The Federal Reserve is toying with the idea of dialing back quantitative easing (increasing the money supply) in the near future. With this, investors can expect interest rates to gradually begin to rise. Bonds, notes, and many other fixed securities issued at the lower rates of interest will begin to decline in value as investors move into higher yields brought about by rising interest rates. Buying opportunities can also flourish with fixed securities that have lower rates of interest as their prices are likely to fall. Let’s take a look at a paradigm I’ve used in the past to purchase bonds and other fixed instruments.
Fixed Securities Type: Any fixed security pays the investor a set rate of interest provided by a contract of some sort. There may be modifying covenants to the contract, but generally speaking the interest returned will not change. The most common types of fixed instruments for private investors are bonds, notes, certificates of deposit, commercial paper, and others. For the purposes of this analysis, bonds will be discussed as they encompass most of the characteristics of how fixed investments work.
Coupon Rate: The coupon rate is how much interest each individual bond pays. It is always computed at par (or face value), generally $1,000 for most bonds. For example, if you buy bonds that have a coupon rate of 6% at a 10% premium, you’ll pay $1,100 each for the bonds, but the annual interest will be 6% of $1,000 or $60. The coupon rate figures into the model, but its importance is often eclipsed by the price and yield to maturity.
Price: Bond prices are referred to in terms of percentages with par being 100 (or 100%). If a bond is paying a higher coupon rate, likely the price will also climb to 105, 110, 120 or 130, etc. I’ve observed the price of certain bonds climbing as high as 195, or nearly twice face value. The price is a great component of the yield, and prices are bid upon in the market like stock prices, so it’s of value to shop for good prices when buying bonds. It’s further wise to confine bond buying to a price range of 100 to 110 or so to avoid paying for excessive premiums.
Yield To Maturity: A 6% bond bought at par and held it to maturity would have a yield of 6%. But seldom are bonds traded exactly at face value. Therefore, the yield (what the bond returns) is of great importance, and is set at the time of purchase. For example, a $1,000 bond bought at 107 will require an investment of $1,070, but pay only $60 annual interest for a yield of 5.6%. The coupon rate of a bond will never change, but the yield will change as the value of the bond changes, thereby creating a statistic known as the current yield. The current yield is what the bond yields at any point in time as determined by the price divided by the coupon rate. The maturity date is highly important as the value of the bond will steadily revert to par the closer the bond gets to its maturity date. As bonds mature, they will only return the par value and not necessarily the original purchase price (if they are called, this might be different depending on the bonds covenants). For most private investors, bonds are a capable “buy and hold” investment. But sometimes certain bonds will build up a premium that can outstrip the yield to maturity (think 195) making the bond expendable in favor of cashing the premium.
Callable: Callable bonds have a provision for the issuer to redeem them at a certain price (sometimes par) when the issuer so desires. This is important when interest rates are falling, as the issuer will be seeking to reissue the debt at a lower rate of interest. Sometimes the call provision will state “make whole,” meaning the issuer will pay a price very near the current price of the bond instead of par. If interest rates are going up, the risk of bonds being called is reduced, and if par is the call price, the value of the bond will have this priced in at the time of purchase.
Coupon Frequency: This is simply how often the interest is paid. Most bonds pay semiannually, but some pay quarterly, annually or even monthly depending on the bond’s covenants. The interest is computed annually but earned on a daily basis, and gets paid to the investor up to date whenever the bond is sold. For example, the $60 annual interest paid semiannually on a $1,000, 6% bond amounts to $30 every six months. If the bond is sold three months after the pay date, the seller receives $15 accrued interest with the sale proceeds, and the buyer pays this amount as he/she receives a $30 payment in only three months instead of six. A good strategy is to stagger the pay dates as much as possible to keep a steady cash flow coming in to the portfolio.
Risks: The risks impacting fixed instruments are two-fold, default risk, and interest rate risk. Default risk is plain and simple—the company invested in cannot pay back the principle or the interest. Each investor needs to study the fundamentals (especially financials) of the company he/she intends to invest in to be satisfied that default is not imminent. Interest rate risk is less destructive but also trickier. Investing in a 6% bond when interest rates rise to 8% should cause a decline in the value of the 6% bond. This doesn’t become near fatal as a default could be, as long as the investor can hold the bond to maturity and collect all that it was originally bought to yield. In this case the risk is more foregone opportunity, as the money could be earning higher interest. Even in default, bonds and secured notes generally have priority in liquidation that will translate into some sort of belated return of principle. Other types of fixed instruments might not be secured and would have a lower status at liquidation.
Credit Rating: Moody’s, Standard and Poor’s, and Fitch’s (among others) all rate bonds as to their credit worthiness. This is significant because many investors trust these credit ratings, and that can affect the value of the bond. Best practices when screening for bond purchases is to set a minimum rating of BBB+ and take it from there. Ratings higher will cost more and therefore yield less, but those lower will be much riskier. The best balance of value versus risk comes more or less at the BBB or Ba level.
Bond Ladder: A good bond portfolio will not have all the bonds maturing at the same time. Why? Because the investor does not know at the time of purchase what the market rate of interest will be when the bonds mature. Without some spacing of the maturity dates, the investor could be faced with a large portion of his/her bond portfolio maturing at the same time when interest rates might be very low. Best practices would be to have all the bonds mature at different times thereby creating a ladder.
Conclusions: For many private investors, fixed investments comprise a significant part of their investment portfolios. The basic 60/40 portfolio consists of 60% equity and 40% fixed. As private investors get older and into retirement, this ratio can get inversed to 40% equity and 60% fixed to provide more cash for the retirees to utilize. The percentage of fixed should rise, but should not reach 100% as private investors should still keep a stream of growth from equities coming into the portfolio even late in life. In the final analysis, investing in fixed securities is simply a loan to a corporation or other entity. There is no equity involved, and only a minimal amount of growth under certain circumstances.