What are the strategies in bonds investing? Bonds are issued by the government or by corporations. Investors buy bonds to obtain higher income from their capital. Most investors don’t think in terms of a total return, however. They are perfectly happy to receive just the percentage they opted for. Income, however, is only their first part of a total return.
The second part comes from the appreciation of bond prices. This appreciation may exceed the income received from bonds for a total return of 30% plus. This is possible during a period of substantial decline in interest rates. When the interest rates rise you can limit your total return just to the income from your bond investment. These periods repeat themselves from three to five years.
In order to take advantage of total returns, investors have to establish the direction of interest rates. Are the interest rates going to go higher, lower, or are they going to be neutral? After you make this assessment concentrate on which bonds to select. To explain, let’s move back to May of 2000. The long government bonds yielded 14%. The difference in yields between the government bonds and bonds with inferior credit ratings was approximately 4%. Most of the bonds in the secondary market were selling at a substantial discount to effectively yield 10% to 14%.
Let’s assume that you correctly predict a substantial drop in interest rate over the period of the next two years. What bond characteristics would you be interested in to take maximum advantage of your correct prediction? Would you buy:
short or long-term bonds? short or long duration bonds? premium or discounted bonds? high or low quality bonds?
The correct answer is to purchase long-term, discounted bonds of long duration which are of low quality. The paragraph below discusses the correlation between bond prices and their characteristics.
Maturity – maturity is the most important bond characteristic. Th longer the maturity the bigger the price fluctuation of the underlying bond. Maturity has the greatest effect on bond prices.
Duration – duration is a key measure of the cash flow the bond throws off, year after year, until it matures. For example, if an investor pays $1,000 for a 12%, for some 20 year junk bond, on day one the investor has $1,000 at risk. In six months, he’ll get a $60 semi-annual interest payment. Now $60 of the $1,000 that was put at risk has been repaid. Each incremental interest payment further reduces the amount the investor has at risk. After 8 1/2 years, the investor has received $1,020 in interest, which is more than the $1,000 that was invested. The maturity of the bond may be 20 years, but the duration is about 8 and a half.
Compare the 12%, 20 year junk bond with a 20 year zero-coupon bond, bought at a discount and paying nothing until it matures. Because there is no cash flow from the zero, its maturity and its duration are the same; 20 years. The zero coupon figures to be more than twice as volatile as the coupon issue and as such is the riskiest bond security an investor can own. A 100 basis-point (one percentage point) rise in rates on a 20 year zero will drop 20% of the value of the security. That’s a huge change in the price of a security with a fairly small overall change in interest rates. The same increase will knock only 2% off a security with a two year duration. That makes sense given the formula: change in interest rates multiplied by the duration equals change in price.
Price level – the price of the bonds appreciates as the interest rate drops and vice versa. Bonds are first issued at $1,000 per bond (par). If the price of a bond declines below par (because the interest rates rose) they are discounted. If they rise above par, they are sold at premium. The price of discounted bonds rise rapidly and fully participate in an advance as the interest rates decline. The price of par bonds rise more slowly and premium bonds the slowest because of the fear of bond redemptions.
Quality – when interest rates are at their highest, investors are fearful about the economy and are seeking bonds of the highest quality. This causes bonds of substandard quality to yield much more in order for them to become attractive to more venturesome investors. It’s not unusual that the spread between the bonds of the highest quality and lowest quality is 4%. When interest rates decline this spread narrows to approximately 1%.
Investors who correctly predicted the decline of interest rates in May of 2000 bought long-term, long duration, discounted bonds of inferior quality. The income they made varied from 14% – 18 % and 18% – 20% from their price appreciation for a total return of over 32% annually. What: should you do today? If you believe that the interest rates are likely to rise; you should buy short-term, short duration par bonds of the highest quality. The total return will be limited to only the income stream from these bonds, however. Your bonds will be subjected only to minimum market fluctuation. In the future, if and when your forecast on interest rates changes, you’ll be ready to repeat the 2000 scenario and to buy long-term, discounted, low quality bonds.