FWIW #47 Tactical Fix Income Strategy

Tactical fixed income investing begins with understanding what the investor intends the fixed income securities to do for the overall portfolio. Here’s the first decision to be made: Are they selected to give both current income and capital appreciation? In other words, should these securities have the same objective as the common stocks in the portfolio? An alternative strategy is to focus on current cash flow without regard for any potential capital gains (or losses) resulting from interest rate volatility. This decision is critical to successful fixed income investing.

What are fixed income securities?

Let’s start by defining fixed income securities. Any bond or preferred stock that pays a set amount of interest or dividends each year is a fixed income security. If the interest rate or dividend changes periodically, the investment is not a fixed income security.

            Understand that a bond is an investor’s loan to a government, corporation, partnership, or other entity that agrees to borrowing terms, and these terms are formalized in a legal document called a bond indenture. A preferred stock is similar to a common stock in that it’s an ownership position, but it has a right to a designated amount of assets or income to be paid before the common stock receives any assets or income. A bond has a claim on income and/or assets before the preferred stock does.

            Bonds are the primary fixed income securities in a portfolio. Think of the preferred stock, which is usually in the lowest investment grade category or even slightly below investment grade, as the icing on the cake. Bonds and preferred stocks invariably have a call provision (they can be redeemed earlier than the stated maturity date), which means they can give the investor nasty surprises when or if interest rates decline. More on this issue shortly.

            Bonds are issued by state and local governments and agencies, the federal government and agencies, corporations, and other entities, such as partnerships or legislated authorities.

What are the critical factors in building a fixed-income portfolio?

1. Credit rating

The overwhelming majority of bonds and preferred stocks are analyzed by regulator-sanctioned rating agencies for credit quality and are assigned a credit rating when initially issued. The credit rating is reviewed periodically and changed (either raised or lowered) if the creditworthiness of the issuer changes.

2. Maturity dates

Bonds have future maturity dates, when the issuer will give the investor/lender back their money and pay off the debt. A correctly designed fixed income portfolio will have a series of maturities happening each year or, at the most, every two years. This series of maturities will modify the damage the portfolio suffers when monetary authorities manipulate rates or inflation. So, the next step is to determine the maturity spectrum of the fixed-income assets. Should it be 10, 15, or 20 years? Personal factors determine the length. If the bond has an early redemption date, place the bond on the maturity spectrum at the call date to avoid a negative surprise. If the bond is not called, shift it into the next year maturity since it is essentially a one year maturity after the early redemption date passes.

3. Interest rates

When initially sold to investors, bonds and preferred stocks are given an interest rate that reflects the current interest rate environment for the credit quality assigned to the issuer and the maturity of the security. For instance, if a AAA US Treasury note (the highest credit quality security) issued for 10 years has a 4% interest rate, a 20-year note may have a 4.35% rate, a 10-year A-rated corporate bond may have a 5% interest rate, and a 20-year A corporate bond may have a 5.6% interest rate.

4. Price volatility

Once a fixed income security is issued, the interest rate paid each year never changes unless the company gets into financial trouble. As the overall interest rate environment changes, those interest rate adjustments impact the market value of the security, not the interest or dividend paid. For instance, if a security is issued when overall rates for that credit quality and maturity are 4%, and interest rates for that credit quality and maturity later change to 4.5%, the price of the security will decline even though at maturity the investor will get the full value of the security. In the same way, if interest rates declined from 4% to 3.5%, the market value of the bond would rise. For any given credit quality or maturity, the higher the stated interest rate, the less volatility in the price of the security.

5. Shape of the yield curve

Notice that the example in the paragraph about interest rates showed a higher interest rate for a bond issued with a longer maturity than one issued the same day with a shorter maturity date. The difference in interest rates based on the maturity date is called the yield curve. A normal yield curve is one with interest rates that rise as the maturity lengthens. When the yield curve is inverted, meaning when the short-maturity bonds have a higher interest rate than the longer-maturity bonds, it’s a sign that the monetary authorities are manipulating the credit markets.

6. Dynamic spread between credit quality and maturities

The fixed income markets are volatile. When thinking about the future, the market makers don’t just think about the economy in the short term or inflation for a given period; they have opinions that may differ based on time segments. For instance, the market may reflect a 3% inflation rate for 10 years, but only a 2.25% inflation rate for 20 years. Further, market makers follow the creditworthiness of bond issuers along with the potential economic health of the sector or industry. As the economy shifts, the spread between credit qualities will also shift.

For instance, at any time, the interest rate difference between a AAA bond and an A-rated bond may be 2.25% for 20-year securities. If the outlook for the economy turns neutral or negative, that spread (difference) may become 2.75%. If a particular sector or industry is having economic difficulties, the bonds issued by companies in that sector or industry may have a higher interest rate spread, such as an A-rated mining company bond paying 5.76% when an A-rated food company is paying 4.87% for the same maturity.

            As discussed above, six critical factors influence an investor’s ability to use fixed income securities to enhance the returns in a portfolio other than just generating cash flow. Generating cash flow is the most important function of the portfolio’s fixed income securities. In thinking about taking tactical steps with these securities, it’s vital to take care so the steps won’t diminish the resulting cash flow.

How can an investor use these six factors to their advantage?

If monetary authorities are manipulating interest rates, the yield curve will be inverted, and the investor should use that inversion to determine the tactical steps at that time. If the yield on the 10-year US Treasury note is above 3.75% and the curve is inverted, the strategy should be to continue placing new investments and current maturity proceeds in the maximum desired maturity.

For instance, if a portfolio objective is to have fixed-income securities in a maturity spread from 1 to 12 years, when the current-year securities mature, the proceeds should be used to invest in 12-year notes. If the 10-year yield is below 3.75% and the curve is inverted, just place new funds in next year’s maturity, thus building more money to mature next year. Monetary authorities can manipulate interest rates and confiscate interest that should rightly go to creditors for a long time, as they did from 2008 to 2017. If manipulation is part of a repression period (artificially low interest rates), it’s important to build liquidity with the fixed income assets.

            The initial portfolio will use the interest rate spectrum at the time the series of securities are bought. When securities mature, the proceeds should be placed at the end of the maturity line. Eventually all of the securities, no matter their stated maturity, will have been bought in the longest maturity acceptable to the investor, thus generating greater cash flow than the yield curve would indicate.

            There are three reasons to tactically manage fixed-income investments: create tax losses to offset capital gains elsewhere in the portfolio, enhance the portfolio income, and change the portfolio credit quality.

            Consider the following information as an example scenario.

1. A $25,000 par value of A-rated bonds with a stated interest rate of 4% bought at par value with a maturity of 5 years is now selling at $940 per bond.
2. A similar bond with the same credit rating and the same 4% interest rate with a 15-year maturity now sells for $930 per bond.
3. A similar bond with the same 15-year maturity but an interest rate of 4.125% is selling for $940.
4. A BBB-rated bond with a 4% stated interest rate with the same 15-year maturity is selling at $900.

Given the above information, the investor can take one of the following steps:

1. Sell the original 5-year maturity bonds, creating a loss to offset gains elsewhere, and buy the same bonds with a 15-year maturity. Keep the price difference and the same portfolio credit profile with a longer maturity for that security.
2. Sell the 5-year A-rated bonds and buy the 15-year maturity with the 4.125% interest rate and increase portfolio income.
3. Sell the 5-year A-rated bonds and buy 15-year bonds rated BBB with the proceeds. In doing so, the investor can buy $26,000 face amount of 4% bonds, thus adding to the eventual (at maturity) value of the portfolio and enhancing the annual income with a small decline in portfolio credit quality.

            The investor chooses the amount of bonds, the interest rate, and maturity of the fixed income securities in the portfolio. The market controls the credit quality, price, yield curve shape, and credit spread. All of these factors should be considered when looking to change securities in the fixed-income portfolio. Professional investors have the resources to fine-tune these factors, but investors don’t need to be that precise. Common sense is all they need:

• Does the investor need a tax loss to offset a capital gain?
• With current interest rates can annual income increase by accepting a longer maturity?
• Can the credit quality of the portfolio improve or allow for more income?