Wednesday, November 27, 2013

Curiouser and Curiouser

As Alice said so long ago, "It would be so nice if something would make sense for a change."

As the economy continues to strengthen, the bond market continues to weaken. Stocks want good news, while bonds want bad news. A bad economy implies continued Fed intervention, continued Fed intervention implies continued support for bond prices. 

But what happens when bond prices begin to fall in earnest? At some point, the economy will be unquestionably strong and the Fed will undoubtedly step back from its bond-buying smorgasbord.

What is a retiree to do when faced with absolute income needs yet also faced with the absolute certainty that bond prices will fall when interest rates rise? One solution is to buy the shortest maturity bond which produces the yield necessary for the retiree to continue his or her lifestyle. How else can a retiree lessen his or her bond portfolio volatility? The next step after limiting the maturity of the portfolio is to increase the coupon size of the purchased bonds. All thing being equal, the 7% coupon at a 5% yield will be quite a bit less sensitive than a 4% coupon at a 5% yield. 

What about those discount bonds that are held in the portfolio? One alternative is to swap them for high coupon bonds. There are ways to protect oneself as we move into the higher interest rate environment we all expect. Be proactive, seek out competent bond managers, and ride the rising rate environment with much less stress than those who choose to do nothing.

Wednesday, November 20, 2013

Fed Taper of Bond Purchasing

Federal Reserve minutes released today indicated that "tapering" of the Fed's roughly $85 billion per month in bond purchases may begin soon if the economy improves. Fed tapering of bond purchases isn't a surprise, but nonetheless the Treasury market moved to some of the highest yields seen in almost 2 months. Interday yields on the US Treasury 10 Year Note hit 2.76% and yields are expected to move higher over the next 14 months. As is almost always the case, the devil is in the details.

It was not clear whether the Fed would reduce mortgage back security (mbs) purchases or whether it would reduce Treasury purchases. The market took the news in a mixed fashion with yields moving up slightly and the stock market moving down very slightly.

Fed tapering is a far cry from tightening however. The vast majority of bond market participants do not expect the Fed to raise the Fed Funds rate at any point soon. The fear is that tighter short money will only slow the economy, lessen borrowing, and increase the odds of the economy slipping back into a recession.

Blue Haven Capital still recommends a somewhat defensive posture in retiree's fixed income portfolios. Balancing income needs with interest rate risk continues to be a challenge, but now that rates are 1% higher than a year ago, that risk is slightly less than in 2012. Contact us if you are interested in how we conserve and grow portfolios over time.

Thursday, October 31, 2013

Interest Rate Risk in Bonds

For years now, investors have only considered credit risk, and not interest rate risk, in their bond portfolios. In addition to municipal defaults and deteriorating credit situations at large corporations, one now needs to ask about bond volatility. Questions such as "What happens to the value of my bond portfolio if interest rates rise 1%" should be as common as the usual credit questions.

Why do bonds fall in price when interest rates rise? Rather than get into the math behind the question, let's look at what is probably a more intuitive example:

Let's say that a couple years ago, you bought a new issue bond due in 2028 at 5%.
Let's move ahead to today. Let's say that same company is offering a new bond due in 2028 at 6%. In other words, rates have gone up.

Which bond would you rather own? Same company, same bond, same maturity. You would, of course, rather own the 6% bond. Another way of saying this is "The 6% bond is worth more to me than the 5% bond."

That's it in a nutshell. When rates move higher, bond prices fall. People will pay a little less for a lower coupon bond than a higher coupon bond.

How much bonds change in price gets into math that I don't want to cover here. A good rule of thumb is that a 1% rise in interest rates will cause your bond portfolio to fall in price in an amount roughly equal to its average maturity. So, an 8 year average maturity bond portfolio might be expected to fall 8% with a 1% rise in rates.

There are ways for bond portfolio managers to actually lessen volatility while keeping maturity the same. To read more about this, go here.

Don't ignore your bond portfolio. Today's retirees most likely have at least 40% of their portfolio in bonds and that is too much money to leave to chance. It needs to be tended to with the same care that the equity portion of your portfolio has received.

Wednesday, May 1, 2013

$17 Billion Apple Bonds

Aa1/AA+ rated Apple came to market yesterday with $17 billion in debt issuance divided into a few different maturities and structures. Apple's floating rate paper came at +05 to LIBOR for the three year paper, +25 to LIBOR for the five year paper. 10 year fixed rate bonds came at 2.415%, or +75. Interestingly enough, by the end of the day, the bonds had become even more expensive.

Most bond portfolios are full of finance paper such as JPMorgan, Morgan Stanley, and Bank of Montreal, which is part of the reason Apple's sale was so successful. A new name means additional diversification in a portfolio, but the short paper seems quite expensive. 10 year Apple at +75 doesn't seem bad though, although the low coupon made it less attractive (for a discussion on low coupon versus high coupon volatility, see this piece).

Today the paper traded up in price relative to the rest of the market and was the heaviest traded issue according to MarketAxess. We still recommend higher coupon bonds for portfolios that demand less volatility, but we are keeping a close eye on how Apple trades in the secondary.

Thursday, April 25, 2013

How to Safely Retire Early

Recently, published a story titled "6 signs that you are ready to retire early." As the baby boom generation matures and more people hit the "normal" retirement age of around 65, many boomers are asking whether or not at 55 they can retire.

 The first question someone needs to ask is whether they can live on their anticipated retirement income for some period of time. The article recommends 6 months, although 12 months might be a more realistic test period.

The second question one needs to consider is whether or not the retirement portfolio, when paired up with savings, can support the withdrawal rate that will occur when retirement comes along. These days, a 4% withdrawal rate is about the most a person should consider for their portfolio. On $1mm, that means a maximum of $40,000 a year could be safely withdrawn. Lately, with interest rates as low as they are, that can be an immediate deal breaker.

Other points covered in the article are important, but these two seem to be the most important. 1) Can I live on my anticipated retirement income and 2) Am I assuming a 4% or less withdrawal rate from my savings and retirement portfolios.

Thursday, March 28, 2013

Bond Coupons and Price Changes

Here we are in one of the lowest interest rate periods in history, perhaps poised on the edge of a rising interest rate environment. Naturally, a question one might ask is "How much will my bonds fall in price when interest rates rise?"

Bond sensitivity, or the amount a bond changes in price according to an interest rate change, is referred to as "bond duration." Bond duration is tied to bond coupons and bond maturities. As complex as equations like this look:

 V = \sum_{i=1}^{n}PV_i

most investors with a bond portfolio or with a bond fund or bond ETF portfolio need to know only one thing: "What is the average duration of the bonds in my portfolio/fund/etf?"

Once an investor knows his or her average duration, that investor has the information to then answer questions like "What will happen to my portfolio if interest rates rise 1%?"

Let's take a look at an example:
Investor A has a $1mm bond portfolio (or bond fund or bond etf) with an average duration of 10 years. With a 1% rise in interest rates, that investor's portfolio would fall in price approximately 10%. So, a $1mm bond portfolio would fall to $900,000.

Here comes the tricky part: Let's say the investor needs the 5% yield that he or she can only get by going out 15 years in maturity. If that investor bought par bonds at 5% yield to maturity, that investor's duration would be around 15 years. However, if that investor bought 6% or 7% coupon bonds, still at a 5% yield to maturity, some interesting things happen.

First, in both cases that investor would receive a 5% yield to maturity. However, in a 1% interest rate rise, the investor buying par bonds might see a $150,000 price decline in his portfolio. On the other hand, the investor buying the 6% or 7% bonds might see only a $120,000 decline in his portfolio.

That's right. In both cases, the investor achieves a 5% yield to maturity but in the second case, the investor has a less sensitive bond portfolio and saves himself $30,000. This is the sort of thing a bond portfolio manager will work on all day long: how to structure a less sensitive bond portfolio when faced with the possibility of rising interest rates.

Watch your bond portfolio carefully. Does it have high coupon bonds? Low coupon bonds? Is the maturity longer than you need for the yield you need? Is your bond manager actively seeking less sensitive bonds? This could save you $20,000 or more in the next few years if we indeed move into a higher interest rate environment.

Wednesday, February 27, 2013

If You Can't Beat 'Em, Join 'Em

The Journal of Indexes had an interesting article in its March/April 2013 magazine titled "Are Active Mutual Funds Becoming Less Active?"

The conclusion is that yes, active mutual funds ARE becoming less active. One theory behind this movement is that the managers are moving to an indexing management style. Since there has been mounting evidence of increased correlation in the stock market, a manager's "ability" to to choose a security which would outperform the average of the index has become increasingly difficult. Some would argue that there has never been a manager that has been able to outperform his or her index except for pure luck, but we'll save that for another story.

If indeed the active mutual fund managers are moving to an indexing style of management, it is even more important for the investor to look at the cost of doing business with that mutual fund. Many equity mutual funds have internal fees ranging from 1 1/2% to 1 3/4% or more. When these fees are put up against index ETF fees which may range as low as 0.05%, underperformance of the more expensive mutual fund is almost a guarantee.

While consumers may roll their eyes at 1 1/2%, remember, it adds up to real money. For a portfolio of $1mm, that 1 1/2% represents $15,000 per year on wasted mutual fund fees. That is money that could be going to the investor rather than the mutual fund company.

As individuals with larger portfolios enter retirement and search for ways to fund retirement and create retirement income, they should carefully investigate mutual fund fees. $15,000 a year is a lot of money to waste. 

Tuesday, February 5, 2013

Stay in Money Market or Go Out Slightly on Curve?

The most common question we are getting from the media right now has to do with "bonds getting slaughtered" and "do you think we are in a bond bubble?"

The answer to the first question is "which bonds?"

The answer to the second question is "yes."

Let's take a look at staying in money market (currently earning about 2/10ths of 1%) versus buying a 10 year bond. If we were to buy a 10 year bond (say GE 5% due 7/15/23) at 3.50%, what would happen if we have a yield curve rise (interest rate rise) of 1% over the next 24 months? How do we look 24 months from now if we have a parallel shift in the yield curve 100 basis points higher?

Well, rolldown is currently worth 22 basis points a year, meaning in 2015, we'd be looking at 3.50% rolling down to 3.06%. However, add in a 100 basis point rise in rates and voila, we are at 4.06%. In this scenario, our bond has fallen 3.78% in amortized principal value while the client has picked up 7% (3 1/2% x 2 years to make it simple) in yield.

The net gain or loss to the client is a gain of 3.22%. The person sitting in money funds has gotten 4/10ths of 1%...perhaps as much as 1.40% if they captured the move in the funds rate.

At some point, it makes sense to hide out in money funds, but in a steep yield curve environment, it more often than not makes sense to buy the 7-12 year part of the curve.

The difference of a 1% or 2% return may not sound like much, but when you are looking at a portfolio of $2mm, you are talking about anywhere from $20,000 to $40,000 difference in value.

We urge everyone to quantify their bond exposure and not fall prey to the media's hype.