Tuesday, November 4, 2014

Bonds in a Rising Interest Rate Environment

Article excerpt by D Blitzer from S&P Dow Jones Indices

After last week’s FOMC meeting, the time when interest rates begin a sustained rise propelled by the Federal Reserve may be drawing closer.  The received wisdom is that no one should own bonds when interest rates are rising because rising rates mean falling bond prices.  While the math demands that bond prices fall, a deeper look at the math reveals that all may not be lost.

Some investors believe that the yield to maturity on a bond measures the return they will earn if they hold the bond until it matures.  Not quite. There is a hidden assumption that the coupon payments received every six months will be reinvested and will earn the same rate as the yield to maturity.  Since interest rates can vary over time and different rates are available for different time frames, this assumption rarely holds.  When interest rates climb after a bond is issued, the price of the bond drops but the returns earned from reinvesting the coupon income benefits from the higher interest rates.  (The reverse also holds, if rates fall after the bond is issued, its price rises but the returns or “interest on interest” from reinvesting the coupons is less.)  If you buy a bond and interest rise far enough and fast enough, you might do better than if rates never moved at all.

A made-up example shows how this might work and how the investor who holds the bond long enough could benefit.  The table shows a theoretical investment in a 2.5% coupon ten year Treasury note bought on January 15, 2015 at a price of 100.  The yield to maturity when purchased is 2.5%.  If rates don’t change and if each semi-annual coupon payment of $1.25 can be invested at 2.5% annual rate for the remaining life of the bond, the investment will be worth $128.20 on January 15, 2025 when the bond matures. The dashed purple line on the graph illustrates this; the right hand scale is the value of the investment in the bond and the coupons.

Now let’s change the example shown on the table – interest rates rise and the yield paid on newly issued treasury notes rises towards 7% as shown in the second column of the table.  Further, the coupon income is reinvested in six-month T-bills which pay 1.25% less than treasury notes.   The table works out this example: every six months a coupon payment is received and it is added to the past coupon income and the total is invested at the T-bill rate. These coupon payments – the interest paid on the bond – earn “interest on interest.” At the end of ten years the accumulated coupons total $31.10 ($25 of payments plus $6.10 interests earned on the coupons). The total investment is worth $131.10.  The green line on the chart plots the investment value.  In the early years the rising rates depress the bond price and send the investment into negative territory.  As the accumulated coupon interest increases and as the bond approaches maturity, the investment moves into positive territory and surpasses the theoretical case of no change in interest rates (the dotted line).


If it is possible to make money with bonds when interest rates rise, why are so many people worried that rates will rise?  The blue line at the bottom of the chart plots the price of the bond for the same time pattern of rising interest rates.  Just as the math requires, rising rates mean lower bond prices. 

At maturity approaches the price approaches the par value of the bond – the principal to be repaid at maturity. If an investor didn’t reinvest the coupons, if instead he spent the coupon income, all he would have at maturity is the par value.  Likewise, if   the investor had sold out at the low point on the green line (July 15, 2016) the proceeds for the $100 invested would have been $96.50, a loss of $3.50.

There are no magic formulas for bond investing in any interest rate environment, but working the math sometimes helps.

Tuesday, September 30, 2014

Moody's Upgrades J.C. Penney Bonds

Moody's Investors Service recently changed J.C. Penney's rating outlook to stable from negative. 

The change in outlook was prompted by the successful closing of $400 million senior unsecured notes which will be used to fund the partial tender offer for J.C. Penney's $200 million 6.875% notes due October 2015, $200 million 7.675% notes due August 2016, and $285 million 7.95% notes due April 2017. 

At the same time, Moody's changed the Speculative Grade Liquidity rating to SGL-2 from SGL-3 due to improved operating performance and extension of the debt maturity schedule.

Sunday, September 28, 2014

Five Reasons Bill Gross is not likely to have the success at Janus that worked for PIMCO.

1. He is going to work from his home in California while the Janus headquarters remains in Denver.

2. The research staff at Janus pales in comparison to the team at PIMCO

3. Large institutions are not likely to leave the worlds largest fixed income manager - PIMCO for a firm with it's largest fixed income funds that measure in millions versus trillions.

4. Janus appeals largely to retail investors

5. Interest rates are directly opposite where they were when Bill Gross started PIMCO.

Tuesday, September 9, 2014

Low Fund Expenses Result in Higher Returns

One of best ways to win in a low return environment is to keep fees and expenses low. A longstanding pillar for my investments is that reduced mutual fund expenses will improve investment returns.

Unnecessary high mutual fund expenses can ravage investment performance like Pac-man zombies. Furthermore, commissions on investment products can incentivize brokers to promote inappropriate and expensive funds in a world in which most funds are like bananas being displayed in a grocery store.

I have read many studies that show that funds with lower costs tend to outperform funds with higher costs. While there is no Mendoza line for costs, consider this example:

Send two teams of runners out to run a marathon, but require one team to carry 25-pound backpacks. Which team do you think is likely to have the better average time?

Mutual funds with high cost are like runners carrying backpacks. They will drag down your long-term investment performance.

With thousands of funds to choose from expenses can vary wildly. While some stock market index funds feature expense ratios as low as 0.1% (that’s $10 for every $10,000 invested in the fund), the majority of investors are not utilizing these funds.
According to a recent study by Morningstar Research, of every $1 in net investment that flowed into mutual funds last year, 95 cents went into funds that were ranked in the bottom fifth of their category by cost. In most cases the higher cost is used for commissions and marketing for brokers.

The mutual funds with the highest cost are the ones that have a load or sales charge. The simplest load to understand is the front-end load. Nothing too complicated about this one - the day that you buy the mutual fund, you pay a sales fee, anywhere between 3% and 8%…...really!

Wait there is more...Many brokers also recommend back-end load funds. This is a real masterpiece, a state-of-the-art deception product. The expenses mentioned above are parsed from mutual funds annually. In my view, the only purpose of a back-end load appears to be to confuse investors and make them think they are buying a no-load fund when they are not.

Regardless of a front-end or back-end load, investors in these funds are generally not aware that they are needlessly paying excessive fees and expenses.