Tuesday 08 September 2015 by Kieran Quaine Education (advanced)

How to reduce bond reinvestment risk and increase returns

An explanation of why you should think about trading your bonds before they mature

bloomberg machine

Portfolio management strategy - Are you a passive or an active portfolio manager?

A passive manager waits for maturity of a bond before reinvesting the maturing proceeds into another bond. 

An active manager would consider the alternative management strategy of selling the near maturing asset to invest in another bond that becomes available prior to that maturity. 

The first key difference between passive and active management is taking control of reinvestment risk. 

“By waiting for maturity, the passive investor has limited their reinvestment opportunities to those bonds available on the maturity date, or worse, yielding a cash return while they wait for a suitable opportunity”.

A second key difference is maintaining a risk return profile. 

The passive investor will hold a progressively lower yielding and lower risk exposure as the bond approaches maturity.

“As credit risk reduces as you get closer to maturity, so too does the return, resulting in the passive investor yielding progressively less return than their original investment profile”.

This second key difference is clarified below, as many investors will query how they can possibly be yielding less than their original investment if they still hold that investment. 

The key observation here is that the benchmark for comparison is not the actual bond they invested in, but their ‘original investment profile’. Professional bond portfolio managers would label this a duration and credit management strategy. 

Consider that when a corporate borrower issues bonds, the credit margin paid over the risk free rate is higher the longer the bond maturity. That is because quite simply, there is more (credit) risk associated with lending for longer periods than there is for shorter periods of time. All else being equal, as the bond approaches maturity the credit risk decreases and the price of the bond will rally. This is also known as ‘riding the credit curve’. 

A similar relationship exists for the risk free rate due to the time value of money. A normal shaped risk free (yield) curve will have increasingly higher risk free rates (yields) as the term to maturity increases. 

Consider the following example of the fictitious credit curve of the ‘XYZ Company’. 

(A) (B) (C)  (D)  (E)  (F)   (G)  (H)
Term to maturity (years) Credit margin Risk free rate Yield to maturity PAR issue price Fwd term remaining in 2 years Fwd yield in 2 years  Fwd price in 2 years
2 1.00% 2.50% 3.50% $100       
4 2.00% 3.00% 5.00%  $100  3.50%  $102.87 
6 3.00% 3.50% 6.50%  $100  5.00%  $105.38 

 Source: FIIG Securities
 Figure 1

The relationship between the risk free rate, credit margin and yield to maturity can also be represented graphically, as shown below.
 
Risk free rate = credit margin = Yield to maturity
Source: FIIG Securities
Figure 2

If at original issue date XYZ could issue semi-annual coupon bonds for terms as per column (A) at yields as per column (D), then in two years’ time, if neither the market risk free rate or the credit worthiness of the company had changed, then those bonds originally issued for six and four year terms will now have four and two year terms to maturity and will therefore be trading at the respective prices as per column (H). Further, the bond issued two years ago with a two year maturity will have matured.

If we look at the original six year bond with a fixed coupon of 6.50% which now has four years remaining until maturity, the new yield to maturity of 5.00% is lower than the coupon of 6.50%. This 1.50% rally in yield, and subsequent premium in price, is attributable to two component parts:

  1. 0.50% for ‘riding the yield curve’.
  2. 1.00% for ‘riding the credit (or issuer) curve’.

The investors in the original XYZ six year 6.50% fixed rate bond have been handsomely rewarded for taking both duration and credit risk that nets them a 9.00% p.a. return (as shown by the internal rate of return or IRR calculation below, with the bond being sold at the market value of $105.38 plus the semi-annual compounded value of the four coupon payments).  

  (S) IRR ->  9.0%
Date Bond purchase Coupon received Bond sold Total cashflow
21/10/14 -$100.00     -$100.00
20/04/15  $3.25   $3.25
20/10/15  $3.25   $3.25
20/04/16     $3.25   $3.25
20/10/16     $3.25 $105.38 $108.63 

Source: FIIG Securities
Figure 3

However, what to do now? Especially considering we know with certainty that the actual price will eventually gravitate back to a maturing value of $100.00 or PAR, and therefore the IRR will equate the yield to maturity of only 5.00% for the remaining four years. Also known as ‘pull to par’.

This is because the investment, if retained for the remaining four years, has a lower yield to maturity due to both a lower risk free rate benchmark and a lower credit risk exposure as the term to maturity has reduced. If retained (i.e. passive management), this bond will now yield a semi-annual compounding 5.00% return, being far less than the ‘original investment profile’ of 6.50% (for a six year term) and indeed significantly lower than the investor’s actual IRR outcome over the first two years, being 9.00%. This is demonstrated in the table below.

(S) IRR -> 5.0%
Date Bond purchase Coupon received Bond sold Total cashflow
20/10/16 -$105.38 -$105.38
20/04/17 $3.25 $3.25
20/10/17 $3.25 $3.25
20/04/18 $3.25 $3.25
20/10/18 $3.25 $3.25
20/04/19    $3.25   $3.25 
20/10/19    $3.25   $3.25 
20/04/20    $3.25   $3.25 
20/10/20    $3.25 $100.00  $103.25 

Source: FIIG Securities
Figure 4

So, what should an investor do?

It depends on the investor’s strategy and the investment options available.

If the XYZ Company conveniently decide to reissue into the market (having just redeemed their 3.5% bond originally issued with a two year term) and do so for a six year term, our reinvestment dilemma for active investors would be solved.

An ‘active’ investor, who is still positively disposed to XYZ, would consider selling their old exposure to the now four year term to maturity bond, and re investing in the new six year issue. They are simply rolling their risk and return profile up the curve, managing both their duration and their credit exposure to more closely match their ‘original investment profile’.

However, if they were ‘passive’ they would forgo this opportunity in favour of holding their original investment, despite the knowledge that the value of the bond will eventually fall to $100.

(Note that the above discussion assumes a normal shaped yield and credit curve. It is possible to have inverted yield and/or credit curves and different strategies may be applied in those circumstances).

Q&A

Who buys these short dated assets as they approach maturity and for what reason?

The bond market is very large and liquidity is deep. Investors, whether they are HNW SMSF or Institutional Funds, will all have different risk and return profiles. Those who buy short dated low yielding assets will do so because that is the profile to which their ‘investment mandate’ is a subscriber. In particular, there are a number of large credit funds that have a mandate that only allow credit investments with a maximum term to maturity of one year. This often results in increased demand once a bond transitions into the ‘one year bucket’.

What if the sale of a near maturing asset cannot be replaced with another asset that maintains my portfolio diversity?

A very good question. If the increase in total return achievable by the new portfolio does not match or exceed the investor requirement for compensation for the loss of diversity, then the risk is higher than the return required, and the investment opportunity should not be undertaken.

Managing term exposure of capital indexed bonds (CIBs) is especially important. Your inflation protection lasts only as long as the bond remains outstanding or that bond’s maturity date. The closer to maturity the easier it is to predict inflation, and the less meaning any marginal deviation between estimated and actual will have for total returns.

When selling CIBs, if you are unable to buy other CIBs, the best alternate maybe an FRN (floating rate note), as the RBA charter effectively links inflation, the cash rate and the bank bill swap rate.

However, while the FRN headline period return may be correlated with the CIB, the total return will be markedly different for many reasons, not least because the FRN distributes all income whilst a CIB retains a portion and compounds it, care of the face vale increasing. Therefore a ‘duration’ matched FRN may be a better alternate.

Can I earmark these assets for sale in advance of reinvestment opportunities?

Yes, and that would be a wise ‘active’ portfolio management strategy. If there is no current investment alternate, being actively aware of preferred sale targets in advance of forthcoming opportunities will assist an investor’s ability to secure the opportunity.

Summary

Investors should consider the advantages of actively managing their portfolios and the disadvantages of being passive. By letting the maturity date of assets dictate the timing of investment decisions, investors are potentially compromising higher returns.

By understanding their true investment risk and return profile and maintaining a focus to constantly rebalance their exposure given the performance of bonds as they approach maturity, in light of investment opportunities and liquidity that may be offered independent of those maturities, investors are taking active control.

If you wish to discuss any of the observations in this article, please ask your FIIG representative.

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