The secret life of bonds - Part 2

Steve Merrell |
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One of the things I like best about bonds is their mathematical precision. As long as the issuer doesn’t default, you know what the cash flows from the bond will be. Some bond cash flows can be quite complex. However, for the purpose of today’s column, I am going to focus on simple bonds—those that pay a fixed stream of periodic cash flows with a fixed final maturity date.

When structured correctly, a portfolio of bonds can help fund your investment goals while minimizing your exposure to changes in interest rates and equity markets. This idea, known as portfolio immunization, is a key building block in designing solid fixed income strategies.

Owning a bond gives you the right to receive a stream of future cash flows from the bond’s issuer. The market value of the bond is calculated by discounting each of those future cash flows to its present value using current market interest rates. The simplest form of a bond is called a zero-coupon bond. The only cash flow a zero-coupon bond produces is the return of principal when the bond matures. The return you earn on the bond is the difference between the amount you pay to buy the bond and cash flow you receive at maturity.

For example, as I write this column, Charles Schwab is offering $10,000 of the U.S. Treasury strip (a type of zero-coupon bond) maturing on February 15, 2026 at a price of 96.067. Since the price of a bond is always quoted as a percentage of the bond’s maturity value, this means that I can buy the right to receive $10,000 on February 15, 2021 for $9,606.70. If I hold the bond to maturity, I will earn $393.30, the difference between what I paid for the bond and the cash flow the bond’s issuer owes me at maturity. While that isn’t much of a return, I know that the $10,000 payment I am due is about as certain as anything in life. It is guaranteed by the full faith and credit of the United States.

So how does all this help with portfolio strategy? A simple example will help me illustrate.

Let’s suppose I need my portfolio to fund a $10,000 payment every year for the next five years. There are several possible strategies to accomplish this objective. For our purposes today, let’s look at two.

The first strategy is to invest $50,000 in a fixed income mutual fund like the Pimco Total Return fund (symbol PTTRX). It has a modified duration of 5.4 years and an SEC yield of 1.45%. If interest rates remain at current levels, I will be able to withdraw the $10,000 I need each year from the portfolio with a little left over at the end from the interest earned on my investment.

However, if interest rates rise one percentage point, the value of my fund will drop by 5.4 percent (remember our discussion of modified duration from last week) to only $47,300. My portfolio no longer has the ability to fund the withdrawals at the level I originally intended. If interest rates rise further, I will be even further behind. And with interest rates so low, the portfolio will never earn enough to get it back in position to fund my desired withdrawals. The only way the portfolio could get back on track would be for interest rates to fall back to their original level.

A second strategy would be to buy a series of zero-coupon bonds with $10,000 maturing each year for five years. We refer to this kind of portfolio structure as a “laddered portfolio.” Enough bonds will mature each year in my laddered portfolio to ensure that I have exactly the $10,000 I desire from my portfolio. The success of my portfolio is not affected by changes in interest rates. In bond market parlance, I have “immunized” my portfolio.

There are other possible portfolio strategies. For example, instead of using zero-coupon bonds, you could build a laddered portfolio using bonds that make periodic interest payments. The more carefully you match catch flows from your bond portfolio to your withdrawal requirements, the less exposure you have to changes in interest rates. By carefully adjusting the maturity structure of your bond portfolio, you can calibrate your exposure to interest rates based on your own appetite for risk.

 

Steven C. Merrell  MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning.  Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to: smerrell@montereypw.com