Bond FAQs: Answers to your questions about how we manage the bond and fixed income portion of your investment portfolio
Answers to your questions about how we manage the bond and fixed income portion of your investment portfolio
Q: Why do you focus on including individual bonds, rather than bond funds or ETFs, in my portfolio?
A. At Cambridge Trust, we prefer purchasing individual bonds rather than mutual funds because it gives us more control and flexibility.
With individual bonds, your income is “locked in” at the stated coupon rate and, if you hold the bond until it matures, you will receive your full principal amount back regardless of any interim, unrealized mark-to-market price changes along the way.
With a bond fund, you have more volatility around the income it produces each year. In addition, the price of a bond mutual fund and its underlying holdings can fluctuate up and down and create some realized gains or losses along the way that might not be compatible with the goals of your personal portfolio.
We also can tailor a portfolio of individual bonds more precisely to your individual expectations for accessing capital and timing liquidity events. You are not subject to the forced buying/selling that a mutual fund might have to do to deliver its returns, unrelated to your personal situation.
However, there are cases where mutual funds are the most appropriate and best fit for certain portfolio sizes and objectives. For example, we may use bond mutual funds for smaller accounts, where the ability to meet the minimums to purchase several individual bonds may be limited.
In addition, if we find an attractive area of the market that we can’t access easily in an individual bond format, like high yield and emerging market bonds, we may purchase mutual fund shares to create a diversified allocation to that asset class rather than buying a single bond.
Q: What is the difference between a bond’s coupon rate and its yield?
A. A few definitions will be helpful here.
The par value or face value of a bond is the amount of principal the bondholder will receive when the bond reaches maturity. This is the dollar amount that an investor pays to buy a new bond issue. Most bonds have par values of $100 or $1,000. The one exception is a zero coupon bond which is sold at a discount to its par value.
The coupon rate is the bond’s stated interest rate when it is first issued. This is the rate the issuer promises to pay the bondholder each year to use the money. For example, a bond with a $1,000 par value/face value and coupon rate of 3% pays you $30 in interest each year until the bond matures ($1000 X 3%).
A bond's yield is its effective rate of return based on the current price of the bond, which might have moved above or below par since issuance. Expressed as an equation, the yield is the bond’s coupon divided by the current price, or
Yield = coupon rate / current price
When purchased as a new bond issue, the coupon rate and yield equal each other. Most bonds have a fixed coupon rate that never changes, but yields can and do fluctuate throughout a bond’s life. So a bond with a $1000 face value that pays $20 a year has a coupon rate and a yield of 2% ($20/$1000 = 2%). However, if you buy a bond on the secondary market above or below its par value, then its yield is based on the actual price you pay and the par price ceases to be relevant.
For example, suppose you decide to sell that $1000 face value bond with a coupon rate of 2% on the secondary market when interest rates for new issue bonds of the same type have risen above 2%. Because newer bonds that pay higher interest rates are more desirable, the price that investors will be willing to pay for your bond with its lower coupon rate will need to be lower so that its yield will rise to a fair and competitive level consistent with the yield being offered on new issue bonds.
So, if your less-desirable bond ends up selling for $980, its yield for the new owner (using the equation above) will now be $20 return / $980 price or 2.04%. In this case, the yield and price are inversely related. When the price fell, the yield increased, making the bond with a lower coupon rate more attractive to the new buyer.
Because a bond’s yield reflects its value in the current market, investors who want to make an “apples to apples” comparison to decide which bonds to buy and sell will focus on their yield rather than their coupon rate.
Q: If interest rates rise and my bond’s value falls, how will this affect the amount I receive if I hold the bond to maturity?
The bond’s value in the market will drop as rates rise, as outlined above. This is referred to as a “mark-to-market” loss , but it will only temporarily affect the bond’s value as an asset in your portfolio. It will not impact the amount you eventually receive if you hold the bond to maturity, which will still be the full par amount of principal. The temporary markdown of the value of the bond will only materially impact you if you sell the bond and turn this temporary unrealized loss to a realized loss.
It’s also possible that, with rates rising over time, a longer-term bond could record several mark-to-market, unrealized losses along the way to its final maturity. However, whatever those unrealized losses may have been, they will have no effect on the face value of your bond when it matures. You only realize the loss if you sell the bond before then.
Q: Is it always a better idea to hold a bond until it matures?
A:Not necessarily. There’s also the opportunity cost to consider when holding on to bonds in your portfolio when rates rise. That is, what reinvestment opportunity might you be missing by:
Keeping a bond and receive payments at the original lower rate until it matures,
Selling the bond at a loss and purchasing a higher coupon new issue bond in its place that could provide you with larger semi-annual payments and more income over time?
Every portfolio of bonds is different, of course, which is why the fixed income experts at Cambridge Trust use computer-based scenarios to analyze the possible effect of holding or selling each of the bonds in our clients’ portfolios in a rising (or falling) rate environment. For example, if we were to sell a bond at a loss and purchase a new bond to replace it, how long would it take for the income from the new bond to recapture/offset the loss from the sale of the old bond?
Based on this analysis, there might be times when we decide to not hold a bond to maturity in a client’s portfolio because we might do better by selling it before maturity, realizing the loss, and then using the proceeds to purchase a similar, but higher yielding bond investment. (This strategy has the potential to help your tax situation as well because the losses from the bond sale can be used to offset other gains in your portfolio.)
This year, for example, as the yield curve was “flattening,” we made some bond swaps where we sold bonds and took a slight loss, then purchased shorter duration bonds in their place. This gave us an opportunity to shorten the overall duration of the portfolios and actually keep the income approximately the same for the next 2-3 years. As a result, we also lowered the portfolios’ volatility and potential interest rate exposure.
Q: Can you explain the difference between bond maturity and bond duration? Why do you emphasize duration when responding to changing interest rates?
A. While both terms sound alike, they are not the same when applied to bond investing.
A bond's maturity, is simply the length of time until the principal must be paid back: a 10-year bond matures at the end of 10 years, at which time you receive the face value of the bond.
A bond’s duration involves a more complicated mathematical calculation that is used to monitor and manage interest rate risk. It is based on the value of a bond’s future cash flows (the final principal payment and all the intervening coupon payments) and how soon a bondholder will recoup his or her investment at prevailing interest rates.
The resulting duration value (expressed in years) allows your portfolio manager to make an apples-to-apples, standardized comparison of how bond investments with different maturities and characteristics react to changing interest rates. So, all else equal and assuming a parallel shift in the yield curve,
The shorter/lower the duration value, the less sensitive the bond’s price will be to interest rate changes.
The longer/higher the duration, the more sensitive the bond’s price will be.
Q: How do you use the shape of the yield curve to decide which fixed income securities to buy?
A. Generally, the longer a bond’s time to maturity, the higher the chances are that its value will fluctuate over time as economic and interest rate conditions change. Accordingly, longer term/higher duration securities usually have higher yields than their shorter-term counterparts do, largely to compensate investors for the added risk. Our portfolio managers and analysts are constantly monitoring these risk/reward relationships to determine the best relative value opportunities.
The yield curve gives us a graphic way to view the yields of bonds of similar quality but different maturity dates at a particular point in time. In a normal interest rate environment, the curve slopes upward to show the additional yield for longer holding periods.
As an example, the graph below shows how a normal yield curve might look. In a “normal” interest rate environment, the curve slopes upward to show the additional return and greater risk when keeping a bond for a longer time period.
We frequently evaluate securities based on where they fall on the yield curve. We can invest farther out or closer in on the curve, depending on the return we are looking for and the calculated risk/reward profile that we are seeking.
In a rising rate scenario, for example, we might move our durations to be slightly lower on the curve than our typical benchmarks. We do this by selling some long duration securities, and replacing them with shorter duration securities such as two to three year bonds that fall on the front part of the curve. If we’re reinvesting the proceeds from a longer-term bond that has matured, we’ll look for where the optimal part of the yield curve is to put that money back to work.
More recently, as the yield curve has flattened--with interest rates for fixed income securities that have longer holding periods not significantly higher than those with shorter holding periods-- there has been less yield to be gained for the additional risk we must take when going farther out on the curve. This scenario is shown in the chart below.
If we expect interest rates (yields) to fallandbond prices to rise accordingly, we will often add duration and invest further out the curve to best capture price appreciation.
When we expect interest rates to be stable, we manage investment portfolios to be “duration neutral.” and concentrate more on individual security and sector selection opportunities.
Q: I’ve been hearing more about an “inverted yield curve” recently. What is that and what does it mean to fixed income investors?
An inverted yield curve is downward sloping and occurs when the yields for fixed income securities with longer maturities are actually lower than the yields for shorter term ones. It is the opposite, or inverse, of the “normal” yield curve, and looks like the illustration below.
Many economists and investment analysts believe that an inverted yield curve indicates a turning point in the economy, with a recessionary period likely to follow in the next year or two. This is because the Fed has raised short-term rates and longer term rates have declined in anticipation of an economic slowdown or lack of inflation.
However, there is also precedent for a relatively flat yield curve to last for an extended period of time without signaling a recession, as it did from 1994-1999. During that 5-year period, the yield curve remained within a range of about 0.5% (50 basis points), similar to where bonds are today.
Q. What is the difference between a “barbelled” bond portfolio and a “laddered” bond portfolio and when would these strategies be used?
A barbell approach can be effective in an environment where the yield curve is inverting--with front end yields rising and long end yields falling (while the center of the curve remains relatively stable).
To create a barbell portfolio, the portfolio manager emphasizes investments at the two extremes of the yield curve, the very front end and the very long end, with no intermediate securities in between. It is referred to as a barbell because your investments are grouped like the weights on both ends of a barbell.
The portion of your portfolio that is invested in short term bonds offers protection when interest rates rise. They will mature quickly and you will be able to reinvest the principal at the new higher rates. The other portion of your portfolio that is invested in long term bonds offers protection from falling interest rates, as this portion of your portfolio will be locked in at the higher rate you got when you initially invested.
Barbells contrast with the traditional laddered portfolio where interest rate risk is spread evenly over short, intermediate, and long term maturities, much like the even, uniform steps of a ladder.
As the yield curve continues to change over time, and interest rates rise and fall, your Cambridge Trust portfolio manager has the tools and expertise to select the bonds that make the most sense for your growth, income, and principal preservation goals; for your risk tolerance; and for the changing market and economic environment. This article is for informational purposes only and should not be construed as investment or legal advice.
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