Value comes in all shapes and sizes in the world of fixed income. Unlike the stock market, availability of the bonds you like can be limited and offerings might even disappear from the secondary market during the time it takes to conduct proper research. The scarcity of coveted bonds can have several varying effects on the price of a bond. A small bond issuance of a desirable company may be in short supply, and consequently, have higher prices for those investors wishing to own the bonds. Another scenario is that the bond is in such short supply, and trades so infrequently, that when bonds do become available, they trade at wider spreads (lower prices) than their credit rating and appeal suggests. We often target bonds of this nature because we can add yield safely by essentially providing liquidity to the market. Investors who become crunched for cash for one reason or another may find themselves needing to sell one of these small, infrequently traded bond positions. When this happens, small listings (10-25 bonds) will show up on one of the several bond platforms and inventory lists we view daily. In order to move this bond inventory, which is too small to raise the interest of mutual funds, dealers must “mark down” the price to entice those buyers willing to do the research and purchase a small position. These small bond lots, which we call “odd-lot” or “spinach” pieces, offer the buyer anywhere from a few basis points (a basis point is 1/100th of 1%) more than a comparable bond to spreads in the 20+ basis point range.
At NWIC, we view the ability and know-how to buy odd-lots as a huge advantage for our clients. Investment firms smaller than ours rarely have a devoted bond manager with the time to sort through many small issues and either buy bond funds or more expensive new issues. Investment firms that are much larger operate more like mutual funds themselves and often miss the bargain odd-lot pieces. Most dealers will even say first hand that for bond pieces smaller than $100K, there is significantly less fund demand, making those bonds cheaper and preserving their availability to a degree.
As always, there are several caveats. For the same reason we are able to buy these marked down odd-lots at cheaper than normal prices, we strongly reinforce the buy-and-hold principle. Trying to sell one of these pieces prior to maturity can lead to a mark down on the sell-side. Not to fret! Our portfolios contain a diverse array bonds across the corporate, municipal, and government sectors to ensure that we are adding yield over and above going market interest rates while also preserving the bedrock characteristics of a safe and liquid bond portfolio.
It is also important to point out while there is value buying small lots, we also attain institutional pricing for individual clients by leveraging our ability to buy much larger quantities of bonds than is typical for single accounts. If this sounds contradictory to our appreciation above for small quantities, remember that the bond market is a much more fragmented market than the stock market, and that what may be available or cheap now, may change in only a matter of minutes. Finding good deals may take on the form of providing liquidity to other investors who need to sell a rarely traded bond, or doing the homework to find out why a larger issue appears cheap relative to comparable investments.
Below are two examples of odd-lot bonds. One demonstrates the benefit of odd-lots while one presents an area of caution. (Bear in mind that due to the nature of odd-lot bonds, the bonds described herein may not have been purchased directly for your portfolio. If your account was not a recipient in one round of odd-lot purchases, it will likely be a recipient in the next round, should your allocation levels warrant a bond purchase):
1) Juniper Networks 3.1% 3/15/2016 (Baa2/BBB): The most active corporate bonds will have trade amounts in the millions of dollars per day. As we mentioned above, sometimes a good name, such as Juniper Networks will show up as an odd-lot. We recently found a 35 bond lot ($35,000 par value) available and purchased it at an attractive price and yield. This trade was on July 18th and was the only trade that day, a thinly traded bond for sure. The bond was purchased at a yield to maturity of 1.03%, a spread of 55 basis points to a two-year Treasury (despite being just a 20 month bond). We view this as a strong credit that owing to infrequent trading was purchased more cheaply than a comparable bond, or even the same bond had there been more trades on that day.
2) Metropolitan Transit Authority 5.5% 7/1/2017 (Aa2/AA+): As we discussed in an earlier post “What are These Bonds in my Portfolio?” we buy odd-lot municipals that are pre-refunded and backed by US Treasuries. This bond happens to be escrowed to maturity, which is like pre-refunding, but takes place upon maturity as opposed to an earlier call date. At first glance, this bond is a very safe municipal bond, backed 100% by Treasuries and offering a 2.11% yield to maturity on a tax equivalent basis for investors in the highest income bracket. This represents a spread of 116 basis points to a comparable Treasury, despite the fact that the credit is identical (the credit is identical to a Treasury but this bond would be less liquid). The Schwab listing for this bond only shows a yield-to-maturity, which normally implies that what you see is what you get, in this case an annualized return of 2.11%. Further digging into the SEC filings for this bond reveals a more concerning reality. This bond is subject to a sinking fund call (I won’t go into that definition right now but it is another way for an issuer to take back a bond from its holder prior to maturity). The research for this bond involves reading the footnote of an SEC filing from 2002 which states:
Footnote two is the relevant one here and indicates that we can lose the bond prior to maturity. After plugging the offering price into the sinking fund analysis page of our Bloomberg software, we get a yield to the sinking fund call date of -0.73%. It’s hard to say for sure whether this bond will be subject in the end to the sinking fund call, but it would be ill-advised to buy a bond that has even a small likelihood of a negative return.
These examples highlight two of the many ways we seek to create and add value for our fixed income clients and also how our research and relevant knowledge shapes our conservative investment decisions.