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).


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.


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.


The contents of this document are copyright. Other than under the Copyright Act 1968 (Cth), no part of it may be reproduced or  distributed to a third party without FIIG’s prior written permission other than to the recipient’s accountants, tax advisors and lawyers for the purpose of the recipient obtaining advice prior to making any investment decision. FIIG asserts all of its intellectual property rights in relation to this document and reserves its rights to prosecute for breaches of those rights.

Certain statements contained in the information may be statements of future expectations and other forward-looking statements. These statements involve subjective judgement and analysis and may be based on third party sources and are subject to significant known and unknown uncertainties, risks and contingencies outside the control of the company which may cause actual results to vary materially from those expressed or implied by these forward looking statements. Forward-looking statements contained in the information regarding past trends or activities should not be taken as a representation that such trends or activities will continue in the future. You should not place undue reliance on forward-looking statements, which speak only as of the date of this report. Opinions expressed are present opinions only and are subject to change without further notice.

No representation or warranty is given as to the accuracy or completeness of the information contained herein. There is no obligation to update, modify or amend the information or to otherwise notify the recipient if information, opinion, projection, forward-looking statement, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.

FIIG shall not have any liability, contingent or otherwise, to any user of the information or to third parties, or any responsibility whatsoever, for the correctness, quality, accuracy, timeliness, pricing, reliability, performance or completeness of the information. In no event will FIIG be liable for any special, indirect, incidental or consequential damages which may be incurred or experienced on account of the user using information even if it has been advised of the possibility of such damages.

FIIG provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without taking account of your objectives, financial situation and needs. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation, and legal advice, tailored to your specific objectives, financial situation or needs, prior to making any investment decision. FIIG does not provide tax advice and is not a registered tax agent or tax (financial) advisor, nor are any of FIIG’s staff or authorised representatives. FIIG does not make a market in the securities or products that may be referred to in this document. A copy of FIIG’s current Financial Services Guide is available at www.fiig.com.au/fsg.

An investment in notes or corporate bonds should not be compared to a bank deposit. Notes and corporate bonds have a greater risk of loss of some or all of an investor’s capital when compared to bank deposits. Past performance of any product described on any communication from FIIG is not a reliable indication of future performance. Forecasts contained in this document are predictive in character and based on assumptions such as a 2.5% p.a. assumed rate of inflation, foreign exchange rates or forward interest rate curves generally available at the time and no reliance should be placed on the accuracy of any forecast information. The actual results may differ substantially from the forecasts and are subject to change without further notice. FIIG is not licensed to provide foreign exchange hedging or deal in foreign exchange contracts services. The information in this document is strictly confidential. If you are not the intended recipient of the information contained in this document, you may not disclose or use the information in any way. No liability is accepted for any unauthorised use of the information contained in this document. FIIG is the owner of the copyright material in this document unless otherwise specified.

The FIIG research analyst certifies that any views expressed in this document accurately reflect their views about the companies and financial products referred to in this document and that their remuneration is not directly or indirectly related to the views of the research analyst. This document is not available for distribution outside Australia and New Zealand and may not be passed on to any third party without the prior written consent of FIIG. FIIG, its directors and employees and related parties may have an interest in the company and any securities issued by the company and earn fees or revenue in relation to dealing in those securities.