Fixed Income Strategies
- Introduction to Fixed Income Investing
- Optimizing Portfolio Returns
- Laddered Maturity Portfolio
- Barbell Investing
- Matched Asset Program
- Discount Bond Investing
- Premium Bond Investing
- Best Value on the Yield Curve
Introduction to Fixed Income Investing
Raymond James is committed to providing each client with personalized service and we believe that investment strategies should be tailored to meet each investor’s particular financial needs. When it comes to fixed income investments, our strategies emphasize long-term growth and current income foremost while addressing the direction interest rates may be headed. In viewing fixed income as one part of an overall financial plan, we stress long-term objectives, diversification, and discipline, which can help investors to neutralize the emotional pitfalls of investing.
Before investing in fixed income products, every investor should understand what bonds are, their relevant risks and rewards, and factors that influence their prices and returns.
Individuals generally choose fixed income investments for two basic reasons:
(1) for a stable income stream, and
(2) to attempt to protect principal value.
Fixed income investors should begin with a core portfolio that has a solid foundation, acceptable level of risk, stable returns across interest rate cycles, and, if possible, favorable tax considerations. Yields can be enhanced by investing in bonds in sectors that offer the best relative value in terms of yield differential and in positions that are callable to site a couple of examples. Remember, just as interest rate levels change, so can an investor’s objectives. Fixed income portfolios should be reviewed periodically and adjusted, when necessary, to reflect current financial goals and market conditions.
A number of investment strategies can be tailored to meet each investor’s financial objectives.
Optimizing Portfolio Returns
As a general rule of thumb, yields move contrary to bond prices: as interest rates rise, bond prices fall; and, when interest rates fall, bond prices rise. By holding fixed income investments, over time investors may be able to ride out the market's ups and downs.
Below we discuss several time-honored fixed income strategies that may be implemented to help investors to attain their financial goals. Some strategies may be more or less suitable depending on market conditions.
Laddered Maturity Portfolios
This investment technique provides the benefit of blending higher long-term rates with short-term liquidity. The resulting diversification helps to reduce risk, improve returns and allow for reinvestment flexibility, while also providing liquidity and a predictable cash flow.
A laddered portfolio is structured by purchasing several bonds with consecutive maturities. As each bond matures, proceeds are reinvested in a new bond having a maturity that corresponds with the longest term on the ladder, which often is near the highest point of the yield curve. Bond ladders containing non callable bonds may be more predictable as there is no possibility for early redemption by the issuer. Some examples of the ways in which we can structure a laddered portfolio are listed below.
Since most bonds pay income on a semi-annual basis, selecting six specific bonds that pay interest in different months will create a monthly stream of income to supplement other income or provide an opportunity for reinvestment. We can customize cash flows to meet your income requirements.
- Systematic Investing
Investors, who do not have sufficient funds to build a complete ladder but can save enough for a rung each year, should begin in the middle and add positions on either side in subsequent years. For long-term investors, systematic investing also provides the ability to take advantage of swings in interest rates.
From time to time, depending on market conditions, certain opportunities arise to further enhance returns on fixed income portfolios. Below are several general examples.
A barbell strategy entails investing at the short and long ends of the yield curve and is generally employed by investors who expect the yield curve to flatten. Short-term investing provides liquidity and less risk as rates increase. However, when rates start to drop, the long end provides a potential for capital gains.
Matched Asset Program
A Matched Asset Program "matches" higher-risk investments, such as equities, mutual funds, etc. with a U.S. Treasury zero coupon bond to guarantee the return of all or a portion of the original investment value at maturity. This strategy can help a well diversified investor to access potentially higher returns while ensuring principal preservation.
Discount Bond Investing
If high current income is not an objective, purchasing lower coupon bonds at a discount to their par value may offer several advantages:
- Lower cost and lower reinvestment risk as accretion to par value is part of the return;
- Capital gains potential (especially if bonds are callable prior to term) if there is the expectation of lower interest rates;
- In a tax-deferred account, longer maturity deeply discounted zero coupon bonds can provide maximum capital gains potential and little reinvestment risk.
Discount bonds were originally issued in a lower interest rate environment and, today, sell at a discounted price in order to compete with the current yields available in the market. Investors should remember that the market price of a deep discount bond is more volatile than that of bonds trading at par or higher.
The most popular deep discount bonds available are U.S. Treasury Zero Coupon Bonds, also known as STRIPS. These bonds are issued at discounts to the face value of $1,000 per bond. Like other zero coupon bonds, they do not make periodic interest payments, rather these payments are compounded to reach the full face value at maturity. Although interest payments are not made to investors, interest accrued is taxed annually as ordinary income.
Premium Bond Investing
These bonds - which trade at prices above par value - offer superior current income potential. The premium paid at the time of purchase is recouped through higher interest payments. Furthermore, "cushion bonds" (callable bonds trading at a premium) often offer higher yields than non-callable bonds as a compensation for the potential of a call. In a rising interest rate environment when the potential of a call typically diminishes, these bonds also provide a bit of cushion because they tend to remain relatively stable and depreciate less in price than comparable non-callable bonds with lower coupons. In any case, bonds are always quoted on the yield to the worst case scenario.
A technique of rolling callable bonds (continuous purchase of callable bonds with proceeds from previously called bonds) is often utilized by professional money managers in an attempt to increase current returns of an intermediate bond portfolio.
Best Value on the Yield Curve
Depending on the shape of the yield curve, investing in the highest yielding bond may not be the most beneficial. The longer the maturity the more volatile the market value will be to changes in interest rates. In purchasing an individual bond, an investor should analyze the risk-reward ratio between purchasing different maturity bonds.
For example, providing that all other factors remain constant, for every one percent rise in rates, a 10-year bond will drop approximately 7% in price and the 30-year bond will drop approximately 12% in price. So it may benefit the investor to analyze whether the extra yield picked up for extending the investment for 20 more years is worth almost doubling the risk to principal. The answer depends on the shape of the yield curve.
Credit Quality Swaps
Bonds trade at different yields depending mostly on term to maturity and credit quality. The lower the quality the more yield compensation investors will demand. Bonds are usually rated by either Standard and Poor’s or Moody’s Investors Service. However, yields are better indications of the quality of the issuer and the likelihood of the issuer’s ability to continue to pay interest and repay principal at maturity. A Credit Rating of a security is not a recommendation to buy, sell or hold securities and may be subject to review, revisions, suspension, reduction or withdraw at any time by the assigning rating agency. Consistent comparison of yields against benchmarks may provide opportunities to upgrade the holdings in a portfolio. Conversely, at times fundamentally sound issuers may experience temporary increases in spreads (extra yield compensation over the Treasuries) providing additional opportunities for investors.
Considerations When Investing In Bonds
Bonds are subject to risk factors that may decrease (or increase) the market value of your investment.
Interest rate risk is the risk of changing market value of an investment, up or down, due to fluctuations in interest rates in the U.S or the world. Generally, a rise in interest rates decreases market price; a fall in interest rates increases market price.
As always, holding bonds to maturity assures the return of principal at par value, subject to the credit worthiness of the issuer. But, sometimes an investor needs to sell the position prior to maturity. It is then that price volatility becomes an issue. In general, the volatility of the bond equates to its duration. In oversimplified terms, modified duration is a measure of an investment’s sensitivity to interest rate changes. For instance, if a bond's duration is 5, a 1 percent move in interest rates results in a 5 percent move in the bond's price.
Default or credit risk is the risk of issuer’s inability to make interest payments or repay principal when due.
Liquidity risk is the level of difficulty with which a security can be sold in the secondary market. Securities, sold prior to maturity, may result in a gain or loss of principal.
A detailed overview of these and other risks is available at FINRA.org or investinginbonds.com.
Raymond James specializes in preparing customized proposals based on our clients’ specific needs. Call your Financial Advisor to review your current holdings, or help you structure portfolio that addresses your needs. Success in fixed income investing depends on structuring a portfolio that will provide returns that meet investors’ objectives, as well as help to prevent the potential erosion of purchasing power due to inflation. All of these may be addressed through proper diversification of maturities, credit quality, and cash flows.