Background
With bonds being tradable prior to their maturity date, bond investors can improve returns through switching out a position in favour for another. A better return can be achieved, even when moving from a bond trading at a discount to par (i.e. below AUD100)
and switching into a bond trading at a premium to par (i.e. above AUD100).
In this piece, we discuss why it’s more important to focus on the yield of a bond than its capital price, and why a switch of this kind in the portfolio can better overall returns.
Focus on yield not price
One recurring comment we hear is that clients prefer buying a bond that is trading at a discount to par rather than a premium to par. On the face of it, this seems to make sense since it sounds like a bargain if you can buy something with a face value
of AUD100 for less than that. But the purchase price is only one side of the equation, and it ignores the ongoing income.
If you go back to first principles, the price of a bond is an output rather than an input for a given trade. To determine the price of a bond, an investor will consider the current interest rate environment,
determine the risk premium that they should receive (over the risk-free rate) and both data points will provide a target return.
Since bonds have pre-determined cash flows, the price is, simply speaking, the present value of these pre-determined cash flows, i.e. they are discounted by the target return. If the bond pays a coupon higher than the target return, the investor will
be willing to pay more than the face value. On the other hand, if the coupon is lower, than the investor will pay a discount to that face value.
Hence, this perceived bargain of paying below face value is probably overstated. If you compare two five-year bonds that each provide a yield of 8% but one trades at AUD80 and the other one at AUD120, both will provide the same return if held to maturity.
However, the return profile will be very different.
The bond trading at AUD80 will pay a coupon of less than 2%, hence most of the yield will be achieved by receiving AUD100 at maturity. For the bond trading at AUD120, the investor is initially “over compensated” for the risk (because the income
is significantly higher than the target return at over 14% p.a.), with this over-compensation adjusted at maturity (because the investor will only receive back AUD100, despite having paid AUD120).
But do the maths really work? How should investors practically compare the two options? Let’s look at the example above, assuming the same $10,000 face value:
The cumulative return for the bond trading at a premium (calculated as total net cash flow divided by initial cash investment) is lower, but this reflects the time value of money. For the bond trading at a discount, 79% of the aggregate cash receipts
will only come at maturity of the bond and are therefore discounted over a longer period (cash paid at the end of the term is less valuable in today’s money than cash paid earlier).
The lower cumulative return for the bond trading at AUD120 reflects much larger receipts earlier, which enables the investor to reinvest those cash flows. Remember, both instruments have exactly the same return per annum (of 8%, in our example).
Astute investors who are aiming to achieve both stable income and capital stability for their fixed income portfolio will manage these differences in cash flow profiles as follows: for bonds purchased at a premium to face value, because the ongoing income
is higher than the yield, a portion of the income is reinvested to restore the initial premium purchase.
By maturity, the aggregate of all these partial reinvestments should equal the premium over face value paid originally. Conversely, investors purchasing below par can afford to draw down on their capital to support their income because this gradual capital
erosion will be replenished at maturity.
Put into practice
We have below provided a simplified representation of this strategy based on an original face value of AUD10,000.
The first chart represents the position for a bond purchased at a capital price of AUD80 which will generate an annual coupon of about AUD200.
After the initial purchase, based on available initial capital of AUD10,000, the investor will retain AUD2,000. Each year, AUD400 will be drawn from this capital amount to boost the income (from AUD200 to AUD600, giving a notional income return of 6%).
The initial AUD2,000 left after the initial purchase will be fully depleted at the end of the fifth year but the redemption will generate a cash receipt of AUD10,000 to replenish this amount back to the initial AUD 10,000.
The second chart looks at a bond with a purchase price of AUD120.
From an annual coupon of AUD1,405, an amount of AUD400 will be set aside to replenish the capital account (meaning an adjusted income of AUD1,005, equivalent to an adjusted notional income return of 8.375%). After five years, a total of AUD2,000 will
have been set aside, which, when added to the AUD10,000 received at maturity, will fully replenish the capital back to AUD12,000.
As discussed above, the purchase price becomes largely irrelevant, and the focus should remain on the yield.
But how can it make sense to sell a bond at AUD80 and move into a new one trading at AUD120?
During the pandemic, interest rates dropped to historical lows and many investors purchased investment grade bonds that were issued with yields between 2% and 3%. With the recent rise in interest rates, the prices of these bonds have dropped significantly
with many trading between AUD80 and AUD90.
We hear a lot of clients reluctant to part ways with these bonds because of the perception of a capital loss. As further discussed below, the only data point that matters should be the current yield for the existing bond and how it compares to the yield
of the target bond.
Take for example the Melbourne Airport bond, issued in November 2021. This bond was issued with a yield of 3.763% and matures in November 2031. This means that an investor who bought on primary did so on the expectation of a return of 3.763% over 10 years.
With the sharp move in interest rates, investors are now expecting a return of about 5.50% (to November 2031) for this same bond, meaning it trades at about AUD88.50.
The current price means that an original investor has currently experienced a return of about -5% (accounting for income to date and price fall). This is effectively locked in and there are two options. Stay invested in this bond, with the combination
of the past performance (of -5%) and future yield (of 5.50%) delivering the original 3.763%. Alternatively, moving into a bond with a forward-looking yield greater than 5.50% which will deliver a total return that will be greater than 3.763%.
Expanding this example and combining it with our earlier discussion, we look at the maths for a switch from the Melbourne Airport bond (trading at about AUD88.50) into the ANZ Tier 2 bond (trading at AUD102.35). The ANZ bond was issued in September 2022,
with a coupon of 6.405% and is expected to be called in September 2029. At its current price, the yield to call is about 5.95%.
- If you consider this entire trade since the issuance of the Melbourne Airport bond.
- November 2021 – cash investment of AUD10,000
- Three coupon payments received (AUD188 semi-annually)
- Sale proceeds in May 2023 of AUD8,850 (selling at current 88.50 price)
- Sale proceeds reinvested in the ANZ bond (face value of AUD8,550)
- Future semi-annual coupons of AUD274 (i.e. 45% higher than the coupon on the Melbourne Airport bond)
- Principal repayment in September 2029 of AUD8,550
Without looking at the details, this doesn’t appear to be a smart trade because the original investment was for AUD10,000 and the investor only received AUD8,550 at the end. But this ignores the significantly higher coupon post the switch.
Staying in Melbourne Airport would have generated ongoing income of about AUD3,750 until November 2031, while the income for the combined Melbourne Airport / ANZ (to September 2029) would be AUD4,120 (with an opportunity to earn additional income between
September 2029 and November 2031).
And remember the original premise of the Melbourne Airport bond, i.e. a return of 3.763% between November 2021 and November 2031. Because you are moving from a bond trading at a current yield of 5.50% to one trading at a yield of about 5.95%, this means
that the return of this combined trade over its entire life jumps from 3.763% to about 4.10%.
As we discussed above, the purchase price of the target bond becomes largely irrelevant (and so is the sale price of the Melbourne Airport bond). The only data point that matters is the yield to maturity / yield to call of the instrument being sold and
the one being bought.
Conclusion
Bond investors have the flexibility of trading a position in their portfolio prior to it maturing, allowing the ability to improve overall returns. A key part to assessing switch opportunities in a bond portfolio is to focus on the yield offered rather
than the capital price, noting the capital price is a function of the yield, and this information is all captured in the one yield number.
This opens the optionality of switching from a bond that offers a lower return and moving into one that will deliver a total return greater than the existing holding. Through doing so, a bond investor can continuously improve on returns as better opportunities
become available.
Note: All the prices and yields referenced in this article were valid on 16 May 2023 when the original article (which is summarised here) was published.