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.
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.