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.
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.
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.