With the rock bottom interest rate era (as measured by the Federal Funds Target Rate) entering its 6th year, investors who rely upon interest income have likely read close to 1,000 different articles and editorials pontificating upon where to find high yielding investments. Unfortunately, like most things in life, if it seems too good to be true, it probably is. Without taking on substantial risk there are no hidden secrets to finding yield. High yield bonds barely offer more than investment grade bonds, international bonds require a currency crystal ball, and any number of exotic, high interest paying securities do so with equity like risk or complex tax implications, or both. Despite the lack of secret yield stashes there are areas of the bond market that are more overlooked and misunderstood by the typical fixed income investor. We will explore three areas that open up added value without adding credit* risk: Step-up bonds, pre-refunded bonds, and bonds with make whole call options. The intent of this piece is to shed light on what these bonds are as they become more and more common in our composites.
With Step-up bonds there is a little more than meets the eye with respect to coupon and yield. These bonds are typically purchased at a discount (or less than par) and have a coupon that starts low and “steps up” to a higher coupon rate over the life of the bond. The bond may have one or multiple steps and due to the increasing coupon is normally callable by the issuer. The step feature offers the buyer the opportunity to earn higher interest payments and the call feature allows the issuer, or borrower, the opportunity to pay off the debt prior to maturity and re-issue at lower interest rates. The major reason we like these bonds is that we are compensated for the added uncertainty of when the bond will mature or be called with enhanced yield to maturity, a higher current yield (coupon), and the chance to have a very nice return on a shorter bond if it is called. It’s also nice to purchase a bond at a discount for a change. An example is a bond we recently purchased: Federal Home Loan Bank Step Rate Note maturing 5/22/2018. The bond was purchased at a price of 98.9 for a yield to maturity (YTM) of 1.46%, and a yield to worst (YTW) of 1.36%. This bond’s coupon kicks to 1.5% on 5/22/15 where it will stay until maturity. The yield to worst means that if the bond is called on the call date (5/22/15) we will have recognized an annualized return of 1.36%, which is the lowest possible yield. This compares favorably to a bond that simply matures on 5/22/15 and yields around 0.2% (so we’ve picked up over 115 basis points). If the bond is not called, and matures on 5/22/18, we’re picking up around 10+ basis points (0.10%) on a comparable bullet (non-step, non-call) agency bond.
Think of pre-refunded bonds as you would think about refinancing a mortgage. Like a homeowner, municipalities seek to take advantage of lower interest rates. A municipality might have issued debt to pay for a public works project in the early 2000s and the bonds in that issuance may carry high interest rates, such as those juicy 5%+ coupons that are harder and harder to find. When interest rates fall, a municipality will (if it is in good standing with the capital markets) issue new lower interest rate bonds. The proceeds from the new issuance will be used for refunding (paying current maturities) and pre-refunding (paying future maturities). In most cases, the municipality will use the proceeds from the new bond sale to buy Treasuries which then sit in an escrow account and will mature in time to pay off our pre-refunded bonds. One caveat about these bonds is that when you look in your portfolio, you may see a bond that has a long maturity, say 2027. This is the original maturity date, not the new, earlier pre-refunding date. For many reasons we do not like the idea of buying very long dated municipal bonds, and if you see a bond with a maturity outside our typical buying length do not be alarmed, it is very likely pre-refunded. Historically these bonds, which are essentially Treasuries, have very low yields, but more recently and when purchased as small, odd lots, they can be purchased at wide spreads to other muni bonds and at 150-300% of a comparable Treasury….even though they are essentially Treasuries!
Corporate bonds with a make whole call option allow the issuer, or borrower, to call the bonds at any point that they see fit. The benefit to us as the bondholder is that they must pay us a handsome premium to do so (in complex terms a callable bond exhibits negative convexity while a bond with a make whole call is actually positively convex). Why would they do this you may ask? There could be many reasons a corporation would call a bond using this option, but the reason is always rooted in corporate finance. The premium they pay to retire the debt early will either save them interest expense directly or indirectly by deleveraging their balance sheet, thus maintaining a higher credit rating and lower future borrowing rates. Many corporate bonds carry this call option, but it is still a slightly more misunderstood sector of the corporate market then plain vanilla corporate bonds. We buy bonds of sound corporations, even if they carry this provision, knowing it is unlikely that it will be exercised and that we may add value either through a slightly higher yield to maturity or a significantly higher annualized return should the bond be called away from us earlier than expected.
Again, I would like to stress that we are in what can be referred to as a difficult interest rate environment. Understandably, today’s yields have some investors and retirees questioning government policy and scrambling to find the income they need for living expenses. The aforementioned bonds won’t provide sky-high yields, but will offer investors marginal income enhancement in their portfolios when well researched and analyzed on a relative and absolute basis. Please don’t hesitate to contact us if you have questions regarding a bond you see in your portfolio.
*The described bonds do not completely eliminate other types of risk such as risks associated with timing or liquidity.
Alex Dolle, CFA