INSIGHTS

On September 28, 2015

AAM Viewpoints – The Fed Rate Increase & Fixed Income Investment Ideas

The market’s assumption seems to be that the Fed is going to raise rates. Given this assumption, how should money be invested in the fixed income area? It appears to me that opinions about any kind of investing are like elbows, most people have two and just about everybody has at least one. So here goes my two opinions.

1. I am in the camp that the Fed will raise rates because they can and because they do not believe – as many others do – that the Fed Funds rate should be at zero. Given that economic data is not at a point where the economy is growing at a robust pace; that would lead many to believe that rate increases will be measured and limited. If you believe that, then the impact on the overall interest rates may be muted. So, where does the investor invest their dollars?
   
   
   If the Fed raises the Fed Funds Rate, then my opinion is the shorter maturity bonds will be impacted relatively more than intermediate bonds. Many feel this way because the economy is not overheated, rates increases should be minimal and any kind of increase in U.S. Treasury yields may bring additional foreign investment into the U.S. Treasury market, possibly flattening the yield curve somewhat. For non-callable bonds, I would suggest the 5-year to 10-year maturity range, give or take a couple years. There are always relative value plays within maturity ranges, so a little wiggle room in the maturity targets is acceptable. This should position an investor in the shorter to intermediate maturity range where an increase in Fed Funds rate may not directly impact bond values, but still potentially protect the bond values relatively well if rates go up across the yield curve.
2. An equally appealing area and my second opinion is the cushion bond. A cushion bond is a bond that has a large coupon rate, thus a high premium dollar price, and has an optional callable feature. With a premium dollar price bond, the date of the call feature effectively acts as the maturity date of the bond when calculating the value of the bond. As long as there is a premium dollar price, if interest rates move higher, the impact on the bond value should be relatively smaller than a bond with the same maturity but with no call option thus “cushioning” the change in the bond value. See Exhibit A. This strategy can help protect bond values relative to non-callable similar structures while potentially providing the investor higher yields. Typically the yields received on a cushion bond are somewhat higher than an otherwise comparable non-callable bond.

Exhibit A

Market Value Loss with 1% Rise (100 bps (basis points)) from 2.5% yield based on current market rates to 3.5% yield in interest rates on a Cushion Bond vs. a Non-callable Bond with the same final maturity. (The percentage moves are rounded and the dollar value of the bonds are still premiums after the 1% rise in interest rates.)

 *To view formula for how these numbers are calculated, click here.

The down side to a cushion bond? The structure is more complicated, investors may not like paying a premium dollar price for a bond and the investor needs to pay more attention to the investment. These are also among the reasons why the investor can usually obtain better yields on cushion bonds than on a comparable non-callable bond. The cushion bond, when bought for this type strategy, works as described when there is a premium value to the bond. When buying a cushion bond, in my opinion, the premium paid for the bond must be high enough to withstand a rise in interest rates and still carry a significant premium after that interest rate move. There are various stress tests to determine how a bond value will react to an interest rate move. A simple one is to take the current value of a cushion bond and apply a 100 bps move up in interest rates to see what the bond value would be after the rise in rates. For example, the value of a bond is $116 at a given time. If after a 1% or 100 bps move up in interest rates the principal value of the bond is still expected to be in that $106-or-greater range, then you probably have a good cushion structure. The idea is that a cushion bond is a potentially good strategy if the bond structure can withstand a rise in rates and still have a cushion. This a rough example to make a point.

In summary, given the market assumptions outlined, a bond strategy could be to buy non-callable bonds 5 to 12 years in maturity or to invest in cushion bonds in the 10- to 20-year maturity range with shorter call features. Consult your bond professional before making investments.

The types of bonds described above may not be suitable for all investors and investors should consider all details about a bond and consider their own circumstances and risk tolerances before making any investment decisions.

CRN: 2015-0908-4930 R

This commentary is for informational purposes only and is not an offering or solicitation of any product or service. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at https://www.aamlive.com/legal/commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

The examples shown above are not projections or predictions of performance, but are simply descriptions of mathematical principles based on the assumption and formulas outlined above.