TriDelta Financial

Risk Management Series – Bonds, Part 2

0 Comments

October 25, 2013 Lorne Zeiler Bonds, Income, investing, Risk, safe investing, yield

Why Do Bonds Trade at a Premium?

Bond pricing is a function of a number of moving parts: namely, coupon rate, market interest rates, credit quality, and term to maturity. As a result, bonds often trade at a premium or discount to their maturity value (usually $100); this can cause confusion and frustration for investors.

We outline some of the key elements of bond pricing and its relationship to current market interest rates so that you can better understand how bonds are priced. As mentioned in Part 1 “Risk Management Series – Bonds” in between the date when a bond is issued until its maturity date, its market price (the price at which the bond trades in the market) will fluctuate.

When a bond is issued, its coupon rate (interest rate paid on the bond) is reflective of the current market interest rate environment for bonds of similar quality and that have a similar term to maturity. E.g. if Royal Bank of Canada issues a 5 year bond maturing on September 30, 2018 and the market interest rate for similar bonds is 3.0%, then the coupon rate on the Royal Bank of Canada will be approximately 3.0%.

iStock_000000674097XSmall If interest rates decline after a bond was issued, then any bond paying a higher coupon rate than the market interest rate should have a premium value. For example if market interest rates for 5 year bonds decline from 4.0% to 3.0%, then a bond that pays a coupon rate of 4.0% is now worth more, because the investor is receiving 1.0% more in payments per year than the market rate. Consequently, the bond with the 4.0% coupon should trade at a premium (trade at a higher price than it was issued at) to balance out the higher fixed interest payments.

In order to determine how much of a premium (or discount) each bond should trade at, fixed income (bond) portfolio managers compare bonds of similar quality with similar maturity dates using a calculation called Yield to Maturity (YTM). This calculation determines the total return an investor can earn on a bond purchase based on: 1) the bond’s current market price, 2) its coupon rate, 3) maturity date and 4) maturity value (usually $100.00).

For example, let’s say Royal Bank issued a 10 year bond in September 2008 paying a 5% coupon rate with a maturity date of September 30, 2018 (Bond A). Royal Bank also issues a 5 year bond on September 2013 that matures on September 30, 2018 with a coupon of 3.0% (Bond B). So even though the bonds were issued on different dates, they currently have the same maturity date and as such are quite comparable.

Bond A should trade at a premium because from now until maturity, Bond A investors will receive 2% more each year in interest income than Bond B investors ($10 in total benefit over 5 years). Based on the yield to maturity calculation, Bond A would have to trade at the premium price of $109.22 to offer a total return of 3% per year for the investor (the higher price offsets the higher interest payments). Consequently, bond investors today may notice that many of the bonds in their portfolios were bought for prices well above their $100 face values, but that these bonds likely have higher coupon rates. Bond A’s premium will decline each year (also known as price decay) as it approaches maturity, because it is one less year that you are collecting the higher coupon rate. To get a fuller picture, investors need to look at both purchase price AND the coupon rate offered by each bond.

The objective of the portfolio manager is to provide the greatest total return to the investor, which includes both the loss (or gain) on the value of the bond PLUS the interest payments received. If the portfolio manager feels they can earn a higher total return by buying a bond with a higher coupon rate, but it trades at a premium, they will do so. In the example above, if he can buy Bond A for $108, they could earn 3.25% per year for their clients vs. just 3.0% by buying Bond B. A large part of a fixed income portfolio manager’s job is to perform these types of comparisons to try to attain higher total returns for clients.

Accumulated Interest

Another reason that a bond may trade at a premium is to reflect accrued interest. Most bonds only pay interest two times a year (semi-annual payments). For example if the bond was issued in December, it will make coupon payments in June and December; if the bond was issued in March, it will make coupon payments in March and September. But, if you buy the bond on the market in between those coupon payment dates, you essentially are getting additional payments.

For example, if a bond makes payments in June and December and you buy the bond in May, you will have held the bond for one month, but you will have received 6 months’ worth of interest. Bond prices reflect this benefit, typically by adding the accumulated amount of interest owing to the purchase price of the bond. For example, if a $100 bond is paying a 6% interest rate (paying $3 twice a year) and the investor buys that bond at the end of April, there is $2 of interest already built up, so the bond should trade for $102.

Bond pricing, performance and payments are often quite complex and difficult to understand, because unlike equities where investors generally look primarily at its current market price vs. purchase price to see if they made money on their investment, bonds require analyzing both the purchase price AND coupon payments received. As described above, there are many times when a bond investment may appear to have a negative return from a price perspective, but has often provided a positive return once you have included the coupon payments.

Illustration of Pricing of Bonds A and B from the article

Bond A Pays a 5.0% coupon. Bond B pays a 3.0% coupon. Both bonds mature in 5 years, September 30, 2018.

Annual Coupon Payments	Bond A	Bond B
September 30, 2014	$5.00	$3.00
September 30, 2015	$5.00	$3.00
September 30, 2016	$5.00	$3.00
September 30, 2017	$5.00	$3.00
September 30, 2018	$5.00	$3.00
Total Payments:	$25.00	$15.00
Difference:	+$10	Bond A trades at premium due to higher coupon payments

Written By:
Lorne Zeiler, MBA, CFA
VP, Wealth Advisor
Lorne can be reached by email at lorne@tridelta.ca or by phone at
416-733-3292 x225

Risk Management Series – Bonds

0 Comments

October 3, 2013 TriDelta Financial Bonds, Income, investing, Risk, safe investing, yield

Are Bonds Still Safe?

Investors have historically been told that bonds, while generally offering lower returns, are the safe portion of their investment portfolio. Over the past few months through mid-September, nearly all bond (fixed income) investors have lost money and in many cases these losses have been greater than 5%. So this raises the following questions: are bonds still a ‘safe’ investment? Why had they gone down recently? What do we expect in the future? Should they still be included in your portfolio?

What are Bonds?

Bonds are a contractual obligation by the borrower (issuer). The borrower (usually a government, government agency or corporation) agrees to pay a specified amount of interest (coupon) for a fixed period of time and to return the principal amount to the investor on the maturity date.

Why are bonds considered Safe Investments?

If you buy a bond issued by a financially strong company or government and you hold that bond until maturity, you nearly always make a positive return, as the bond issuer repays your principal (amount that you originally invested) AND interest. Bonds are considered safer than stocks, because all that has to happen for an investor to earn this positive return is that the company or government not go bankrupt, i.e. if the company is still an operating business on maturity date, the bondholders have to be paid their principal investment and their interest earned. Even in the event of a bankruptcy, bond holders often get paid in part or in full since bond investors have priority to the company’s assets.

Stocks by contrast are not a contractual obligation. Investors buy stock (equity) based on that company’s future earnings, i.e. the company’s ability to increase profits. If the company is unable to increase its net income (profits) over time, its stock is likely to decline in value.

Why have bonds gone down recently?

In between the date that a bond is issued and the date it matures, its price fluctuates based on a number of factors, including: interest rates, general economy, market sentiment and volatility, default risk, liquidity and for foreign bonds, changes in currency values. As a result, investors can earn more or less than the coupon amount (or even experience a loss) during periods of time in between the purchase date and maturity date of the bond. While the two main factors that typically affect bond prices are credit and interest rates (more will be discussed on these factors at the end of the article), the recent price decline has largely been a result of central bank policy, particularly quantitative easing.

Quantitative Easing – The Main Reason for the Recent Drop

Quantitative easing was initiated by the U.S. central bank, the Federal Reserve, as well as the European and Japanese central banks, amongst others, to help stimulate their economies following the Financial Crisis in 2008. These central banks, in addition to setting overnight interest rates near 0%, bought longer maturity government and mortgage bonds to increase money supply and flatten the yield curve. For example, since September 2012, the Federal Reserve has been purchasing $85 billion of longer-date U.S. treasury bonds and mortgage backed securities each month, which equates to over $1 trillion per year .

The aim of quantitative easing is to suppress interest rates for longer-dated bonds. This forces investors into riskier investments to earn a reasonable return, such as corporate bonds, equities and real estate and encourages businesses to invest and consumers to spend because of the low cost of credit. As a result, interest rates on 10 year bonds have been held near historic lows since 2009 and were between only 1.5% to 2.0% for most of the past year.

This changed in April 2013 when the Federal Reserve Chairman, Ben Bernanke and other officers started talking about tapering (reducing) these bond purchases, i.e. reducing and then eliminating the quantitative easing program. Investors feared that without the central bank as buyers that longer-term interest rates might go way up in the future, so many began to sell (i.e. if supply of bonds remains the same and demand (central bank purchases) goes down, yields go up). The interest rate on the 10 year US Treasury for example has gone from 1.62% in early May to 2.94% as of Friday, September 6th. Holders of those 10 year bonds have lost more than 10% during that three-month period as bond prices have gone down, i.e. for current 10 year bonds to move from a yield of 1.6% to 2.94%, their price must drop by over 10%. TriDelta’s own fixed income portfolios experienced losses during that period of 3.4% for Core and 4.7% for Pension.

What Do We Expect for the Future?

While we at TriDelta believe that interest rates are likely to go up in the future, we expect that this process will take much longer than most people believe, perhaps a number of years. We also believe that bond yields have gone up too high and too fast over the past six months. The performance of bonds over the past two weeks seems to back-up this view. The Federal Reserve decided on September 18th to not taper its quantitative easing program. Since then bond prices have gone up over 3% as reflected by the US 10 year bond. We at TriDelta believe there could be a further opportunity over the next number of months to generate more gains as bond yields continue to decline. We also believe that corporate and high yield bonds provide attractive returns as many of these companies are in a strong financial position with low overall level of debt and offer a premium yield to government bonds.

Why Include Bonds in an Investment Portfolio

In addition to being considered the safe part of the portfolio, bonds provide a reliable income stream and have a low and negative correlation with equity markets.* This means that if the equity market declines, bonds are likely to increase in value, providing downside protection for a portfolio. Investors often sell their equity holdings due to fear, these same investors buy bonds during these periods for security. By including bonds in a portfolio, they reduce overall volatility and often enhance overall returns. Lowering volatility also has the benefit of helping investors stick to their financial plan. While we do expect equity markets to be higher in the long-term, there will be periods where we could experience drops, bonds should help protect client portfolio values, enabling them to attain their investment goals.

*http://blogs.wsj.com/moneybeat/2013/09/06/rising-bond-yields-cast-shadow-over-equities/

Key Risks to Consider for Bonds in Normal Markets

Credit Risk reflects the potential that a bond could go into default, i.e. declare bankruptcy or issuer is unable to refinance. In that case, the investor would not be paid their interest and could lose some or all of their principal investment. This potential risk is reflected in the interest rate paid by the issuer. The higher the perceived credit risk (risk of a default), the higher the coupon (interest) rate. Typically, when the economy declines (recession) or growth slows, investors become more worried about the risk of default. Consequently, investors during those instances demand a higher interest rate (coupon) from corporate and high yield bond issuers.

Bond managers can often enhance returns by buying more corporate or high yield bonds when the economy is improving or growing and credit spreads decline and can protect returns by owning more government bonds when the economy is declining. Typically, government bonds pay the lowest interest rate as they are considered the lowest risk, then high quality corporations pay slightly higher, but still low rates, such as BCE, TransCanada Pipeline and the Royal Bank of Canada, with riskier companies, such as Barrick Gold Corpoation, paying a higher coupon.

Maturity Date / Interest Rate Risk – Bonds with longer maturity dates tend to pay a higher interest rate than those with shorter maturity dates. This is because there is more certainty in what will happen in the short-term, so investors are willing to accept a lower interest rate. In the longer-term, there is more uncertainty (will rates go up? will there be higher inflation?), so investors expect to be compensated with a higher interest rate to take on the risk of this greater uncertainty. When short-term interest rates increase as a result, yields on bonds go up (bond prices go down), but not in a uniform way. Yields on bonds with a longer maturity dates could go up more, meaning that their prices drop more. For example, if interest rates go up 1%, a 5 year bond will likely see its price drop by 4-5%, while a 10 year bond will likely see its price drop by 8-10%. The inverse happens when short-term interest rates go down – longer dated bonds prices go up more.

Portfolio Managers who can anticipate when short-term interest rates may rise or drop and adjust the maturity dates of their bond holdings to reflect their views, can enhance returns for their clients.

Lorne can be reached at lorne@tridelta.ca or by phone at (416) 733-3292 x 225.

Edward can be reached at edward@tridelta.ca or by phone at (416) 733-3292 x 229.

Articles

Risk Management Series – Bonds, Part 2

Risk Management Series – Bonds