Friday, August 10, 2012

The Good News and Bad News in The Bond Market

The bond market has reached the surreal stage.  The flight to safety and the various machinations of central banks around the world have combined to push interest rates down to levels never seen before. Currently, a 5-year U.S. Treasury bond yields.70%, a 10 year bond yields1.65%, and a 30-year bond yields a robust 2.70%.   Indeed, a few weeks ago, high quality German bonds were  sold at a negative yield.  Think of it; for safety’s sake, investors were actually willing to accept less principal back than they invested.  

Our clients have largely been shielded from this collapse in interest rates for two reasons: 1)  For many years, we have emphasized the purchase of bonds with long maturities and calls, thus, we have had to deal only sparingly with re-investing large sums of money in this low interest rate environment. 2) We aggressively bought municipal bonds as recently as early 2010, when prices collapsed and yields soared, after a Wall Street analyst pronounced a dire warning about municipal defaults on the “60 Minutes” television show.  In short, these strategic moves have saved our clients from the full force of the collapse in interest rates and will continue to do so for years to come.    

That being said, we have spent more time in our recent investment policy meetings talking about bonds and bond strategies than at any time in our history.  The reason is a case of bond good news-bad news.  

Even though the projected average life of the bonds in our portfolios currently stands at about 4.5 years, when we bought the bonds the projected average life was nearly 15 years. This shortening of the portfolio’s average life is being caused by the collapse in interest rates.  Almost all of the bonds we own in our clients’ portfolios have interest rates that are higher than the underlying municipality or company would have to pay in today’s market.  The good news is 99% of all the bonds we own have “call” protection, meaning the bonds cannot be redeemed until some time in the future.  Because of this call protection, as interest rates have fallen, investors have pushed up the prices of our bonds.  

This call protection, along with our purchase of long-term bonds, has meant that our overall bond portfolio has averaged nearly a 10% annual return over the last three years.  At first, that would seem impossible.  How can you make 10% per year in bonds when bond yields never came close to that level during the last few years?  

To help clarify what has been going on in the bond market, let’s look at a simple example.  Let’s say we bought $100,000 of a Munster Indiana taxable school bond on August 10th 2009.  The bond had a 6% interest rate and a maturity date of August of 2023.  Importantly, however, the bond could not be redeemed or called prior to August of 2017.  Because a 6% yield is so much higher than the going rate for this kind of bond in today’s market, investors have pushed the price of the Munster Bond up to 112.  That means the $100,000 in bonds we bought three years ago are now worth $112,000.  Over the last three years, we have made 12% extra in price appreciation above the 6% interest rate of the bonds.  If we amortize the 12% over the three year holding period, we arrive at an average annual appreciation of 4.0% (12%/3 = 4.0%).  Then adding the interest rate of 6% to the average annual price appreciation means that our clients who bought this bond in 2009 have made a 10.0 % average annual return.  That is great and far better than we would have ever expected when we bought the bonds.

The total annual return in the example above is very close to actual returns we have made on the nearly $40 million of taxable municipal bonds that we bought in 2009 and 2010.  So what’s the fuss?  Why have we been spending so much time discussing what to do about our bonds when the news seems to be so good?

First, we must sell the bonds to achieve the 12% gain, which doesn’t seem like a very smart thing to do, when interest rates are so low.  But there is just as big a problem if we decide to keep the bond, and this is a problem that few investors ever think about: “What is my rate of return if I hold the bond until it is called?”

A bond calculator is needed to make the actual calculation, but in the spirit of keeping things simple, let’s work through what is going to happen to our Munster Indiana Bond in the years to come.  Remember the bonds are callable in August of 2017.  With rates so low, the odds are very high that the bonds will be called on that date.  In this case, the call price is 100.  Thus between now and 2017 the price of the bond will fall from its current price of 112 to its call price of 100.  To compute the average annual effect of this fall in price, we divide the 12% we will lose by continuing to hold the bond by the number of years (5) until it is called (12%/5= 2.4%).  We then subtract this amortized loss from the 6% interest rate of the bond, and we find that we will earn approximately a 3.6% annual rate of return from this point until the call date.    

In the case of the Munster School Bond, we believe it is still underpriced, and we have decided to hold it for a while longer.  In other cases, the annualized yield to the call date is as low as 1%.  In many of these cases we have begun to take profits and move to higher yielding bonds or preferred stocks. The good news is these bonds have treated us very well. The bad news is, they offer a very poor return between now and the time they can be called. While its tough giving up a bond with high interest rates, if in doing so we can protect a sizable gain, its the right thing to do. 

This is the first of a series of blogs about the current bond market.  In the coming weeks we will discuss our views on corporate bonds, high-yield bonds, and preferred stocks. The bond market has been very good to us over the last 20 years, but the current low rates are requiring deep analysis and new strategies. We will be talking about our thinking on the bond market more and more through the rest of this year.