INSIGHTS

On June 08, 2012

Playing Defense With Your Bond Portfolio

With all the discussion about entering a rising interest rate environment and the accompanying fear of the loss of market value, a defensive strategy conversation may be of value. This defensive strategy involves duration and how premium bonds and length of maturity affect duration. While we do not profess to speculate on interest rate movements, a review of history would suggest that higher rates may be closer than many posit. The old adage of “buy the coupon where you think rates are going” is relevant to our conversation. If you think rates are headed up and want to protect the value in your bond portfolio, then higher coupons and premium bonds may be your best option.

One definition of duration is, “a calculation that portrays to the bond holder when their initial investment is returned in the form of all interest and principal cash flows.” The lower the duration, the less impact a change in interest rates has on the market value of a bond. The prudent advisor recognizes duration as a measurement of risk to the portfolio of interest rate movements.

Two ways to help control duration are maturity and coupon size (premium bonds). Since interest rates on U.S. Treasuries are at or close to all-time lows, short-term rates offer no return to the investor. Given the fact that investors need yield, we need to look elsewhere for yield and how to help control interest rate risk. We will concentrate on the latter while showing how the investor may receive higher yields with the choice of coupon, everything else being equal.

A premium bond is a bond that is selling at a price higher than its face value. A par bond sells at a price equal to its face value. All else being equal, a premium bond has a larger coupon than the coupon on a par bond.

There are numerous reasons why investors shy away from premium bonds.

• Premium bonds are hard to understand.
• Why pay more for a bond than its maturity value – it has a “built in loss.”
• It is just “easier” to buy a par or discounted priced bond.

Let’s explore these reasons.

Premium bonds are hard to understand.

Actually they are not. A premium bond has a larger coupon, higher current yield thus larger cash flows than a par bond with a lower coupon payment. This extra cash flow makes up for the premium dollar price paid above the maturity value and in many cases more than the premium paid.

For example, the market price of a 5%, 10-year maturity bond and a 3%, 10-year maturity bond both priced at a 3% yield to maturity is approximately $1,170 and $1,000 respectively. The coupon payment difference between the 5% and 3% coupon rate is $20 a bond received annually for 10 years or $200 more cash flow over the life of the bond which more than covers the $170 premium paid.

Why pay more for a bond than its maturity value – it has a built in loss.

See the above explanation. Most of the time, the overall return (yield to maturity) on a premium bond is greater than the comparable par bond. Stated simply, there is no loss as the premium is returned to the bondholder through the coupon cash-flow. The difference between the current yield, less the yield to maturity, is the return of principal paid as “premium” over par.

It is just “easier” to buy a par or discounted priced bond.

Par bonds may be easier – easier to explain, easier to understand or easier to account for, but it may not be the best value. Generally speaking, many investors want par bonds. It is simply a supply and demand issue. There are fewer par bonds and when the demand is greater for those par bonds, investors are willing to pay more or conversely when something is less desirable, premium bonds, there is less demand and they are priced more attractively - a higher yield to the investor.

This “higher yield” that can be obtained by buying premium bonds is subject to the type of bond, the current market conditions, quality, etc. With this disclaimer, an unscientific polling of traders indicates that in this market environment an investor can get anywhere between a 25bps and 50bps pickup in yield when buying premiums, all other factors equal. This means the investor would receive a ¼ to ½ percentage point more interest over the par bonds just for buying a premium, which in our example above, would make the difference between the interest over the life of the bond and the premium paid even greater. This yield differential is significant to the investor!

Besides the pickup in yield, the other reason to buy premium bonds is the duration. In a rising interest rate environment, the lower the duration the less impact rising yields have on market values. As previously stated, the two ways to help control duration is the size of the coupon and the maturity date.

The larger the coupon, the faster the investor receives their money back. In our example, the 3% 10-year par bond has a duration of 8.36 while the 5% 10-year bond at a 3% yield has a duration of 7.85. If yields move 1% higher to a 4%, the par bond loses 8% market value while the premium loses 7.5% market value.

The higher the coupon, the less of an impact interest rate moves have on market values. Couple this with the greater yield that might be obtained with premium bonds and that might make premium bonds the choice whether interest rates rise or stay flat.

 The maturity of a bond impacts duration and market price as well. Take our 5% bond due in 10 years vs. a 5% bond due in 5 years and 20 years.

Finally, there may be some significant tax issues that surround a bond that drops to a discount. Certain municipal bonds may be subject to a “deminimus” tax that can cause a discounted municipal bond to be bid at a greater discount because of the negative effect of the tax on the investor. Premium bonds are never subject to this tax and thus make the investor’s and accountant’s life easier.

If you are a believer that interest rates will rise sometime in the future and seeing how a combination of these three factors; larger coupon, higher yield and shorter maturity impact market value, one may want to look at investments that provide these characteristics.

An investment in bonds is subject to numerous risks, including higher interest rates, economic recession, deterioration of the bond market, possible downgrades and defaults of interest and/or principal. Interest rate risk is the risk that the value of a bond will fall if interest rates increase. Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Bonds with a longer period before maturity are often more sensitive to interest rate changes. Additionally, the financial condition of the issuer may worsen or its credit ratings may drop. A bond issuer might also prepay or “call” a bond before its stated maturity.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.