When investors think an economy has reached the high or low point in the economic cycle are crucial times to rethink the emphasis of your portfolio allocation. The high point in the cycle means the next expected interest rate movement will be a cut as the RBA will have slowed growth sufficiently so that inflation, amongst other measures, is contained. These points are difficult to determine, so we would always suggest investors hold all three main types of bonds: fixed rate, floating rate and inflation linked.
If investors expect lower rates in future the emphasis of their portfolio should change from floating rate notes which capture changes in interest rates by being tied to the Bank Bill Swap Rate (BBSW) and inflation linked bonds where the coupon is tied to the Consumer Price Index (CPI) to fixed rate bonds where coupons are fixed for the life of the bond.
1. Hold until maturity
More of a portfolio allocation strategy, these investors hold their bonds until maturity.
2. Sell at a premium and buy at a discount
Using expected supply and demand theories as well as economic cycle theories, sell your bonds when you think they are “fully priced” and look for discounted securities that you know will return $100 at maturity or more if the economic cycle turns.
- Sell bonds trading at a premium from around two years to 18 months before maturity
Bonds will only repay $100, so if your bonds are trading at a premium it’s best to crystallise the gain as the bond price will typically start to move towards the $100 form this time onwards. Investors may be content to hold bonds trading at a premium until maturity if the bonds are paying high coupons and the income is needed to support the investors’ lifestyle.
3. Sell bonds with a call date around two years to 18 months before maturity or if there is any doubt regarding the call
If there is any uncertainty regarding the call of a bond, think about selling two years to 18 months prior to the first call. Bonds that are not called at the first opportunity usually fall in price as the maturity date is extended or becomes unknown. This increases risk and investors require higher returns for higher risk, thus the securities’ price would usually fall and the yield would increase.
4. Look for relative value throughout the capital structure
- Sell high risk securities for lower risk securities by the same issuer to reduce risk
Anomalies occur in markets. Sometimes lower risk securities in a company’s capital structure have higher yields than more risky assets that sit lower in the capital structure. In this case, buy the lower risk assets and sell the higher risk assets (see Chapter 4 Capital Structure).
- Move down the capital structure if you are comfortable with the credit worthiness of the issuer for a higher return
For example, subordinated debt should provide higher yields than senior debt and hybrids should provide higher yields again. If you are sure of the company’s ability to survive and that it will be able to repay you, it’s worth considering moving down the capital structure for a higher yield.
- Compare pricing of new issues to that on offer from existing issues
Sometimes new securities will be priced higher or lower than existing securities with similar terms and conditions.
- Compare pricing of A$ securities with foreign currency bonds sitting in similar positions in the capital structure
There can be anomalies across international markets. For example, during the European debt crisis, bonds issued by Australian banks in international markets traded at much wider spreads than bonds issued domestically. Those investors with foreign currency, or who were prepared to accept or hedge the foreign currency risk could access much better yields by investing in foreign currency bonds. The opposite was also true where A$ bonds issued by European banks traded at much wider margins than bonds of equivalent risk in their domestic markets.
5. Sell your bonds in one entity and seek better returns in another sector for similar risk
Bonds issued by companies with similar risk profiles, but in different industrial sectors may offer varying returns. For example, a bond issued by a property company rated by S&P as a single ‘A’ may trade at better spreads than a bond issued by a bank with the same single ‘A’ rating.
6. Sell physical property and buy residential mortgage backed securities
Physical property requires maintenance and can be left vacant interrupting your cashflow. It is also fairly illiquid, meaning it’s difficult to sell at short notice without loss of value. Consider selling physical property and purchasing bonds or residential mortgage backed securities (RMBS) issued by property companies such as Stockland or Mirvac for an increase in certainty regarding return and higher liquidity. RMBS have various risk/reward combinations which can help investors better allocate for risk.
7. Sell bonds trading at a discount with a long term maturity for bonds still trading at a discount but with a shorter maturity
This strategy aims to maintain return but decreases time to maturity for greater certainty.
8. If bond prices move lower (assuming you have confidence in the issuer) buy more bonds to lower the average the purchase price
For various reasons, bond prices can decline. If you hold bonds where the price has declined and you have confidence in the issuer, you could keep investing in the same bond, which will lower the average price you paid for the parcel and increase your yield
9. Sell small parcels of bonds as prices increase to ensure a profit
If you purchase a bond that can be sold in smaller parcels and the price of the bonds rises, you can sell down small parcels to lock in a profit. You don’t have to sell your holding in a single transaction (e.g. If you hold a $500,000 face value Praeco senior debt nominal bond and the price of the bond has risen since first purchased, you can sell down face value $50,000 parcels to ensure a profit).
10. Barbell strategy
A barbell strategy is used to earn more interest without taking more risk when investing in bonds. In a barbell strategy, an investor invests in short term bonds, say one to two years and long term bonds such as those maturing in 15 to 20 years. When shorter term bonds come due, the investor reinvests the funds in other short term bonds, thus keeping a balance between short and long term bonds. The goal is to earn more interest without taking more risk than having a portfolio of just intermediate term bonds.
11. Assess regulatory changes
Regulatory changes such as Basel III may make some securities more attractive in terms of likelihood of first call and others less attractive, providing opportunities.