Bond Investment Strategies

The way you invest in bonds for the short-term or the long-term depends on your investment goals and time frames, the amount of risk you are willing to take and your tax status.

When considering a bond investment strategy, remember the importance of diversification. As a general rule, it’s never a good idea to put all your assets and all your risk in a single asset class or investment. You will want to diversify the risks within your bond investments by creating a portfolio of several bonds, each with different characteristics. Choosing bonds from different issuers protects you from the possibility that any one issuer will be unable to meet its obligations to pay interest and principal. Choosing bonds of different types (government, agency, corporate, municipal, mortgage-backed securities, etc.) creates protection from the possibility of losses in any particular market sector. Choosing bonds of different maturities helps you manage interest rate risk.

With that in mind, consider these various objectives and strategies for achieving them.

Preserving Principal and Earning Interest

If keeping your money intact and earning interest is your goal, consider a “buy and hold” strategy. When you invest in a bond and hold it to maturity, you will get interest payments, usually twice a year, and receive the face value of the bond at maturity. If the bond you choose is selling at a premium because its coupon is higher than the prevailing interest rates, keep in mind that the amount you receive at maturity will be less than the amount you pay for the bond.

When you buy and hold, you need not be too concerned about the impact of interest rates on a bond’s price or market value. If interest rates rise, and the market value of your bond falls, you will not feel any effect unless you change your strategy and try to sell the bond. Holding on to the bond means you will not be able to invest that principal at the higher market rates, however.

If the bond you choose is callable, you have taken the risk of having your principal returned to you before maturity. Bonds are typically “called,” or redeemed early by their issuer, when interest rates are falling, which means you will be forced to invest your returned principal at lower prevailing rates.

When investing to buy and hold, be sure to consider:

• The coupon interest rate of the bond (multiply this by the par or face value of the bond to determine the dollar amount of your annual interest payments)
• The yield-to-maturity or yield-to-call. Higher yields can mean higher risks.
• The credit quality of the issuer. A bond with a lower credit rating might offer a higher yield, but it also carries a greater risk that the issuer will not be able to keep its promises.

Maximizing Income

If your goal is to maximize your interest income, you will usually get higher coupons on longer-term bonds. With more time to maturity, longer-term bonds are more vulnerable to changes in interest rates. If you are a buy-and-hold investor, however, these changes will not affect you unless you change your strategy and decide to sell your bonds.

You will also find higher coupon rates on corporate bonds than on U.S. treasury bonds with comparable maturities. In the corporate market, bonds with lower credit ratings typically pay higher income than higher credits with comparable maturities.

High-yield bonds (sometimes referred to as junk bonds) typically offer above-market coupon rates and yields because their issuers have credit ratings that are below investment grade: BB or lower from Standard & Poor’s; Ba or lower from Moody’s. The lower the credit rating, the greater the risk that the issuer could default on its obligations, or be unable to pay interest or repay principal when due.

If you are thinking about investing in high-yield bonds, you will also want to diversify your bond investments among several different issuers to minimize the possible impact of any single issuer’s default. High yield bond prices are also more vulnerable than other bond prices to economic downturns, when the risk of default is perceived to be higher.

Managing Interest Rate Risk: Ladders and Barbells

Buy-and-hold investors can manage interest rate risk by creating a “laddered” portfolio of bonds with different maturities, for example: one, three, five and ten years. A laddered portfolio has principal being returned at defined intervals. When one bond matures, you have the opportunity to reinvest the proceeds at the longer-term end of the ladder if you want to keep it going. If rates are rising, that maturing principal can be invested at higher rates. If they are falling, your portfolio is still earning higher interest on the longer-term holdings.

With a barbell strategy, you invest only in short-term and long-term bonds, not intermediates. The long-term holdings should deliver attractive coupon rates. Having some principal maturing in the near term creates the opportunity to invest the money elsewhere if the bond market takes a downturn.

Smoothing Out the Performance of Stock Investments

Because stock market returns are usually more volatile or changeable than bond market returns, combining the two asset classes can help create an overall investment portfolio that generates more stable performance over time. Often but not always, the stock and bond markets move in different directions: the bond market rises when the stock market falls and vice versa. Therefore in years when the stock market is down, the performance of bond investments can sometimes help compensate for any losses. The right mix of stocks and bonds depends on several factors.

Saving for a Definite Future Goal

If you have a three-year-old child, you may face your first college tuition bill 15 years from now. Perhaps you know that in 22 years you will need a down payment for your retirement home. Because bonds have a defined maturity date, they can help you make sure the money is there when you need it.

Zero coupon bonds are sold at a steep discount from the face value amount that is returned at maturity. Interest is attributed to the bond during its lifetime. Rather than being paid out to the bondholder, it is factored into the difference between the purchase price and the face value at maturity.

You can invest in zero coupon bonds with maturity dates timed to your needs. To fund a four-year college education, you could invest in a laddered portfolio of four zeros, each maturing in one of the four consecutive years the payments will be due. The value of zero coupon bonds is more sensitive to changes in interest rates however, so there is some risk if you need to sell them before their maturity date. It is also best to buy taxable (as opposed to municipal) zeros in a tax-deferred retirement or college savings account because the interest that accumulates on the bond is taxable each year even though you do not receive it until maturity.

A bullet strategy can also help you invest for a defined future date. If you are 50 years old and you want to save toward a retirement age of 65, in a bullet strategy you would buy a 15-year bond now, a 10 year bond five years from now, and a five-year bond 10 years from now. Staggering the investments this way may help you benefit from different interest rate cycles.

Reasons You Might Sell a Bond Before Maturity

Investors following a buy-and-hold strategy can encounter circumstances that might compel them to sell a bond prior to maturity for the following reasons:

1. They need the principal. While buy-and-hold is generally best used as a longer-term strategy, life does not always work out as planned. When you sell a bond before maturity, you may get more or less than you paid for it. If interest rates have risen since the bond was purchased, its value will have declined. If rates have declined, the bond’s value will have increased.
2. They want to realize a capital gain. If rates have declined and a bond has appreciated in value, the investor may decide that it’s better to sell before maturity and take the gain rather than continue to collect the interest. This decision should be made carefully, as the proceeds of the transaction may have to be reinvested at lower interest rates.
3. They need to realize a loss for tax purposes. Selling an investment at a loss can be a strategy for offsetting the tax impact of investment gains. Bond swapping can help achieve a tax goal without changing the basic profile of your portfolio.
4. They have achieved their return objective. Some investors invest in bonds with the objective of total return, or income plus capital appreciation or growth. Achieving capital appreciation requires an investor to sell an investment for more than its purchase price when the market presents the opportunity.

Total Return

Using bonds to invest for total return, or a combination of capital appreciation (growth) and income, requires a more active trading strategy and a view on the direction of the economy and interest rates. Total return investors want to buy a bond when its price is low and sell it when the price has risen, rather than holding the bond to maturity.

Bond prices fall when interest rates are rising, usually as the economy accelerates. They typically rise when interest rates fall, usually when the Federal Reserve is trying to stimulate economic growth after a recession. Within different sectors of the bond market, differences in supply and demand can create short-term trading opportunities. For some ideas, read the content articles under “Profiting from Market Signals” and “Which Trade?”—in Learn More-Strategies Section.

Various futures, options and derivatives can also be used to implement different market views or to hedge the risk in different bond investments. Investors should take care to understand the cost and risks of these strategies before committing funds.

Some bond funds have total return as their investment objective, offering investors the opportunity to benefit from bond market movements while leaving the day-to-day investment decisions to professional portfolio managers. Source: investinginbonds.com

Remgro vs Satrix 40

We recently got a questions. Who is best? Remgro or Straix 40. Herewith an article that gives a comparison between the two: The marketing schpiel tells us Exchange Traded Funds (ETFs) are an efficient means to enter the market and that ETF’s over a period of time will outperform the vast majority of peer group managed funds. What if, however you had completely ignored the unit trust and ETF universes and invested solely in investment holding company Remgro over the past decade? (And at the risk of sounding like a financial services ad: historical returns are no guarantee of future performance.)

Click Here and have a quick look at BondSwingTrades for a trading platform Sure, your financial adviser would have had a heart attack and cursed you for a lack of diversification – but the evidence suggests you would have done rather well over five and ten years. So well in fact that it turns out that diversification would have been a bad thing.

An investment of R1000 invested in Satrix 40 vs Remgro over both five and ten year periods see the investment holding company significantly outperforming the ETF. Over a five year period resource heavy Satrix 40 would have grown to R1588 vs Remgro’s R2481. The outperformance is amplified over the past decade where the Top 40 index (as a proxy as ETF’s have not been around that long) would be worth R5573 and the Remgro holding R9802.

Rearview mirrors provide outstanding trivia benefits but give little valuable insight as to what the next decade holds for Remgro without British American Tobacco in the fold (remembering of course that despite its size the firm is also not included in the top forty) due to the absurdities of exchange control regulation.

Brett Landman, CEO of Satrix points out that despite its significant resource bias, Satrix 40 provides ordinary investors a level of diversification they might not otherwise afford, plus it reduces risk. Investors however have to choose whether they want market performance or outperformance and the greater that level of diversification; the less likely you are to get that.

“The outperformance of Remgro relative to the resource heavy Top 40 Index can largely be explained by the fact that industrials have strongly outperformed resources over the past five years,” says Landman. He argues a more appropriate comparison therefore would be vs the Satrix Indi – an ETF which tracks the performance of the FTSE/JSE Industrial index. It has delivered 17.34% per annum over the past five years, outperforming its unit trust peer group. Landman however concedes Remgro has done even better than that but he again points to the advantages of diversification limiting risk.

The big question therefore for private investors goes to who you believe is the better asset manager? Remgro without its stake in BAT remains largely SA focused with stakes in a broad universe of local listed and unlisted financial and industrial firms. It’s recently announced plan to acquire up to 22% of shipping and logistics group Grindrod broadens not only its global exposure but also gives it interesting Africa trade connection as well.

“The problem with index funds,” says Rudi van der Merwe at Standard Bank Stockbroking “is that it can take many years of underperformance for a company to be excluded from the index. Remgro has a number of interesting investments including FirstRand which they might choose to unbundle one day, plus investments now in shipping and fibre optics – that one is still small but will be substantially cash generative into the future.”

Stockmarket veteran of four decades David Shapiro would choose a handful Top 40 shares over the next ten years including BHP Billiton, Richemont, Aspen, Sasol and Bidvest, over either Satrix 40 or Remgro. Forced to choose between the either the ETF or the investment company – he would pick the latter.

In his recent newsletter to clients – Chief Investment Strategist at Brenthurst Wealth Management Magnus Heystek cautioned his clients against ETF’s which in bull markets are shown to be highly effective investment instruments. However in more volatile markets there is not enough investment flexibility.

US based Vanguard Investments founder John Bogle might fundamentally disagree. In his world, there was no grey area between active investment and index funds. His lower cost approach to investing earned him a strong following in the US. He is no longer associated with the firm and its 21st century managers are taking a different approach including actively managed portfolios into their mix. Explained Gus Sauter, Vanguards CIO in a letter titled: Active and index funds: No contradiction he explained the thinking behind the strategic switch: “I don’t think the markets are completely efficient. They are reasonably efficient, but there are mispricings. While I think there’s a very prudent argument for index investing, that argument doesn’t rule out well-executed active management at a reasonable price.”

In that lies the secret – the purchase of assets at a reasonable price.

Investors with experience, cash, lashings of wisdom and patience have a significant advantage over those who invest blindly by debit order on a monthly basis. While those who put money into ETF’s do so in the hope that markets will continually move steadily higher, those that put cash directly into equities or to managed funds have the opportunity to time or allow professionals to do it for them, their entry and exit from specific asset classes at particular times.

Independent research into how well Vanguard’s active managers did vs the index showed up some interesting facts: Just 8/20 beat the index by more than one quarter of one percent – enough to make up for the added cost of having a human manage the money – it suggested to the researchers that finding the perceived mispricings in the market are really difficult to find.

Says Landman: “The benefit of ETF’s is that you can hold Satrix 40 or Satrix Swix as the core of your equity portfolio and hold stocks like Remgro and other funds such as Satrix Divi as satellite holdings to enhance overall performance. A more sophisticated investor could also underweight or overweight industry sectors using the Satrix sector ETF’s based on an evaluation of market mispricing.” Source: Finweek 2011