INSIGHTS

On May 29, 2018

AAM Viewpoints – Grade Point Averages and Portfolio Returns: Numbers Don’t Lie

Typically, by Memorial Day weekend, the spring academic calendar has come to an end and college students across the country should have received their final grades for the semester. For the students who tested well and came out with high GPA scores, a summer filled with rest, relaxation, and opportunities for career development potentially await them. For those who did not fare quite as well, summer classes and sober reflection might be more realistic options. From an optimist’s point of view, a low GPA score might be the perfect catalyst an underperforming student needs to take his or her academics studies more seriously. Ironically, the same logic could be applied to fixed income investors unsatisfied with their year-to-date portfolio returns.

Nearing the midway point of 2018, Treasury yields have been rising for nearly three consecutive quarters. Fed policy tightening, recent fiscal stimulus, stable economic growth and employment are all supporting higher levels. First quarter 2018 portfolio returns were likely not a welcome sight for fixed income investors, given that this portion of the portfolio is typically meant to be the ballast to their equity exposure. As it stands today, second quarter year-to-date performance might not provide any relief for them either. Similar to a student on a mission to turn a low GPA score around, a conscientious investor should view an underperforming portfolio as a wake-up call to understand what he or she owns. This includes identifying structures susceptible to more price volatility, and seek opportunities to build a more defensively-minded portfolio, in our opinion.

While interest rate risk is inherent in virtually all fixed income investments, there are certainly ways to mitigate it. At AAM, we have long advocated our clients build fixed income portfolios with high coupon bonds and maintain defensively structured positions because we believe these two structures have the potential to be effective in insulating portfolios against rate volatility. For those who need a little more convincing, a few total return scenario illustrations show how certain bond structures behave during various rate environments:

The Case for Higher Coupons

In this first scenario, we compared two municipal bonds of equal maturities over a 1-year time horizon: to the left, a 3% coupon and to the right, a 5% coupon. The two bonds are of the same issuer in order to eliminate discrepancies due to differences in credit risk. As interest rates rise (going down the Yield Shift column), the Adjusted Yield on the bond increases, the bond market Price decreases, and the 1-Year Total Return declines as a result.

While the outperformance of the 5% coupon bond versus the 3% coupon grows when interest rates rise, the change in market price between the bonds becomes the real difference maker. In this scenario, the price of the 3% bond falls below the par value rather easily after a +100 basis point move in rates. When a bond prices below par (also known as a “discount bond”), the De Minimus tax rule comes into effect, which triggers uncertainty in how the bond should be taxed — either as ordinary income or as capital gains. Knowledgeable bond traders are typically cautious around discount bonds. In general, they do not bid them as aggressively as they do with premium bonds because of the additional layer of tax consequences to consider. That said, if the owner of this 3% bond needed to liquidate his position under this scenario, he might receive a high bid several basis points lower than the stated $97.66 market price (depending on the size of his holding). Under the same circumstances, the owner of the 5.0% coupon has the potential to fare better (will not be subject to De Minimus rule) and receive more competitive bids relative to the market evaluation.

The Case for Callable Structures

In this next scenario, we compare two municipal bonds with similar maturity dates over the same 1-year time horizon but the bond on the left is a 10-year noncallable bond (also known as a “bullet”) while the bond to the right is a 10-year maturity with a 7-year call option. This option means that the bond is eligible for redemption by the issuer as early as three years prior to the stated maturity date (typically callable every subsequent year until maturity). All things being equal, the bond is priced to the 2025 call date, which means that the callable bond will have a modestly lower yield and subsequently a lower duration than the bullet bond. However, if the bond does not get redeemed by the first call date, the investor will receive a higher yield – also known as a yield "kick" – as compensation for the structure change.

While many consider the yield kick to be one of the most attractive aspects of a callable bond, its lower stated duration (versus similar non-callable structures) is arguably just as valuable in a rising rate environment. In this scenario, after a +100 basis point move in interest rates, the decrease in price of the callable bond is only a fraction of the price decrease of the bullet bond. Due to their defensive properties, callable bonds (especially with shorter calls) have the potential to add versatility and modest price insulation versus noncallable bonds to bond portfolios.

For the investor who has developed less of an appetite for interest rate risk over recent months, we believe a sensible response of dialing down portfolio duration (through the use the callable structures) and dialing up average coupon can have the potential to drastically reduce market volatility in the unknown quarters to come. Perhaps with a higher “GPA” in the picture, these investors will have more opportunities to relax and enjoy their summer break.

CRN: 2018-0507-6653R