10-key-lessons-for-bond-investors

10 Key Lessons for Bond Investors “WHAT WE HAVE LEARNED FROM OVER 50 YEARS COLLECTIVE EXPERIENCE IN FIXED INCOME INVESTING�

Introduction Over the last 30 years, most increases in interest rates have caused great anxiety for bond investors due to declining prices. The assumption that all rates will rise in tandem for an extended period actually causes many investors to reduce their long term results out of fear.

Lesson #1--Set Clear Objectives What is your total return objective?

Set a base level of income for this portion of the portfolio to match necessary expenses. Reinvestment of cash flow can add reliability as well as inflationary protection. To illustrate this lesson in compounding, over a 20 year period, a 5% annual interest payment reinvested becomes as important as the original investment amount. (see Exhibit 1).

Exhibit.1 (Par Bond Calculation graph courtesy of Bloomberg LP)

Lesson #2-“Κ” (Kappa): Seek to Maximize Net Portfolio Cash Flow Interest Coupon Bond investors were at one time referred to as “coupon clippers” because bearer bonds required the owner to clip the coupon payment and turn it in at the bank for payment. Every six months a row of matriarchs would materialize at the bank to claim the tax free income payment. Not until maturity was the value of the bond a factor.

By seeking to maximize the amount of interest payments a portfolio receives, investors can gain advantage during periods of dislocation often caused by a spike in interest rates.

Lesson#3-“Ε” (Epsilon): Seek to Maximize Maturity Value Under Control At maturity a bond issuer has committed to pay the face amount of the bond. The fixed maturity payment is referred to as par value.

After observing the pricing cycles for bonds over decades, we believe that bonds tend to go back to par value because that is where they will mature.

Buying discounts (to par value) for the Fixed Maturity portion of the portfolio allows investors to control more maturity value than the cost of purchase.

Exhibit.2 (Discount Bond calculation graph courtesy of Bloomberg LP)

Lesson#4-“Γ” (Gamma): Convexity is a Valuable Tool The Power of Discounts to Par Value Convexityi When a bond falls below maturity value due to rising rates, the risk of future price declines is lower because of the discount.

Potential for capital gains is actually higher because of the discount.

Lesson#5-Respond Proactively to Market Corrections Example of Fear due to Credit Risk During 2008, there was a dark day that Andrew Orton, the “Ortonator,” was able to buy A rated airport bonds below 70 percent of par value. The bonds recovered to par 100 within 24 months.

When the municipal market snaps, prices can move dramatically lower very quickly. What should we do when the storm hits? In today’s markets irrational behavior provides a buying opportunity.

In December 2010 an analyst went on “60 Minutes” claiming that 50100 major municipal bankruptcies were in store for 2011 alone. There was a corresponding selloff in the bond markets during Q4 2010 and Q1 2011.

However, there were only 4 major bankruptcies that we counted during 2011ii. Prices in the longer duration bond market generally recovered providing a capital gain opportunity.

Example of Fear due to Duration Risk

The “2013 Air Pocket” refers to the movement of bond prices from premium overvaluation to discounts below par value. In our view, this represents an opportunity to buy long term values below fixed maturity. Due to recent tax law changes, taxable equivalent yields will be higher in the upper end of the income spectrum. In many cases those equivalent yields are more than double the yield on comparable US Treasuries.

Exhibit.3 2013 Air Pocket –“Long Municipal Bond Index vs. 30 Treasury Rate (graph courtesy of Bloomberg LP)

Lesson #6-Prepare for Recessions In 1999 Bonds were an Effective Hedge for the Recession Ahead

Exhibit.4 S&P vs Vanguard Total Bond Market Index 1999-2002 (graph courtesy of Bloomberg LP)

Between 1999 and 2000, stocks were trading at 30 times earnings corresponding to an earnings yieldiii of about 3%; however, at the same time bonds were yielding 6%.

In our opinion, this provided guidance on portfolio construction to place a larger concentration of portfolio assets into fixed income versus equity.

Scenario 1994: Rate Spikes Can Correspond to a Correction In Equity Prices Exhibit.5 S&P 500 Index Price Versus 30 Year Treasury 1992-1995 (graph courtesy of Bloomberg LP)

Lesson #7-Control Duration by Harvesting Premiums There is a price which could be so high that the expected return is very small compared to price risk. The tendency to return to par provides guidance to harvest premiums.

We believe one way to control duration risk is by harvesting bonds as they go to premium prices. Due to the tendency of a bond to return to par value it is often prudent to sell, lock in the capital gain and forego the risk of the premium price returning to par.

Exhibit.6 iShares National AMT-Free Bond ETF Versus 30 Year Treasury 2011-2013 (graph courtesy of Bloomberg LP)

Lesson#8-Remember 1981: The Inflation Perfect Storm According to the Federal Reserve estimates, inflation touched 14% in 1981. Bond investors have tended to overreact to the Fed’s change in posture to neutral or tightening rates since the 1981 inflation crisis.

It took about 5 years for prices to recover. By 1986, rates had returned to a more normal level. Investors who purchased attractive discounts and patiently clipped interest coupon payments were generally rewarded with additional gains.

In retrospect, 1981 was a very opportune time to build a bond ladder and 1986 was a fine opportunity to harvest premium gains.

Exhibit.7 Fed Funds Rate 1975-1991 (graph courtesy of Bloomberg LP)

Lesson#9-Investors can Benefit By Using Several Asset Classes By estimating the current expected returns from a variety of asset classes, investors can compare choices to identify potential bargains.

Sometimes the asset classes that have just provided the best returns have become overvalued. The grid below illustrates that some asset classes become undervalued with attractive recoveries to follow. By estimating the current rate of return, a rational comparison can follow.

Exhibit.8 Asset Class Returns 2003- current (graph courtesy of JP Morgan “Guide to the Market Q3�)

Lesson#10-Investors should have a Total Return Focus TOTAL RETURN = NET CASH FLOW + CHANGE IN VALUE FIXED INCOME/MATURITY   

Change in Value –When bonds are out of favor, we are net buyers at a discount below par value.

Interest Payments - Coupon payments add to the total return equation.

Risk - In the current environment, the fixed income portion of the portfolio is the risk offset to the overall market. In a cold crisis, when stock markets are down, money flows to this space providing gains and the opportunity to move cash to high cash and dividends.

HIGH CASH FLOW   

Change in value – We buy assets at a discount to NAV. Dividends – Buying at discounts generate a larger yield adding to the total return equation.

Risk – In a hot crisis- meaning stocks are good, we potentially benefit from a large dividend payment AND an increase in capital gains; taking profits at targets near or above NAV.

GROWTH AND INCOME  Change in Value – We seek companies that are inexpensive relative to earnings projections, represent an inflation hedge, and offer acceptable dividend yields.  Dividends – We focus on free cash flow analysis in order to determine the assets ability to pay.  Risk –We diversify risk in this portion of the portfolio through buying a basket of various asset classes.

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Convexity = The relationship between bond prices and bond yields that demonstrates how the duration of a bond changes as the interest rate changes. http://taxfoundation.org/blog/municipal-bankruptcies-1988 Earnings Yield- The earnings per share for the most recent 12-month period divided by the current market price per share. The earnings yield (which is the inverse of the P/E ratio) shows the percentage of each dollar invested in the stock that was earned by the company. www.investopedia.com ii

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Past performance is not indicative of future results. Investments are subject to market risks including the potential loss of principal invested. Individual portfolios are reviewed for asset size and investment start dates. This information is required in order to reflect adequate investment history and size along with a mix of equities and fixed income closely associated with the MGAM investment strategy.

Bond Risk In general, bond prices rise when interest rates fall, and vice versa. This effect is usually more pronounced for longer-term securities. You may have a gain or loss if you sell a bond prior to its maturity date.

Municipal Bond Risk A portion of municipal bond’s income may be subject to state or local taxes. A portion of a municipal bond’s income may be subject to the federal alternative minimum tax.

Credit risk The risk for bond investors that the issuer will default on its obligation (default risk) or that the bond value will decline and/or that the bond price performance will compare unfavorably to other bonds against which the investment is compared due either to perceived increase in the risk that an issuer will default (credit spread risk) or that a company's credit rating will be lowered (downgrade risk).

Duration risk The duration of a bond is a measure of its price sensitivity to interest rates movements, based on the average time to maturity of its interest and principal cash flows. Duration enables investor to more easily compare bonds with different maturities and coupon rates by creating a simple rule: with every percentage change in interest rates, the bond's value will decline by its modified duration, stated as a percentage. Modified duration is the approximate percentage change in a bond's price for each 1% change in yield assuming yield changes do not change the expected cash flows. For example, an investment with a modified duration of 5 years will rise 5% in value for every 1% decline in interest rates and fall 5% in value for every 1% increase in interest rates.

Bond duration measurements help quantify and measure exposure to interest rate risks. Bond portfolio managers increase average duration when they expect rates to decline, to get the most benefit, and decrease average duration when

they expect rates to rise, to minimize the negative impact. The most commonly used measure of interest rate risk is duration.

Asset class A category or type of investment which has similar characteristics and behave similarly when subject to particular market forces. Broad financial asset classes are stocks (or equity), bonds (fixed income) and cash. Real estate, precious metals and commodities can also be viewed as asset classes.

Total return Investment performance measured over a stated time period which includes coupon interest, interest on interest, and any realized and unrealized gains or losses.

Authors: Spencer McGowan, President, Certified Investment Management Analystâ„ Dominique Henderson, Director of Trading and Information Technology Andrew Orton, Director of Research Alex Tollen, Director of Client Development and Equity Trading

McGowanGroup Asset Management, Inc is Federally Registered Investment Advisory Firm. Securities offered through independent firm, Spire Securities, LLC., a Registered Broker/Dealer and member FINRA /SIPC .