interest.

  • An escrowed bond is one for which the issuer has set aside U.S. Treasury securities in an amount equal to the bond’s total principal and interest payments through maturity of the issue.
  • A pre-refunded bond is one that will definitely be called on its first stated call date. U.S. Treasury securities in an amount totaling principal and interest up to the call date and including the call price have been set aside to “fund the call.”

Other Types of Enhancements

Municipal bonds that are AAA-rated based on some form of direct collateral other than U.S. Treasuries can be tricky. For example, a bond that is collateralized by a CD does not carry the full faith and credit guarantee of the U.S. Treasury as to timely payment of principal and interest like one backed by a GNMA, for instance. A AAA-rated bond backed by a CD is backed by the bank issuing the CD and, in the event of the bank’s default, by the government agency that insures banking institutions. The creditworthiness of a Congressionally budgeted government agency, such as the FDIC, is not the same creditworthiness that is offered by agencies with guarantees that are direct obligations of the U.S. Treasury, as is the case of GNMA or Strips or U.S. Trust Certificates.

Banks also become the payor of last resort when the bonds are backed by Letters of Credit (LOC). The creditworthiness of the bank issuing the LOC is subject to change with the financial well-being of the bank. If the bank is down-rated, the muni bond supported by its LOC is also down-rated, despite the status of the municipality. In the event of a municipal default, the bank is the payor of last resort. Investors should note that foreign bank LOCs are frequently issued by their U.S. subsidiaries, and it may be that there is no recourse to the parent foreign bank in the event of financial difficulty.

Similarly, there are implied AAA-rated bonds with indirect government backing from agencies like the Federal Housing Administration (FHA) or Federal National Mortgage Association (FNMA). The agencies have a perceived tie to the federal government as institutions established under federal legislation but carry greater risk than those guaranteed by the U.S. government. Since September 2008, the Federal Housing Financial Agency became the conservator of the two housing mortgage insurance agencies: FNMA and FHLMC. As such, the U.S. Treasury has committed to provide necessary funding to support the net worth of the agencies. While no agency has ever failed to fulfill its guarantee, no law or contract prohibits it from doing so. In any case, practically all government agencies have an implied AAA rating regardless of their financial health.

Municipalities and Municipal Bond Insurance Companies

Some municipalities are so financially strong that their bonds are issued with AA+ or AAA rating without any credit enhancement. As typical in the risk-reward equation, these bonds are regarded as more secure than those underwritten with municipal bond insurance and offer lower yields than insured bonds.

Last in your investigation of the origins of a bond’s AAA rating is the insured bond. With municipal bond insurance, it’s even possible to buy a AAA-rated bond from a municipality that is actually bankrupt! No insurance company yet has been put to the test with an overwhelming amount of simultaneous municipal bond defaults, though in 2008 some municipal bond insurance companies did experience severe downgrades in their AAA-rating due to losses in their non-municipal bond insurance areas. Nevertheless, bonds that carry AAA-rated municipal bond insurance, despite their underlying municipality’s rating, carry the same AAA-rating as bonds backed by U.S. Treasury securities.

Clearly, the degree of risk with any AAA-rated bond is nominal compared with a lesser rated bond. But, if ultimate security is your goal in muni bond investing, take a moment to ask how that bond earned its AAA grades.

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Should You Sell a Few Stocks to “Stock Up” on Munis?

Those of us born between 1946 and 1964, known as “baby boomers” have dictated the major consumer trends of the past 25 years. Now, as we enter middle age and retirement, we are responsible for yet another trend, one which will have a special impact on fixed income investing.

Munis: Tax-Advantaged, Lower-Risk Retirement Investment

Many boomers have experienced stock gains over the past 20 years, both in their personal investments and in their companies’ retirement plans. The stock portion of their total investment portfolio has grown disproportionately large with these gains.

To maintain balance, the profits on stock purchases are likely to be or already have been reallocated to other asset classes, such as real estate and bonds, including municipals, for the purpose of diversifying risk.

Also, as is typical of people when they retire, when the baby boomers near retirement, they too will reallocate their portfolios to reflect a change in lifestyle. This generally means an increase in the amount of money allocated to the fixed income portion of their portfolios and, in particular, to municipal bonds. Why municipals? Municipal bonds are usually one of the only tax-advantaged vehicles left to individuals once they leave their companies.

Demand Up, Supply Low = Lower Rates and Yields

I believe that municipalities may become financially healthier, leading them to issue fewer bonds. This will reduce the supply of munis at the same time that Baby Boomers will be reallocating their portfolios more heavily into tax-advantaged bonds. The result will be higher prices for munis, lower yields, and lower coupon rates. Add to this the prospect of higher income taxes, and municipal bonds will become even more dear.

An Ameliorating Factor

A characteristic of boomers – one that has helped the economy – is that they are spenders, not savers. This may well mean that they will not leave the kind of wealth to their heirs that their parents left to them and, in fact, may be inclined to sell bonds to raise spending money.

Those who are used to active involvement in the management of their portfolios may tend to sell bonds to realize gains and losses and to reinvest. This behavior would cause an increase in the turnover of the existing supply of bonds and contribute to a more active secondary market and tighter spreads between the bid and offering sides of the muni markets. Tighter spreads and active markets mean fairer prices and more liquidity for everyone.

The Impact?

What does all this mean to purchasers of fixed income investments? They may want to begin purchasing a selection of very long-term municipal bonds now, with higher coupons and higher yields, and simply hold on to them. Then, when they reach retirement age if there is a high demand for municipals (and presumably lower coupon rates and yields), they would have the potentially profitable advantage of having set aside money that was invested at much higher rates.

It also means that investors may want to begin the reallocation of their portfolio into a greater portion of fixed income securities earlier than they expected – say, while they are in their early 50s rather than when they are in their early 60s. In advising baby boomers, I emphasize that while municipal bond yields may appear to be low today, investors may want to look toward the future, say 10 to 15 years out, when bond yields may well be significantly lower. The difference could mean attractive reasons to buy long-term bonds now, ahead of the rest of the baby boomers. Of couse, no one can predict the markets with any certainty.

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Bonds That Build the House and Raise the (Yield) Ceiling

I sometimes encounter people who find bond investing boring! This rather old-fashioned notion was fostered by the general obligation (GO) bond and the essential service bond (e.g., electric or water utility) which are paid off by property taxes and utilities revenues, respectively. Although these types of municipal bonds pay reliable, predictable returns, some investors find them too “vanilla.”

Housing Bonds

Here’s how you may be able to raise the yield roof a little with your municipal bond purchases. Housing bonds may offer a substantial yield advantage to investors — from .50% to .75% over vanilla-type munis. This advantage stems from the added risk of early, unexpected calls, a risk that is inherent in all housing bonds.

These bonds are issued by a Housing Finance Authority to raise funds for mortgages for individuals buying homes, typically in large affordable-housing projects, either as “multifamily housing bonds” or “single-family housing bonds,” an important distinction I’ll explain later.

I won’t go into great detail on the various individual characteristics related to credit enhancements or protection of the revenue streams supporting the individual type of housing projects (i.e., VA, GNMA, muni insurance, Section 8, etc.). These factors matter when selecting a specific bond, but for the topic at hand, how to minimize the risk of early calls, let’s assume that we are discussing high-quality, AAA rated bonds.

The key to prudent investing in these muni bonds is calculating up front the effects of an early call. In some cases, an early call can eliminate the yield advantage over non-housing bonds. The following is a review of the kinds of calls that must be considered when purchasing housing bonds.

Stated Calls

It is not unusual for bonds to be called by the issuer prior to maturity. This means that the bond issuer could call for the redemption of part or all of the bond issue at the call date(s) stated on the bond, usually 8 to 10 years from the date of issue. This date(s) is printed clearly and is known from the moment of issue.

Your financial advisor can calculate what your yield would be if the bond is called at the stated call date and price, and can help you compare that yield with a similar call and yield of a non-housing bond with a maturity of the same date.

Your financial advisor should also calculate yields in the instance of “extraordinary calls.” These are a bit trickier to anticipate, but equally important to take into account.

Extraordinary Calls

Extraordinary Calls allow the housing authority to call in bonds (return investors’ capital) for any number of unusual and unexpected reasons (i.e., catastrophes, natural disasters, changes in the status of underlying credit enhancement, unused funds, and early prepayment). Some of the extraordinary circumstances that lead to a call cannot be predicted, so a yield cannot be determined. Nonetheless, ask about the replacement of the credit enhancement supporting the housing bond issue. Letters of Credit or CDs on loans, all of which have periodic renewals, may trigger a call. Compute your yield to that date and determine if the bond is still attractive. A few other extraordinary calls also give us the opportunity to “guesstimate” a yield, to help us determine whether or not to buy any particular bond.

Unexpended Funds Call

Usually a housing project is given 1.5 to 3 years to pay out the money raised by the bond issue in the form of mortgages to project homeowners. If the project can’t or doesn’t use all of the money raised by the bond issue, money must be returned to investors. The issuer returns the capital raised from the bond issue by calling in bonds.

An interesting phenomenon of the 1990s, and again beginning in 2008, was that funds may also go unused because, due to a dramatic drop in interest rates, it becomes impossible for the housing project to make mortgages at rates that are competitive with the rates that project homeowners could get elsewhere.

Thus, if you are considering purchasing housing bonds, your financial advisor will want to do a “what if ” yield calculation based on a 1.5-year call. You might also calculate the yield to a 2-year call, 3-year call, etc., until you reach that call date which results in a zero or negative yield. Then assess the risk of being called at that break-even date against the greater yield you receive for each successive period that your bonds are not called. The prevailing mortgage interest rate environment should be a significant factor in your assessment.

By the way, multi-family housing bonds do not seem to share the frequent extraordinary call experience that single-family housing projects do. Be sure to take this into consideration too when assessing your call risk.

Early Prepayment Calls

Just like with mortgage-backed securities, housing bonds are very sensitive to movements in the mortgage interest rate market. A significant decline in mortgage rates will result in some individuals refinancing their higher-rate, original mortgage. When an individual returns money to the Finance Authority (who made the original mortgage), the Finance Authority returns the money to the investors by calling in bonds.

Don’t let all these call features scare you! There can be opportunity in housing bonds when mortgage rates are stable or moving only modestly. Don’t pay too big of a premium for a single-family housing bond, as it might be called away from you quickly and result in a negative yield. Consider buying them at or slightly above par price and regard them as a shorter-term investment. (Buying any housing bonds at a discount means that you may have to wait until redemption to realize a portion of your yield, and that might be a very long time away!) When rates are falling, try to stick with multi-family housing bonds too. They don’t happen to experience the same frequency of extraordinary calls as single-family housing bonds, probably because a great deal of the project’s buildings would have to be refinancing their mortgage(s) and this is a more different set of circumstances for the project to accomplish.

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How to Get a Bargain By Paying a Premium

Many people object to paying a premium for anything! They feel like they are not getting a “good deal,” or are somehow being taken advantage of by the sale. The opposite is true most of the time in the bond markets. “Premium” bonds are generally good buys. In order to illustrate this fact, I’m going to explain two sets of terms in the bond market… “Par” versus “Premium” bonds, and “Current Yield” versus “Yield to Maturity.”

“Par” Bonds Versus “Premium” Bonds

A “Par Bond” is a bond whose current market price is exactly equal to its maturing value. For instance, a bond with a face value of $1,000 will be redeemed at maturity for $1,000 and it is trading in the market at a price of 100. This means that it is trading at 100% of its face value. We call this 100% price “Par,” and we call this bond a “Par Bond.” A “Premium Bond” refers to a bond that is trading at a price over 100. Let’s say it is at a price of 104 or 106 or even 110. These numbers represent the percentage of the face value that the bond is currently trading for in the market. So in the case of a bond that is trading at, say, 104, we would have to pay $1,040 in order to purchase this $1,000 bond.

“Current Yield” Versus “Yield to Maturity”

“Current yield” (also called “coupon rate” or “cash flow”) is the rate of interest that is printed on the bond certificate. A 6% coupon means you will be paid $60 of interest income a year on a $1,000 bond (face value). Current yield does not reflect your return on investment, since it does not take into consideration the price you paid for the bond, which may be more or less than face value.

“Yield to Maturity” is the TRUE indicator of the return on your investment, since it DOES take into account the price you paid for the bond. Changes in the price will affect the bond’s yield to maturity (or yield to call). An increase in price lowers the yield, while a decrease raises the yield. The return on your investment or the “yield to maturity” (or “yield to call”) is what you can earn on your investment. It is this number that helps you compare bonds in the market, not the coupon rate nor the price.

Yield fluctuates with the interest rate environment. As “the market” interest yield changes, each individual bond adjusts its price so that it has a yield comparable to the market yield for similar types of bonds. When you hear on the news that “rates are going up,” it means the expected return on investment, or your yield to maturity, is going up and the market price of bonds is going down. Similarly when you hear in the news that “rates are going down,” it refers to “yields” are going down or yield to maturity is going down. This is a very important distinction and one that people confuse all the time. “Current Yield” is not the same as “Yield to Maturity” or “Yield to Call.” Current Yield refers to a stream of income; Yield to Maturity (or call) refers to a return on your investment.

Why “Premium” Bonds May Be a Good Bond Investment

O.K., so why do I think that premium bonds are such a good bond investment? Here are a few reasons:

Premium bonds cost more than par. But most premium bonds also provide a higher yield in order to entice investors to overcome their psychological aversion to paying a premium for anything. Since yield is what we can earn on our investment, premium bonds are attractive because they yield more.

A second reason I like premium bonds is that they are higher coupon bonds. We pay a premium price because we get a higher cash flow than with a par bond. A higher cash flow means a greater amount of cash to reinvest and provide the opportunity to earn “interest on interest.” Earning interest on interest can be lucrative over a long period of time! Also, it’s almost always better to get income now rather than later (the old bird in the hand…). This allows investors to use the interest now before the value of the money declines over time through inflation.

A third reason I favor premium bonds is that in a declining interest rate environment, premium bonds provide a higher cash flow than newer issue bonds. In a declining rate environment, premiums move to even higher valuations, presenting the investor with opportunity for capital gains and the potential risk of being “called.” (Note: This call risk may also be an opportunity to improve the bond portfolio’s total return through things like pre-refundings and defeasements and was discussed in another article on managing your bond portfolio.)

A fourth reason is that in a rising interest rate environment, premium bonds hold their value better than par bonds (or discount bonds). Premium bonds’ already existing higher coupons are more comparable to the bonds being issued in a new, higher interest rate environment, and this is what helps them hold their value (as well as the simple mathematics of it!).

So often I hear the objection, “but I lose that premium because I don’t get it back at the end.” No, you have NOT lost that premium. It comes back all along the way in the form of higher interest income.

Par vs. Premium
(both rated Aa3/AA+; actual prices on 3/11/11: for illustrative purposes only)

Premium Bond Par Bond
Essex County, NJ Upper Trinity, TX
Buy: $100,000 bond @102.936 Buy: $100,000 bond @ 100 (par)
Spend $102,936 Spend $100,000
6.0% coupon, due in 19 years 4.75% coupon, due in 19 years
YTM=5.6% YTM=4.75%
Cash Flow: Cash Flow:
$100,000 bond $100,000 bond
x6.0% x4.75%
$6,000 annually $4,750 annually
x19 years to maturity x19 years to maturity
$114,000 lifetime interest $90,250 lifetime interest
-1,029 premimum paid
$112,971 net return over life of investment $90,250 net return over life of investment

One last note. Say a high coupon bond is bought at a price of 110 and has a 10-year maturity. 7 years pass, and now it is a 3-year bond. It still has a very large premium, all things being equal, because of its high coupon and short maturity. But on its maturity date in three years it must have a price of par (100), because that is the face value of the bond. As the bond moves from three years to maturity, down to its redemption date, that premium is going to erode, slowly, toward par. It must(!) because the bond has to be redeemed at par, the face value. Instead, consider selling the bond at that 3-year point, retaining the remaining amount of premium, and move back out to a longer-term, new premium bond. In this way, you will recapture some or all of the premium (thereby actually raising your yield for your holding period), and have gained the advantages of the higher stream of income all along the way.

Bottom line: Put ice cubes in your veins and make an objective, emotionless choice and buy the bond with the higher yield and don’t be afraid to pay a big premium, assuming the other bond features are attractive and appropriate for you.

(A discount bond is a bond for which you pay less than face value – a price below 100. The difference between the discounted price paid and the maturing value of the bond represents a part of the bond’s yield to maturity, and one will not receive that yield until the bond matures. This type of bond is even less attractive for me than a par bond: there is less opportunity to earn interest on interest; the capital gain at maturity is taxable on municipal bonds, and, because of inflation, a flow of capital today is worth more than a flow of capital later.)

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If your portfolio is greater than $500,000, Sharon Alister can provide a free analytic review to help ensure that your portfolio is in line with your investment goals. Call Sharon Alister at (800) 745-7110 or email info@AlisterTalksBonds.com

 

Interest Rates (Indications only)

Please note the rates for Ins’d and Pre-Res are not available from Bloomberg and will be updated as soon as possible.

Treasuries AAA Munis
3mo 1.815 N/A
6mo 2.009 N/A
1yr 2.237 1.74
2yr 2.482 1.87
5yr 2.809 2.19
10yr 2.970 2.53
30yr 3.145 3.14
today's rates chart

AAA Rated Munis

Pre-Res Ins’d Pure*
2 yr 1.91 2.05 1.87
5 yr 2.23 2.49 2.19
10 yr N/A 2.89 2.53
15 yr N/A 3.20 2.82
30 yr N/A 3.50 3.14

*Rated AAA on its own
Source: Bloomberg

Investment Strategies

Give Me a Ginnie Mae Any Day

Riding and Rolling the Yield Curve in Government Securities

Adding Pizzaz to Your Bond Portfolio

Maybe It’s Time to Drop a Few Zeros From Your Retirement Plan?

Why You May Want to Pass on Investing in Bond Funds

Why Would You Sell a Perfectly Good Bond and Reinvest in a Lower-Yield Bond?

Don’t Buy and Forget!

Climbing the Bond Ladder

How Did that Bond Become AAA-Rated?

Should You Sell a Few Stocks to “Stock Up” on Munis?

Bonds that Build the House and Raise the (Yield) Ceiling

How to Get a Bargain by Paying a Premium


Give Me a Ginnie Mae Any Day

They sound complicated and get a bad rap; however, for risk-averse investors who include bonds in their portfolios, this much maligned mortgage-backed security (MBS) can offer generally lower risk, a higher yield, and monthly income.

What are MBS’s?

They are bonds comprised of a pool of mortgages that all share similar features, such as interest rates, scheduled payoff dates, property quality, etc. (i.e., 30-year single-family home mortgages at a similiar fixed interest rate all from the same community).

MBSs are often disregarded by investors because the mortgage-backed security returns a portion of the principal along with each interest payment. This can disturb investors who are not used to being subject to uncertainty in the redemption date of their bond. Owning an MBS is like owning a bond that has monthly calls for a portion of the principal.

Nevertheless, I believe that the following benefits of MBSs far outweigh any drawback.

MBS Advantages

MBSs are available from private insurers, ranging in credit quality from BBB to AAA (as rated by S&P). Those issued by government-sponsored entities, like FNMA (Federal National Mortgage Association, or “Fannie Mae”) and FHLMC (Federal Home Loan Mortgage Corporation, or “Freddie Mac”) carry an implied AAA rating, and as of September 2008, the Federal Housing Finance Agency became the conservator of these mortgage insurance agencies. As such, the U.S. Treasury has committed to provide necessary funding to support the net worth of these agencies. GNMA (Government National Mortgage Association, or “Ginnie Mae”) bonds carry the full faith guarantee of the U.S. Treasury as to prompt payment of principal and interest, just like Treasury bills, notes, and bonds. This guarantee does not remove market risks if sold prior to maturity.

Ginnie Maes, Fannie Maes, and Freddie Macs are actively traded, and there is a long history of their prepayment and return of principal behavior. If you stick with these bonds, you should find them to be lower risk, easy to buy or sell at market value, and relatively easy to understand. Government agency mortgages tend to yield from 0.75 to 1.25 percentage points higher than a comparable term Treasury Note. Concerns about reinvesting principal that is returned from MBSs can be remedied with a little education and organization. Each month, when you receive the principal and interest payment, put the principal into a money market for easy reinvestment. Your broker may be able to set up your account to separate these portions for you automatically.

How Do MBSs Work?

When you have a mortgage on your home, you make monthly payments to the bank until the mortgage is repaid. In the early years, monthly mortgage payments are made up of mostly interest, with just a small amount of principal payment. In later years, those payments are made up of mostly principal, with just a small amount applied to interest. When you own an MBS, you are on the receiving end of those monthly mortgage payments.

Let’s say that ABC Bank gives you and each of your neighbors with the same quality properties a 30-year, fixed-rate, single-family mortgage. ABC Bank then sells these mortgages, totaling $2 million to $3 million, and sells them to Ginnie Mae, and ABC Bank uses this money to reinvest in new mortgages. A second bank, XYZ Bank sells the same types of mortgages from the same neighborhood to GNMA, which then puts them together into a “pool” of $10 million to $12 million of 30-year, same fixed-rate, same quality, single-family mortgages. GNMA then creates a security, backed by this pool of mortgages, that is guaranteed by the U.S. Government as to the timely payment of principal and interest.

For that guarantee, GNMA charges a service fee which reduces the interest that passes through to investors. GNMA then sells this bond to an investment bank, which divides the bond into $1 million increments and resells them to brokerage houses, which divides them and sells them to investors in pieces as small as $25,000.

Now, when you make your mortgage payment to ABC Bank (or XYZ Bank), the bank passes it through to Ginnie Mae, who passes it through to an investment bank, who passes it to a the brokerage firm and, finally, through to the investor. That’s why these are called “pass-through” securities. Therefore, in the early years of an MBS, the investor is going to receive payments primarily comprised of interest with just a small amount of principal, and vice versa in later years.

Important MBS Issues.

An MBS made up of 30-year, single-family home mortgages has an average life of only 10 to 12 years because of various “mobility factors” that affect repayment of mortgages (i.e., death, job changes, relocation), any of which may cause mortgages to be paid off early.

Significant changes in interest also may have an impact on the average life and yield of an MBS. When interest rates drop, people tend to refinance their mortgages. When this happens, investors will receive payments of principal from their MBS earlier than anticipated, thereby shortening maturity and lessening yield. If interest rates rise, the average life of an MBS tends to lengthen and yield tends to rise. In periods of dramatic interest rate moves, investing in MBSs can be a bit tricky. If you anticipate dramatic interest rate swings, buy a bond with a coupon that reflects your interest rate expectation. If rates are climbing, for example, you can buy higher coupon Ginnie Maes. Your financial advisor should explain how MBSs react to different market conditions.

If you are looking for an investment that provides steady income, low credit risk, and offers market liquidity, government-backed MBSs like Ginnie Maes may be a good option.

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Riding and Rolling the Yield Curve in Government Securities

An investment strategy that you may want to consider is Riding and Rolling the Yield Curve. Using $1.5 million, for example, purchase $500,000 each of the 4-year, 3-year, and 2-year Treasury Notes. (Or 12-month, 9-month, and 6-month bills; any term structure of maturities is possible.) Each year as the notes age, the 4-year note will become a 3-year note, the 3-year note will become a 2-year note, and the 2-year note will become a 1-year note.

The Strategy

When the 2-year note becomes a 1-year note, it should be sold and a new 4-year note should be bought. A continual roll out of the current 1-year note and back into a new 4-year note should be maintained year after year, for whatever period of time is appropriate. Because there is an active and huge market in government securities, these notes can be easily liquidated. Because of this convenience, this strategy can be maintained indefinitely and liquidated as needed.

Please look at this illustration of typical (not actual) Treasury Note rates:
4 Yr. Note 3 Yr. Note 2 Yr. Note 1 Yr. Note
1.85% 1.50% 1.00% 0.50%

The average annual yield of the portfolio for the first year would be 1.50%. Each year (in a normal, steepening yield curve environment) the lowest yielding note would be sold and a new highest yielding note would be purchased. Throughout the life of the investment, average annual yield for the portfolio would remain somewhere around the prevailing 3-year note level.

Assume that rates prevailing in the market were to remain constant. Then, when the 4-year note would have aged to become a 1-year note, its price would have appreciated from par (100) to approximately 101.5. This price appreciation will necessarily occur in order for the note to be a comparable investment to the 0.50% yield that would be the current market yield for the 1-year note. For the 4-year note, this appreciation would represent an approximate +2% capital gain over three years. As the 3-year and 2-year note age (roll down the yield curve) to the point of having a 1-year maturity they, too, would have to experience capital appreciation in order to be comparable to the prevailing 1-year note yield. In addition to these capital gains, the portfolio continuously earns income at approximately the 3-year note rate.

Consider

1. If interest rates remain constant, the 1-year note will likely be sold at a gain.

2. If interest rates are declining, the 1-year note will likely be sold at a larger gain.

3. If interest rates are rising, the 1-year note may or may not be sold at a gain, depending upon the magnitude of the interest rate rise. Remember, moving back along the yield curve from a 4-year to a 1-year maturity necessitates pick-up (gain) in the price of the note in order to maintain the appropriate yield spreads between the different maturities. This gain acts as a hedge against the price loss due to rising interest rates.

Importantly, at all times the portfolio is earning an annual interest rate considerably higher than the rate that could be earned on a single, short-term treasury note or bill period. And, if rates rise to the extent that this strategy ceases to be profitable, simply hold the notes until maturity.

Another Option: Use actively traded Government Agency Notes rather than Treasury Notes. This will likely result in a yield pick up for the portfolio with only a slight increase in risk.

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Adding Pizzaz to Your Bond Portfolio

Many first-time and veteran investors are comfortable with the reliability and low risk of high-quality bonds. While they may lack the heart-racing excitement of a hot stock on the rise, for those who can live without the thrill and the volatility, there are alternatives to the straight AAA-rated bond-buying rule.

The alternatives listed below may boost returns on various bond types. Also, varying the terms within your bond portfolio and the makeup of the portfolio may boost overall return. Read On!

Single and Loving It

Even if you are very wary of anything but the highest-grade investments and have a strict policy of “AAA-rated only,” you should be aware that there are many good bonds available with an investment-grade rating but with significantly higher yield than some AAA-rated bonds.

For example, in the municipal bond market, Orlando Aviation bonds, are not likely to default, in my opinion, as long as Disney World remains in business. A bond such as this could increase your tax-free yield by half a percentage point or more over most AAA-rated muni bonds. Also, in the taxable bond markets, there are many A-rated bonds from issuers with good credit histories, and they offer a significant yield advantage over AAA-rated corporate bonds.

Bond Shifting

If you have a portfolio of bonds, you can shift its makeup to boost total yield. Weight your portfolio with a variety of differently rated bonds to boost its overall return without giving up too much creditworthiness. In the segment of the bond portfolio with shorter-term maturities, you may want to consider investing in lower-rated investment-grade bonds, and in the longer-term end of the portfolio maintain the higher-rated investment-grade bonds. In the intermediate-term of the portfolio, mortgage-backed securities, such as GNMAs and FNMAs, which often provide a yield advantage over comparable-term Treasuries, should be considered. However, keep in mind that mortgage-backed securities represent an investment in a pool of mortgage loans; thus, the yield and average life will fluctuate depending on the rate at which mortgage holders prepay the underlying mortgages and changes in interest rates. Your financial advisor should explain how mortgage-backed securites react to different market conditions. In a municipal bond portfolio, total return may be boosted by maintaining the shorter-term bonds in the lower-rated investment-grade municipals and the longer-term bonds in the higher-rated municipals. Also consider housing bonds, a type of municipal bond with a variety of redemption possibilities that generally reward investors with extra return for taking the uncertainty of redemption.

Go Long

You may want to increase your portfolio’s percentage of long-term bonds (15 to 20 years), up to a maximum of 25% of the bond portfolio. This may provide greater portfolio yield, as long-term yields are generally higher than short-term yields. Remember, you don’t have to hold long-term bonds to maturity. Today’s bond markets are so liquid that many bonds can be easily sold before maturity, perhaps when you feel there will be material change in interest rates, since when interest rates rise, bond prices will fall. Of course, the price you receive on a sale prior to maturity may be higher or lower than what you paid for the bonds.

“Cushion” Bonds

Consider including a few “cushion” bonds. These are high-coupon bonds (which are bought at a premium) that have very long maturity dates but which have calls in the 5- to 10-year range. If the bond is called, the yield to call will generally be from 0.5 to 1 percentage point higher than the yield to maturity of a comparably rated bond that matures in the year of the call. Because the coupon on the bond is so much higher than current coupons in the market (which is why you pay a premium), the likelihood of the bond being called is very high.

Up the Ladder

Most investors are familiar with the wisdom of having a laddered structure of maturities for their portfolio. Maturities should range from 3 to 12 or 15 years. Rather than selecting bonds that mature in each of those years, purchase bonds of various maturities, types, and yields based on a portfolio divided into segments: short-term of 3 to 7 years; intermediate, 7 to 12 years; and longer-term, 13 years or longer.

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Maybe It’s Time to Drop a Few Zeros From Your Retirement Plan?

Back in the 1980s and early 1990s, a warm enthusiasm for zero-coupon bonds developed among long-term investors, such as pension and profit-sharing plans. “Zeros” are deeply discounted, non-interest-bearing bonds that accrete in value annually to equal their par or redemption value at maturity.

Zeros had (and still have) much appeal. If you had a relatively new plan with fewer dollars to invest, you could buy a lot of zeros at a very small cost and receive a sizable sum when they mature on a specific date in the future. Since the intention of a retirement investment plan is to grow capital, it was reassuring to know that the initial investment in zeros would remain intact and you could count on the amount of money you would have at retirement.

With zeros, you can match their maturities and amounts to meet known future liabilities, such as payouts to pensioners or specific annual payouts to yourself. Plus, you could ladder zeros at maturities to correspond with specific retirement dates and payout periods. However, you may want to look at the investments in your pension and profit-sharing plans and determine if you have too many zeros, thus unnecessarily dragging down your overall pension and profit-plan earnings. Because you aren’t earning “interest on interest,” you probably aren’t getting the highest yields you could from a variety of other zeros and interest-bearing bonds comparable in risk to your zeros. Let’s compare the non-interest-bearing zeros with other interest-bearing bonds.

When you buy a bond, the issuer is giving you a promissory note to repay a specific amount of principal to the note holder on a certain redemption date (the call date or the maturity date). On an interest-bearing note, the issuer agrees to pay in cash, usually semi-annually, the amount of interest that accrues on the note each year until it is redeemed.

With an interest-bearing bond, the interest can be reinvested, and you can earn “interest on interest.” Meanwhile, the original principal continues to collect interest at its stated yield. With zeros, a fixed accretion (growth) rate is locked in; you can’t enhance the bond’s earnings to anything greater than the accreted principal value. Because zeros pay no interest, you cannot earn “interest on interest.” (However, accreted interest income on these bonds may be subject to annual taxation as ordinary income even though no cash payments are received.)

You can advance yields by taking advantage of cycles in the interest rate market. Both U.S. Treasury strips (zero-coupon Treasuries) and long-term U.S. Treasury bonds (interest-bearing) are very liquid, and there is plenty of time between purchase and maturity for you to “play” the interest rate fluctuations with these easily marketable securities.

If interest rates fall, there is usually a big increase in the value of long-term bonds, and an opportunity to realize a capital gain if you sell. Because strips pay no interest over this long-term period, their price is more volatile than the interest-bearing bonds. If rates drop, strips will outperform bonds during this rate move. Of course, there’s a flip side. When rates move up, strips will greatly under perform interest-bearing bonds, not only because they are more volatile, but because the interest earned on higher interest-bearing bonds can be invested at increasingly higher rates, helping to offset adverse price moves of the original investment. Of course, with both types of bonds, you can simply hold on to the original investment and wait for the next interest rate cycle. During this “holding-on” period, the interest-bearing bond, but not the zero, will pay cash interest to investors while they wait.

We’ve focused primarily on boosting yields in pension and profit-sharing plans, but many individuals buy zeros to cover children’s college or to give them a down payment for their first home. Zeros used for these purposes, too, may be a mistake. Over the long term, historically, no financial instrument has grown more than equities. If you have, say, 10 years to invest, you may profit most by investing in high-grade, well-established blue chip stocks and reinvest the dividends and capital gains. Also, you can probably put away more money for your children in the form of equities than in the form of bonds before you hit the $1,900 mark of annual income that is tax-advantaged for children under 19 (or 24 if full-time student) according to current IRS rules. For instance, if a bond yields 5% annually, you can invest about $38,000 before reaching $1,900 of income. If a stock’s dividend yield is 3% annually, you can invest about $63,000 before reaching $1,900 of income. Remember, once your under-19-year-old investment income exceeds $1,900, taxes are paid on the excess income at the parents’ tax rate. (After the age of 19, or 24 if full-time student, children establish their own tax rate.)

I strongly advise having a significant amount of retirement and pension-plan investments in equities.

Other Options

If you insist on owning zeros, consider those offering higher yields. Several yield a higher rate of return than U.S. strips. For example:

  • Government Trust Certificates

    are guaranteed by the U.S. Defense Department and, like T-strips, carry the full faith and credit guarantee of the U.S. government as to the timely payment of principal and interest. However, these zeros yield 20 basis points more than the comparable term T-strip.

  • Government Agency Securities

    historically have not carried the full faith and credit guarantee of the U.S. government. The agencies have a perceived tie to the federal government as institutions established under federal legislation, and thus have an implied AAA rating, but carry greater credit risk than those guaranteed by the U.S. government. Since September 2008, the Federal Housing Finance Agency became the conservator of the two housing mortgage insurance agencies: FNMA and FHLMC. As such, the U.S. Treasury has committed to provide necessary funding to support the net worth of these agencies. From time to time some agency securities yield more than other “agencies” due to debt issuing schedule or other financial circumstances. Look for and take advantage of these potential opportunities. These may yield 15-25 basis points more than the comparable term Treasury.

  • Corporate Zeros

    are typically issued by quality corporations with high credit ratings. Historically, these have provided a rate advantage over both Treasuries and Agencies and are still very creditworthy.

  • Yankee Zeros

    are zeros issued by foreign governments or corporations but denominated in U.S. dollars. Some sovereign country Yankee Zeros are highly rated, provide more yield than Treasuries or Agencies, and are more creditworthy than corporate zeros. They maintain a higher yield than other comparably rated zeros in order to boost sales, since investors are not very familiar with them. So sit down with your portfolio and consider the merits of zeroing out some of your zeros!

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Why You May Want to Pass on Investing in Bond Funds

While they appear to have some of the same positive characteristics of mutual funds: spreading risk through diversification and professional management, bond funds generally do not offer the key benefits that are characteristic of individual bonds. Most investors are attracted to bonds for two reasons: the preservation of capital if held to redemption, and to lock in a known, steady stream of income. Bond funds provide neither of these.

In My Opinion, here’s why:

A bond is a contract

like any other. It spells out the rights and obligations of the parties involved — in this case — the bond issuer and the bond holder. The issuer contractually promises the return of the principal on a specific date, and an annual stream of interest income at a particular rate. If the issuer defaults, the bond holder can seek recourse through the courts.

Bond fund shares are equities — ownership.

Like all business owners, one risks one’s investment capital for the potential greater return in the future. Equities do not involve contracts or guarantees regarding return of principal or fixed interest rates.

With these essential differences in mind, let’s look at how the two investment types compare when it comes to preservation of capital. When you buy a bond, the value (price) of the bond will fluctuate with the interest rate environment. But, you can ignore that fluctuation because you have the option of holding your bond until redemption (by call or maturity) when you will get back the face value of the bond, unless the bond defaults.

When you buy a bond fund, you are buying into a fund that lives on into perpetuity. There is no known end date when your principal will be returned to you. The fund is in the business of trading and managing an inventory of bonds and cash and possibly other financial derivatives. You are completely dependent upon the trading acumen of the fund’s managers and upon the interest rate environment returning the value of your shares back to their original price or higher. Thus, with bond funds, there is only a potential for preservation of capital.

Now let’s compare owning individual bonds and bond funds when it comes to locking in a known, steady stream of income.

When you buy a bond, the instant you pay for it you know the yield to call and maturity, and the annual current yield of your investment until the bond is redeemed. When you buy shares of a bond fund, there is a prevailing dividend payout rate, but there is no guarantee that this rate will continue. If rates fall in the bond market, it seems inevitable that there will be a cut in the dividend payout rate of your bond fund. As rates continue to fall in the interest rate market, so will the dividend payout rate of your bond fund. You do not lock in a yield to maturity. You do not lock in current yield.

There are additional risks and costs associated with bond funds that do not exist with bonds. For instance, you pick up “trading risk.” The managers of a bond fund are in the business of trading bonds and/or using derivatives strategies in an attempt to increase the total return of the bond fund. Sometimes the trading is not profitable and this poor trading performance is reflected in your share price. You also pick up annual management expenses which come out of the bond fund, and that is reflected in your share price.

Finally, in open-end bond funds, there may be a sudden and large amount of share redemptions such as we typically see following substantial market upheavals (1987, 2004, 2008). The bond fund managers MUST meet those requests for redemptions, and in order to do so, they may have to sell some of their inventory of bonds, very likely at a very disadvantageous time and price. The remaining bond fund holders may see the result of that “forced redemption” reflected in the lowered value of their shares. Closed-end bond funds take away the “forced redemption” risk but they do not take away any of the other risks associated with bond funds.

Am I a proponent of buying individual bond issues? Clearly. If you are seeking preservation of capital and a known income stream, buy bonds. If you are seeking potential growth and a decent dividend payout rate, invest in the stock market. But don’t be misled by thinking that you can get all the advantages of these diverse types of investments by buying bond funds!

One positive note on bond funds: Bond funds have low investor minimums which may help small investors achieve some diversification. However, this may also be accomplished through other investment alternatives. Bond funds also would not be as affected by call risk as individual bonds.

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Why Would You Sell a Perfectly Good Bond and Reinvest in a Lower-Yield Bond?

Perhaps to increase your total return!

I’m going to tell you about a strategy that on first glance doesn’t seem to make sense. But stay with me to learn about a way that you might sell a perfectly good bond and reinvest in a bond with a lower coupon and be right on the money to increase your total return given all other conditions are right.

For example, I encountered an opportunity to sell a bond with a 6.75% coupon and to reinvest in a bond with a 6.35% coupon and improved the total return by more than $20,000.

Here’s how:

The 6.75% bond had become pre-refunded, which means that the issuer had backed the bond with enough U.S. Treasury Securities to cover interest and principal up to the first call date (in 5.5 years) and made a guarantee to call the bond at that time. When a bond becomes pre-refunded, there is a ‘pop-up’ in its price. This is because the bond has become Treasury quality, which increases its creditworthiness and value (price). Also, the fact that it becomes a shorter-term bond because of the certainty of being redeemed at its first call date contributes to an increase in price. Shorter-term bonds usually yield less than longer-term bonds, and now that this bond has become shorter-term, it’s price must rise in order for it to yield less if sold to a new investor.

By selling the bond well before its call date, the investor would have captured the sudden rise in the bond price. Reinvesting in another tax-free bond enabled an investor to continue earning tax-free interest in a vehicle consistent with a low risk investment profile while improving the total return by more than $20,000.

Here are more of the particulars:

In this example, an investor had purchased $250,000 of 6.75% bonds at par (100) a year earlier. Because of the decline in interest rates, the issuer saw that it would be able to call the 6.75% bonds and reissue new bonds at a much lower cost. In order to finance the calling of the bonds, the municipality issued new refunding bonds with lower coupons, for use in purchasing Treasury securities to back the original higher coupon bonds. Thus the bonds become pre-refunded. (These types of bonds are frequently referred to as “pre-res.”)

The bond’s call date was in 5.5 years at a price of 101, which would return to the investor a total of $252,500 if held until call redemption. However, newly backed by U.S. securities and with a shorter term, the bonds became more valuable. Trading at a price of 11.426 points over par, the bonds appeared to be near the peak of their value five and a half years before the call! As early as three years before the call date, the price of the bonds would begin to slide toward the call price of 101, regardless of prevailing interest rates. Selling would realize a net gain of $28,565 ($278,565 less the purchase price of $250,000). A new bond with a 6.35% coupon was available for purchase with the original $250,000 principal. Although over a five and a half year period, the new bond investment would net less interest income, the total return was still $20,000 more than it would have been had the original bond been held to its call date.

I want to emphasize that you aren’t likely to be trading bonds every month in order to use this strategy. However, you could reinvest the same dollars every two or three years in another potential candidate for pre-refunding and earn yet another round of capital gains. Of course, the capital gains would be subject to capital gains tax.

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Don’t Buy and Forget!

Why a Buy-and-Hold Bond Portfolio Strategy May Be Leaving “Total Return” on the Table

In this article, we’re going to discuss the differences between a “buy-and-hold” strategy for the bond portfolio versus a modestly managed bond portfolio.

Under the modestly managed bond portfolio strategy, we are neither actively trading nor passively buying-and-holding bonds, but rather, we are making changes in our bond portfolio as opportunities present themselves in the normal course of a bond’s life or a bond portfolio’s life. Reacting to and taking advantage of these changes is the means by which the individual investor may procure capital gains from a bond trade, in addition to enjoying the interest that accrues in the bond portfolio from holding bonds. As the portfolio is not actively trading bonds with great frequency over a short period of time, say every day, or every week, there’s no apparent trading risk in this strategy. For instance, if the investor can’t get an attractive bid price on a bond, then what had appeared to have been a good opportunity to realize capital gains is indeed not such a good opportunity. The bond in this case can simply continue to be held until another opportunity presents itself or until the bond is redeemed. So, as in an actively managed portfolio, we use capital gains to enhance total return, but unlike an actively managed portfolio, our goal is not the “art of trading,” nor do we pick up those risks.

So you ask, “what do you mean when you say managing a portfolio?” Well, first of all, with any bond portfolio strategy, there should be a laddered structure of maturities. This provides some protection from having to predict with perfect accuracy the direction of interest rates. Also, try to have all the bonds in the portfolio be approximately the same dollar amount (eggs in a basket, etc.) and diversify geographically, by type of security, and by rating.

It is very important to note that I am not interested in owning bonds that are less than 2-3 years to redemption. Adequate funds are almost always to be found in our money market or from interest that is being paid on our existing bond portfolio or that can be made available from other securities that cover the cash equivalent portion of the portfolio. I let these resources substitute for the 0 to 3 year range of the ladder. Let’s consider a maturity ladder that runs from 3 to 15 years.

Having laid the groundwork for a portfolio, let’s talk about how to manage it. First, when a bond is within three to four years to redemption, I look to sell it. “Three years to redemption” means either that the bond is going to be maturing in three years, or because it has a very high coupon relative to the new issue market, it is likely to be called by the issuer within the next three years. In either case, I suggest selling the bond and purchasing a new bond at the longer end of the maturity ladder. Why? Many bonds that were bought several years ago that were, say, 10-year bonds then are 3- to 4-year bonds now and are trading with significant capital gains. This is because the bond has become a short-term bond and its coupon rate, meant for a longer-term bond, is high relative to “now current” short-term bonds (the bond has “moved down the yield curve”). This makes it more valuable, higher priced.

But once a bond is within about three years years to redemption by call or maturity, its price starts to quickly erode toward par because it must be redeemed at the price of par (100 or the call price usually 100 – 102). That’s a contractual obligation. So take advantage of those capital gains before they’ve been reduced as the bond’s price moves toward par value. You can sell the bond at this point and move back out to the long end of the ladder. This is one of those “events” that should be taken advantage of because it may provide the portfolio with an extra bit of gain that will enhance total return over and above the return from a simple buy-and-hold portfolio.

Pre-Refundings

In the course of owning bonds, there may be an occasion when a bond has become pre-refunded. We say that a municipal bond becomes “pre-refunded” and a corporate bond becomes “defeased.” In both cases, this means that the bond has become backed in U.S. Treasury securities so that the issuer can get the debt liability off of its balance sheet. This Treasury backing is usually tagged to the first call date of the bond and, at that date, the bond will be redeemed. The issuer usually issues new bonds at lower rates in order to raise the funds to buy the Treasuries necessary to effect this process.

From the bond owners’ point of view, we now own a bond whose credit quality has risen to U.S. Treasury quality. We also have a bond, in the case of those which have been pegged for redemption to a call date, which is certainly going to experience shorter term than was expected prior to the act of refunding. Those two characteristics — shorter term and higher quality — cause a bond’s price to jump up. Take advantage of that unexpected capital gain opportunity, and consider selling. Look for another bond that fits the portfolio’s investment parameters and which may also be a candidate, a few years from now, for this same kind of refunding. Again, taxes will apply for any capital gains.

Rating Changes

Another event that occurs in a portfolio is that bonds become up-rated or down-rated and, as a result, their value (price) changes. A perfect example is former New York utility company Long Island Lighting Company (LILCO). LILCO was the creditor for both municipal bonds from New York City, as well as for corporate bonds in their own name. They had been experiencing declining credit ratings, and the value of their bonds had experienced declining prices. The State of New York bailed them out with a partial takeover of the corporation and better financial management. All at once LILCO’s bonds jumped from deep discounts, to par prices and higher. Also, because of its improved financial situation, LILCO’s bonds would likely be called through refundings financed with lower coupon bonds. This event caused an unexpected kick-up in the value of the bond. In this type of instance, you should consider selling the bond, taking the capital gain, and finding another bond that meets your investment parameters. These gains would not be realized in a buy-and-hold strategy.

These are just a few of the unexpected events that frequently occur in a bond portfolio. If your bond portfolio is following a buy-and-hold strategy, it will be leaving total return on the table- an earnings boost over simply collecting bond interest. However, if you pursue a moderately managed portfolio strategy, you have the potential to enjoy a much higher return if you recognize and take advantage of these types of opportunities and make strategic changes in response to them. A 1% or 2% increase in the overall return of the portfolio, year after year after year, can become significant.

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Climbing the Bond Ladder

Laddering. It’s not just a way to get things off the top shelf. It’s a top-shelf financial strategy that may give you significant protection from interest rate volatility.

When I talk to clients who are thinking about their children’s futures, they usually think about laddering as a simple technique to ensure that a certain amount of cash becomes available each year of their children’s progress through college. They typically fund this ladder with zero coupon bonds. They use zeros and targeted laddering as a way to make sure that secure assets have been put away to fund a future stream of liabilities.

As security-conscious investors become more involved in managing their bond portfolios, however, they quickly recognize that the larger purpose of laddering a portfolio is to hedge against interest rate risk.

This article will cover various laddering strategies that may help you hedge against interest rate risk, and sometimes boost the return of your bond portfolio.

The Ladder as an Interest Rate Hedge

We may make our best-educated guesses about the direction of interest rates, or we may faithfully follow our favorite economist guru, but in the end, we don’t know with absolute certainty whether rates will remain flat, make a mild move, spike, or plunge. If we knew this, we would invest all of our bond money in the appropriate maturities for that known interest rate move. But we don’t know.

Therefore, the wary investor wants some protection. I prefer that Bond maturities be laddered in a range from 3 to 15 years and perhaps invest 10% of the portfolio with maturities in the 15 to 30 year range.

Why? Let’s say that interest rates go up. We may feel sorry that we have invested in longer-term bonds at rates that could be beaten now, but at least we have short-term bonds regularly maturing that we can reinvest at the prevailing higher rates.

What if interest rates go down. We may regret having invested in shorter-term bonds that will have to be reinvested at these lower prevailing rates, but at least we have locked in higher rates at the long-term end of our ladder. A laddered structure provides a mid-range rate of return and the overall income stream.

Weighting the Ladder

If you are a person who feels confident about making modest predictions about the direction of interest rates, and if you happen to be right, you can boost the yield of your laddered bond portfolio by weighting one end of the ladder, or in certain instances, weighting both ends of your ladder.

Say that you think interest rates will be steady or lower for the next several years. The economy is experiencing modest growth and little inflation and the rest of the world is at peace. In other words, you see a replay of the late ’50s and ’60s. You believe interest rates will be steady, give or take a half a percentage point or so.

With this scenario, you might want to weight your ladder lightly with bonds that would mature during the first five years of the ladder and more heavily in the later years of your ladder. If you believe that interest rates will be going significantly lower, you may want to buy only a few bonds for the short-term years (1-5), one bond every other year for the mid-term years (6-15), and weight the long-term (15-30) more heavily to pick up additional yield. You never completely abandon a presence in each of the segments: short-term, mid-term, or long-term as you could be wrong in your interest rate predictions.

Similarly, if you think inflation is likely to return and “run away” higher, you may want to weight your ladder more heavily at the short end, say during years one through five. That way, as interest rates rise in the next several years, you’ll have more bonds to reinvest at higher rates.

Varying the Ratings Along the Rungs of the Ladder

If you are strictly a treasury buyer, consider taking on a very modest risk and buy government agency bonds to mix with your U.S. treasuries. If you are slightly more risk tolerant, mix in several investment-grade bonds with ratings of BBB, A, or AA This can significantly improve your portfolio’s overall yield.

Consider these scenarios for using this mix in a bond ladder. Remember, short-term is 1- to 5-year maturities, intermediate-term is 6 to 15 years, and long-term is 15 years or longer to maturity.

Buy government or high-rated bonds for the intermediate and long end of the ladder, then use the short end of the ladder, perhaps those maturities from one to seven years, to invest in lower investment-grade bonds or in those bonds that are higher-rated “junk bonds” by Standard & Poor’s and Moody’s, say BB rated.
If you can tolerate a bit more risk, you can alternate every third bond on your ladder with a lower-rated bond.
Remember that mortgage-backed securities, such as Ginnie Maes, Fannie Maes, and Freddie Macs, can be looked at as bonds with a series of monthly and annual calls on them because of the mix of mortgages that are retired at different times. So, for your intermediate-term bonds in the ladder, say, years 7-12, you might want to purchase a larger-sized mortgage-backed bond than the others in your ladder and let it represent several years’ maturities. Ginnie Maes carry the full faith and credit guarantee of the U.S. Treasury as to the timely payment of principal and interest but pay nearly a full percentage more than a 10-year Treasury note. However, keep in mind that mortgage-backed securities represent an investment in a pool of mortgage loans; thus, the yield and average life will fluctuate depending on the rate at which mortgage holders prepay the underlying mortgages and changes in interest rates. Your financial advisor should explain how mortgage-backed securities react to different market conditions.

Taking Two Rungs at Once

If you don’t feel you have enough cash to diversify your bond portfolio into 15 different years, you may want to consider buying smaller bonds of $10 thousand or $15 thousand each, instead of several larger bonds. Or if you do prefer to purchase securities in larger denominations, you can skip every other rung on your ladder. The important point is to have bonds that adequately cover the short-, intermediate-, and long-term ranges of the maturity ladder in an organized manner.

It is better to spread even the most limited bond holdings over a longer maturity range. If interest rates do go much lower, and you don’t have enough of a spread for the term structure of maturities in your portfolio, your ladder won’t be much of a hedge and won’t help you maintain your portfolio yield.

The whole point of laddering your bond portfolio is to keep you from getting “wrung out” by fluctuating interest rates!

Bond laddering does not assure a profit or protect against loss in a declining market. Yields and market values will fluctuate, and if sold prior to maturity, bonds may be worth more or less than the original investment.

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How Did That Bond Become AAA-Rated?

You Ought to Ask

Did you know that all AAA bonds are not the same? Some bonds may have achieved their AAA status through a “credit enhancement”; for example, something like an escrow account backing a bond issue, or collateral, such as a Government National Mortgage Association (GNMA or “Ginnie Mae) bond, or a bank-issued certificate of deposit (CD). The AAA rating of a bond may not be based on the creditworthiness of the issuing municipality. What does this mean to an investor? If you are an investor who seeks the very safest of investments, it’s important to know how a bond achieved its AAA rating and the creditworthiness of the “payor of last resort,” that is, what entity provided the final principal backing. Also, if you are confused about why one AAA-rated bond offers a higher yield than another, you may find that the reason is tied to how the AAA was achieved.

The Safest Credit Enhancement

The safest municipal bonds are those that are Escrowed to Maturity (ETM) or Pre-refunded. These bonds are backed dollar-for-dollar by U.S. Treasury securities for both principal and interest.

  • An escrowed bond is one for which the issuer has set aside U.S. Treasury securities in an amount equal to the bond’s total principal and interest payments through maturity of the issue.
  • A pre-refunded bond is one that will definitely be called on its first stated call date. U.S. Treasury securities in an amount totaling principal and interest up to the call date and including the call price have been set aside to “fund the call.”

Other Types of Enhancements

Municipal bonds that are AAA-rated based on some form of direct collateral other than U.S. Treasuries can be tricky. For example, a bond that is collateralized by a CD does not carry the full faith and credit guarantee of the U.S. Treasury as to timely payment of principal and interest like one backed by a GNMA, for instance. A AAA-rated bond backed by a CD is backed by the bank issuing the CD and, in the event of the bank’s default, by the government agency that insures banking institutions. The creditworthiness of a Congressionally budgeted government agency, such as the FDIC, is not the same creditworthiness that is offered by agencies with guarantees that are direct obligations of the U.S. Treasury, as is the case of GNMA or Strips or U.S. Trust Certificates.

Banks also become the payor of last resort when the bonds are backed by Letters of Credit (LOC). The creditworthiness of the bank issuing the LOC is subject to change with the financial well-being of the bank. If the bank is down-rated, the muni bond supported by its LOC is also down-rated, despite the status of the municipality. In the event of a municipal default, the bank is the payor of last resort. Investors should note that foreign bank LOCs are frequently issued by their U.S. subsidiaries, and it may be that there is no recourse to the parent foreign bank in the event of financial difficulty.

Similarly, there are implied AAA-rated bonds with indirect government backing from agencies like the Federal Housing Administration (FHA) or Federal National Mortgage Association (FNMA). The agencies have a perceived tie to the federal government as institutions established under federal legislation but carry greater risk than those guaranteed by the U.S. government. Since September 2008, the Federal Housing Financial Agency became the conservator of the two housing mortgage insurance agencies: FNMA and FHLMC. As such, the U.S. Treasury has committed to provide necessary funding to support the net worth of the agencies. While no agency has ever failed to fulfill its guarantee, no law or contract prohibits it from doing so. In any case, practically all government agencies have an implied AAA rating regardless of their financial health.

Municipalities and Municipal Bond Insurance Companies

Some municipalities are so financially strong that their bonds are issued with AA+ or AAA rating without any credit enhancement. As typical in the risk-reward equation, these bonds are regarded as more secure than those underwritten with municipal bond insurance and offer lower yields than insured bonds.

Last in your investigation of the origins of a bond’s AAA rating is the insured bond. With municipal bond insurance, it’s even possible to buy a AAA-rated bond from a municipality that is actually bankrupt! No insurance company yet has been put to the test with an overwhelming amount of simultaneous municipal bond defaults, though in 2008 some municipal bond insurance companies did experience severe downgrades in their AAA-rating due to losses in their non-municipal bond insurance areas. Nevertheless, bonds that carry AAA-rated municipal bond insurance, despite their underlying municipality’s rating, carry the same AAA-rating as bonds backed by U.S. Treasury securities.

Clearly, the degree of risk with any AAA-rated bond is nominal compared with a lesser rated bond. But, if ultimate security is your goal in muni bond investing, take a moment to ask how that bond earned its AAA grades.

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Should You Sell a Few Stocks to “Stock Up” on Munis?

Those of us born between 1946 and 1964, known as “baby boomers” have dictated the major consumer trends of the past 25 years. Now, as we enter middle age and retirement, we are responsible for yet another trend, one which will have a special impact on fixed income investing.

Munis: Tax-Advantaged, Lower-Risk Retirement Investment

Many boomers have experienced stock gains over the past 20 years, both in their personal investments and in their companies’ retirement plans. The stock portion of their total investment portfolio has grown disproportionately large with these gains.

To maintain balance, the profits on stock purchases are likely to be or already have been reallocated to other asset classes, such as real estate and bonds, including municipals, for the purpose of diversifying risk.

Also, as is typical of people when they retire, when the baby boomers near retirement, they too will reallocate their portfolios to reflect a change in lifestyle. This generally means an increase in the amount of money allocated to the fixed income portion of their portfolios and, in particular, to municipal bonds. Why municipals? Municipal bonds are usually one of the only tax-advantaged vehicles left to individuals once they leave their companies.

Demand Up, Supply Low = Lower Rates and Yields

I believe that municipalities may become financially healthier, leading them to issue fewer bonds. This will reduce the supply of munis at the same time that Baby Boomers will be reallocating their portfolios more heavily into tax-advantaged bonds. The result will be higher prices for munis, lower yields, and lower coupon rates. Add to this the prospect of higher income taxes, and municipal bonds will become even more dear.

An Ameliorating Factor

A characteristic of boomers – one that has helped the economy – is that they are spenders, not savers. This may well mean that they will not leave the kind of wealth to their heirs that their parents left to them and, in fact, may be inclined to sell bonds to raise spending money.

Those who are used to active involvement in the management of their portfolios may tend to sell bonds to realize gains and losses and to reinvest. This behavior would cause an increase in the turnover of the existing supply of bonds and contribute to a more active secondary market and tighter spreads between the bid and offering sides of the muni markets. Tighter spreads and active markets mean fairer prices and more liquidity for everyone.

The Impact?

What does all this mean to purchasers of fixed income investments? They may want to begin purchasing a selection of very long-term municipal bonds now, with higher coupons and higher yields, and simply hold on to them. Then, when they reach retirement age if there is a high demand for municipals (and presumably lower coupon rates and yields), they would have the potentially profitable advantage of having set aside money that was invested at much higher rates.

It also means that investors may want to begin the reallocation of their portfolio into a greater portion of fixed income securities earlier than they expected – say, while they are in their early 50s rather than when they are in their early 60s. In advising baby boomers, I emphasize that while municipal bond yields may appear to be low today, investors may want to look toward the future, say 10 to 15 years out, when bond yields may well be significantly lower. The difference could mean attractive reasons to buy long-term bonds now, ahead of the rest of the baby boomers. Of couse, no one can predict the markets with any certainty.

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Bonds That Build the House and Raise the (Yield) Ceiling

I sometimes encounter people who find bond investing boring! This rather old-fashioned notion was fostered by the general obligation (GO) bond and the essential service bond (e.g., electric or water utility) which are paid off by property taxes and utilities revenues, respectively. Although these types of municipal bonds pay reliable, predictable returns, some investors find them too “vanilla.”

Housing Bonds

Here’s how you may be able to raise the yield roof a little with your municipal bond purchases. Housing bonds may offer a substantial yield advantage to investors — from .50% to .75% over vanilla-type munis. This advantage stems from the added risk of early, unexpected calls, a risk that is inherent in all housing bonds.

These bonds are issued by a Housing Finance Authority to raise funds for mortgages for individuals buying homes, typically in large affordable-housing projects, either as “multifamily housing bonds” or “single-family housing bonds,” an important distinction I’ll explain later.

I won’t go into great detail on the various individual characteristics related to credit enhancements or protection of the revenue streams supporting the individual type of housing projects (i.e., VA, GNMA, muni insurance, Section 8, etc.). These factors matter when selecting a specific bond, but for the topic at hand, how to minimize the risk of early calls, let’s assume that we are discussing high-quality, AAA rated bonds.

The key to prudent investing in these muni bonds is calculating up front the effects of an early call. In some cases, an early call can eliminate the yield advantage over non-housing bonds. The following is a review of the kinds of calls that must be considered when purchasing housing bonds.

Stated Calls

It is not unusual for bonds to be called by the issuer prior to maturity. This means that the bond issuer could call for the redemption of part or all of the bond issue at the call date(s) stated on the bond, usually 8 to 10 years from the date of issue. This date(s) is printed clearly and is known from the moment of issue.

Your financial advisor can calculate what your yield would be if the bond is called at the stated call date and price, and can help you compare that yield with a similar call and yield of a non-housing bond with a maturity of the same date.

Your financial advisor should also calculate yields in the instance of “extraordinary calls.” These are a bit trickier to anticipate, but equally important to take into account.

Extraordinary Calls

Extraordinary Calls allow the housing authority to call in bonds (return investors’ capital) for any number of unusual and unexpected reasons (i.e., catastrophes, natural disasters, changes in the status of underlying credit enhancement, unused funds, and early prepayment). Some of the extraordinary circumstances that lead to a call cannot be predicted, so a yield cannot be determined. Nonetheless, ask about the replacement of the credit enhancement supporting the housing bond issue. Letters of Credit or CDs on loans, all of which have periodic renewals, may trigger a call. Compute your yield to that date and determine if the bond is still attractive. A few other extraordinary calls also give us the opportunity to “guesstimate” a yield, to help us determine whether or not to buy any particular bond.

Unexpended Funds Call

Usually a housing project is given 1.5 to 3 years to pay out the money raised by the bond issue in the form of mortgages to project homeowners. If the project can’t or doesn’t use all of the money raised by the bond issue, money must be returned to investors. The issuer returns the capital raised from the bond issue by calling in bonds.

An interesting phenomenon of the 1990s, and again beginning in 2008, was that funds may also go unused because, due to a dramatic drop in interest rates, it becomes impossible for the housing project to make mortgages at rates that are competitive with the rates that project homeowners could get elsewhere.

Thus, if you are considering purchasing housing bonds, your financial advisor will want to do a “what if ” yield calculation based on a 1.5-year call. You might also calculate the yield to a 2-year call, 3-year call, etc., until you reach that call date which results in a zero or negative yield. Then assess the risk of being called at that break-even date against the greater yield you receive for each successive period that your bonds are not called. The prevailing mortgage interest rate environment should be a significant factor in your assessment.

By the way, multi-family housing bonds do not seem to share the frequent extraordinary call experience that single-family housing projects do. Be sure to take this into consideration too when assessing your call risk.

Early Prepayment Calls

Just like with mortgage-backed securities, housing bonds are very sensitive to movements in the mortgage interest rate market. A significant decline in mortgage rates will result in some individuals refinancing their higher-rate, original mortgage. When an individual returns money to the Finance Authority (who made the original mortgage), the Finance Authority returns the money to the investors by calling in bonds.

Don’t let all these call features scare you! There can be opportunity in housing bonds when mortgage rates are stable or moving only modestly. Don’t pay too big of a premium for a single-family housing bond, as it might be called away from you quickly and result in a negative yield. Consider buying them at or slightly above par price and regard them as a shorter-term investment. (Buying any housing bonds at a discount means that you may have to wait until redemption to realize a portion of your yield, and that might be a very long time away!) When rates are falling, try to stick with multi-family housing bonds too. They don’t happen to experience the same frequency of extraordinary calls as single-family housing bonds, probably because a great deal of the project’s buildings would have to be refinancing their mortgage(s) and this is a more different set of circumstances for the project to accomplish.

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How to Get a Bargain By Paying a Premium

Many people object to paying a premium for anything! They feel like they are not getting a “good deal,” or are somehow being taken advantage of by the sale. The opposite is true most of the time in the bond markets. “Premium” bonds are generally good buys. In order to illustrate this fact, I’m going to explain two sets of terms in the bond market… “Par” versus “Premium” bonds, and “Current Yield” versus “Yield to Maturity.”

“Par” Bonds Versus “Premium” Bonds

A “Par Bond” is a bond whose current market price is exactly equal to its maturing value. For instance, a bond with a face value of $1,000 will be redeemed at maturity for $1,000 and it is trading in the market at a price of 100. This means that it is trading at 100% of its face value. We call this 100% price “Par,” and we call this bond a “Par Bond.” A “Premium Bond” refers to a bond that is trading at a price over 100. Let’s say it is at a price of 104 or 106 or even 110. These numbers represent the percentage of the face value that the bond is currently trading for in the market. So in the case of a bond that is trading at, say, 104, we would have to pay $1,040 in order to purchase this $1,000 bond.

“Current Yield” Versus “Yield to Maturity”

“Current yield” (also called “coupon rate” or “cash flow”) is the rate of interest that is printed on the bond certificate. A 6% coupon means you will be paid $60 of interest income a year on a $1,000 bond (face value). Current yield does not reflect your return on investment, since it does not take into consideration the price you paid for the bond, which may be more or less than face value.

“Yield to Maturity” is the TRUE indicator of the return on your investment, since it DOES take into account the price you paid for the bond. Changes in the price will affect the bond’s yield to maturity (or yield to call). An increase in price lowers the yield, while a decrease raises the yield. The return on your investment or the “yield to maturity” (or “yield to call”) is what you can earn on your investment. It is this number that helps you compare bonds in the market, not the coupon rate nor the price.

Yield fluctuates with the interest rate environment. As “the market” interest yield changes, each individual bond adjusts its price so that it has a yield comparable to the market yield for similar types of bonds. When you hear on the news that “rates are going up,” it means the expected return on investment, or your yield to maturity, is going up and the market price of bonds is going down. Similarly when you hear in the news that “rates are going down,” it refers to “yields” are going down or yield to maturity is going down. This is a very important distinction and one that people confuse all the time. “Current Yield” is not the same as “Yield to Maturity” or “Yield to Call.” Current Yield refers to a stream of income; Yield to Maturity (or call) refers to a return on your investment.

Why “Premium” Bonds May Be a Good Bond Investment

O.K., so why do I think that premium bonds are such a good bond investment? Here are a few reasons:

Premium bonds cost more than par. But most premium bonds also provide a higher yield in order to entice investors to overcome their psychological aversion to paying a premium for anything. Since yield is what we can earn on our investment, premium bonds are attractive because they yield more.

A second reason I like premium bonds is that they are higher coupon bonds. We pay a premium price because we get a higher cash flow than with a par bond. A higher cash flow means a greater amount of cash to reinvest and provide the opportunity to earn “interest on interest.” Earning interest on interest can be lucrative over a long period of time! Also, it’s almost always better to get income now rather than later (the old bird in the hand…). This allows investors to use the interest now before the value of the money declines over time through inflation.

A third reason I favor premium bonds is that in a declining interest rate environment, premium bonds provide a higher cash flow than newer issue bonds. In a declining rate environment, premiums move to even higher valuations, presenting the investor with opportunity for capital gains and the potential risk of being “called.” (Note: This call risk may also be an opportunity to improve the bond portfolio’s total return through things like pre-refundings and defeasements and was discussed in another article on managing your bond portfolio.)

A fourth reason is that in a rising interest rate environment, premium bonds hold their value better than par bonds (or discount bonds). Premium bonds’ already existing higher coupons are more comparable to the bonds being issued in a new, higher interest rate environment, and this is what helps them hold their value (as well as the simple mathematics of it!).

So often I hear the objection, “but I lose that premium because I don’t get it back at the end.” No, you have NOT lost that premium. It comes back all along the way in the form of higher interest income.

Par vs. Premium
(both rated Aa3/AA+; actual prices on 3/11/11: for illustrative purposes only)

Premium Bond Par Bond
Essex County, NJ Upper Trinity, TX
Buy: $100,000 bond @102.936 Buy: $100,000 bond @ 100 (par)
Spend $102,936 Spend $100,000
6.0% coupon, due in 19 years 4.75% coupon, due in 19 years
YTM=5.6% YTM=4.75%
Cash Flow: Cash Flow:
$100,000 bond $100,000 bond
x6.0% x4.75%
$6,000 annually $4,750 annually
x19 years to maturity x19 years to maturity
$114,000 lifetime interest $90,250 lifetime interest
-1,029 premimum paid
$112,971 net return over life of investment $90,250 net return over life of investment

One last note. Say a high coupon bond is bought at a price of 110 and has a 10-year maturity. 7 years pass, and now it is a 3-year bond. It still has a very large premium, all things being equal, because of its high coupon and short maturity. But on its maturity date in three years it must have a price of par (100), because that is the face value of the bond. As the bond moves from three years to maturity, down to its redemption date, that premium is going to erode, slowly, toward par. It must(!) because the bond has to be redeemed at par, the face value. Instead, consider selling the bond at that 3-year point, retaining the remaining amount of premium, and move back out to a longer-term, new premium bond. In this way, you will recapture some or all of the premium (thereby actually raising your yield for your holding period), and have gained the advantages of the higher stream of income all along the way.

Bottom line: Put ice cubes in your veins and make an objective, emotionless choice and buy the bond with the higher yield and don’t be afraid to pay a big premium, assuming the other bond features are attractive and appropriate for you.

(A discount bond is a bond for which you pay less than face value – a price below 100. The difference between the discounted price paid and the maturing value of the bond represents a part of the bond’s yield to maturity, and one will not receive that yield until the bond matures. This type of bond is even less attractive for me than a par bond: there is less opportunity to earn interest on interest; the capital gain at maturity is taxable on municipal bonds, and, because of inflation, a flow of capital today is worth more than a flow of capital later.)

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If your portfolio is greater than $500,000, Sharon Alister can provide a free analytic review to help ensure that your portfolio is in line with your investment goals. Call Sharon Alister at (800) 745-7110 or email info@AlisterTalksBonds.com

 

Interest Rates (Indications only)

Please note the rates for Ins’d and Pre-Res are not available from Bloomberg and will be updated as soon as possible.

Treasuries AAA Munis
3mo 1.815 N/A
6mo 2.009 N/A
1yr 2.237 1.74
2yr 2.482 1.87
5yr 2.809 2.19
10yr 2.970 2.53
30yr 3.145 3.14
today's rates chart

AAA Rated Munis

Pre-Res Ins’d Pure*
2 yr 1.91 2.05 1.87
5 yr 2.23 2.49 2.19
10 yr N/A 2.89 2.53
15 yr N/A 3.20 2.82
30 yr N/A 3.50 3.14

*Rated AAA on its own
Source: Bloomberg

Investing involves risk, including possible loss of principal. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. Conversely, as interest rates fall, bond prices will rise.

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