Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
Fixed income portfolios utilizing individual bonds allow investors to create tailor made strategies based on individual goals and situations. As such, commentaries usually comprise broad tactics and over-arching themes in an effort to educate, expose, discuss, debate, or consider various fixed income strategies or uncover market conditions that potentially can have an effect. I am diverting from this “norm” to deliberate on a working strategy to consider.
Cash Flow Enhancement with Increased Duration
We have openly promoted increasing duration over the last several months. Duration is a measurement of price volatility. An increase may seem like an odd “wish” as it implies taking on greater price risk. Rarely does an action stand isolated. Increased duration goes hand in hand with extending maturities. The longer a bond is exposed to market conditions, the more likely its’ price can be affected. In bond language, interest rate risk is increased. However, this simultaneously suggests that reinvestment risk is decreased. By extending, an investor lowers the risk of having to reinvest maturing dollars but trades that off for potentially increasing price movement.
Why would an investor do this? Many investors and financial experts believe interest rates are heading down. If this happens, the risk of having to reinvest maturing assets at lower rates may be perceived as more uncertain than holding bonds exposed to greater potential price movements. After all, most fixed income allocations are bought with the intention of holding the asset until it matures. If this is the case, market price movements over the holding period may change the way a monthly statement looks but have no effect on a bond’s cash flow, income earned, or future maturity when its face value will be returned. Therefore, barring an outright default, price movements are, in some respect, rendered irrelevant.
Perhaps more importantly, today’s extensions are likely locking into higher levels of income for longer. Interest rates have started to decline but remain at high levels not seen in well over a decade. Many extension swaps permit investors to lock into more income during a high-interest rate environment and for longer periods.
The example portfolio to the left is based on a live trade and highlights many of these changes. In this portfolio, short, lower-coupon corporate bonds, many of which were maturing within 12 months, were exchanged for longer, tax-exempt, 4% coupon municipal bonds. The swap exchanged close to dollar for dollar with only $80 additional cash required. Cash flow was increased annually by $3,534. The duration increased significantly from 2.97 to 13.45. By locking into higher coupons and income for longer, the investor stands to pick up 161 basis points in annual income. Another way to look at this is that instead of waiting for lower coupon, lower yielding bonds to mature and then reinvest, the bonds were sold and pre-invested during a period of time when it is known that interest rates are elevated.