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Bond Investing Strategies


Income Investing

with Bonds

The essence of bonds investing

Bond Income Investing Strategies - animated picture of a three dimensional model shopping trolley with a United States of America hundred dollar money bill inside it for the bonds investor

The main theme with income investing is to receive the coupon payments until maturity and to preserve capital. Basic income investing strategies are not concerned with capital gains, however there are specific bond investing strategies and even speculative bond strategies which do seek a realized capital gain.

There are a vast variety of reasons why investors seek the income provided by bonds. They include a short-term place to keep funds safe, saving for a home or college education and providing retirement income. The reasons themselves are not important and what they all have in common is that preservation of capital and an income is of utmost importance. These investors may also have stocks in their portfolio and the income from bonds is merely a portion of that portfolio.

Direct Purchase Income Investing

The most basic income investing strategy is to buy treasury bonds or municipal bonds and hold them until maturity. This simplistic approach is used extensively by novice investors who usually only hold a few different bonds and some only hold one bond. It is fairly common for these investors to have little to no real knowledge of either the bond market or the stock market. The amount invested is typically only a small amount - maybe a few thousand dollars, rather than a few hundred thousand dollars.

When the bond matures they will typically either buy another bond to replace the one that matured or they will use the principle to buy their home or finance their kids' college education.

There is nothing wrong with this approach and it is simple enough for investors without bond market education to buy treasury bonds and municipal bonds. With the long-term bonds, inflation risk starts to become a problem and they may be better off with the shorter term bonds if inflation continues to increase.

Income Investing with Bond funds

An alternative to Direct Purchase Income Investing is to buy a bond fund. While bond funds do charge fees, these are very low with passive managed bond funds and these funds would basically suit the passive income investor. The investor can choose from a mutual fund, a closed-end fund or an exchange traded fund.

Bond funds make it easy for investors

to hold a bond portfolio

The main advantage of using a bond fund is that they hold a large range of bond maturities which helps reduce the long-term inflation risk.

The investor still receives the relevant coupon payments from the bonds held by the fund, but the return of the full principle is not assured if the investor exits the fund as there might be some capital losses. Generally over the long-term the increased coupon payments tend to outweigh any capital losses. Any capital gains/losses are only relevant to the income investor when they exit the fund, however there may be some capital gains taxes while the fund is being held.

The following tables list some of the many mutual bond funds available.

Table 1. below shows a selection of U.S. Treasury bond mutual funds with various holding periods (data based on May 19, 2017).

Table 1. U.S. Treasury Bond Mutual Funds

Income Investing with Bonds - Table showing Treasury mutual funds bonds for investors to use in their portfolio

The above mutual funds are no-load funds. They all have a minimum initial investment requirement (but there's no minimum for ongoing contributions).

Table 2. below shows a selection of U.S. Treasury bond mutual funds with various holding periods (data based on May 19, 2017).

Table 2. U.S. Corporate Bond Mutual Funds

Income Investing with Bonds - Table showing corporate mutual funds bonds for investors to use in their portfolio

The above mutual funds are no-load funds. They all have a minimum initial investment requirement (but there's no minimum for ongoing contributions).

Laddered Income Investing Tactics

Rather than buying a single bond or several bonds with the same maturity, laddering is a tactic where several maturities are included in a bond portfolio. The main reason for laddering is to help reduce the effect of interest rate changes over the life of the bond. With laddering, the bonds are replaced with the longer term current interest rate bond whenever a bond matures - the bonds are not sold before maturity.

Bond Income Investing Strategies - picture of a blackboard with writing saying bond market in large yellow font and white font writing saying corporate, government, fixed income and coupon

An example of a simple ladder is buying treasury bonds with maturities of say two, five and ten years. The basic idea is to keep buying the longer term bond (which is this example is ten years) after any of the bonds mature. So when the two year bond matures, it is replaced by a ten year bond. The reason that a ten year is used rather than another two year bond is that in two years time the five year bond has three years remaining and the ten year has eight years remaining. Thus in two year's time the maturities will be ten, three and eight years which is close to the original setup.

The basis for laddering is that if interest rates rise, then the reinvested principle is at a higher interest rate. Should interest rates fall, then the portfolio is still earning higher interest rates from the existing bonds that have not yet matured.

Laddered portfolios can be constructed with any number of maturities. As bonds keep maturing into the future, the maturity setup tends vary somewhat from the initial setup (as with the example with an initial setup of two, five and ten years). The effect of this varying maturity setup reduces as the number of maturities used is increased. For example, laddering with five maturities of two, three, five, seven and ten years will more closely maintain the initial setup as these bonds mature.

The disadvantage with laddering is that it requires more time to manage a portfolio and it also requires more bonds to be purchased which can be a problem for investors with limited capital. Bond funds are a popular alternative for many retail investors as they typically utilize laddering tactics and the minimum capital required is very low with ETF bond funds.

The following tables list some of the many ETF bond funds available.

Table 3. below shows a selection of U.S. Treasury bond ETFs with various holding periods (data based on May 19, 2017).

Table 3. U.S. Treasury Bond ETFs

Income Investing with Bonds - Table showing Treasury ETF exchange traded funds bonds for investors to use in their portfolio

Treasury bond ETFs provide the investor with a bond portfolio containing a range of maturities. Keep in mind that when buying ETFs the investor buys shares just like when buying stocks (there's no fractional shares, only whole shares).

Table 4. below shows a selection of U.S. Corporate bond ETFs with various holding periods (data based on May 19, 2017).

Table 4. U.S. Corporate Bond ETFs

Income Investing with Bonds - Table showing corporate ETF exchange traded funds bonds for investors to use in their portfolio

Corporate bond ETFs provide the investor with a diversified portfolio of bonds. Keep in mind that when buying ETFs the investor buys shares just like when buying stocks (there's no fractional shares, only whole shares).

Dollar Cost Averaging Tactics

The popular strategy of dollar cost averaging can be applied to any bond strategy. The only problem being that the dollar amount to be regularly invested is for most investors considerably less than the minimum face value of most bonds (which is $1,000). An easy solution is to buy shares in a bond fund.

Fortunately treasury bonds have a $100 minimum and this may be low enough for investors to utilize a variation to the laddering tactic discussed above.

The purpose of laddering is to reduce the effect of interest rates increasing after the bonds are bought. When an investor incorporates a dollar cost averaging tactic, the potential interest rate increase problem can be managed by simply buying the same bond maturity at regular intervals.

For example, an investor plans to add $400 per year to their bond portfolio using a buy and hold approach. This allows the investor to buy $100 of say a 30 year treasury bond every 3 months. When adding the same bond maturity to the portfolio at regular intervals, the interest rates are averaged out over time. If interest rates rise then the investor is buying the current higher rates and if interest rates drop then the investor still has some higher interest rate bonds in their portfolio.

Over the long-term, the investor ends up holding some low interest rate bonds and some high interest rate bonds.

Bond Investing Strategies

There's more to bonds than just receiving the coupon payments

Bond Investing Strategies - animated picture of a large sign with writing saying bonds in light grey large font style for investors with a graph behind increasing to the right

Stock investors are usually under the impression that investing in bonds is nothing more than income investing - it's perceived as being dull and boring. While it is true that the primary purpose of bonds is to provide an income rather than a capital gain, there are actually a wide variety of bond strategies that profit from capital gains.

These strategies often combine stocks and bonds together to form a single strategy. Indeed there are also speculative bond strategies for the more experienced investors who are able to manage the higher level of risk.

Capital Gains Investing

This strategy is essentially the bond equivalent to long-term stock trading with stocks that pay dividends.

While the value of all marketable bonds fluctuate around their face value, corporate bonds tend to be more volatile and it is this volatility that produces the large price swings which this strategy benefits from.

After a bond is issued the resale price is subject to supply and demand in a secondary market such as NYSE Bonds. While it is the yield that drives the price of the bond, the yield itself is based on the markets perception for the economic outlook and the company's financial position.

A popular trading strategy is to buy a corporate bond or even a municipal bond when the bond value is less than their face value with the expectation that new bonds will be issued at lower interest rates. Should the investors view prove correct then the price of older bonds will rise so that their current yield is attractive compared to newly issued bonds.

When bonds are bought below their face value, the investor has the option of selling the bond when the price is sufficiently above the face value or they can hold the bond until maturity. In either case the investor is assured of a capital gain and they also receive the coupon payments.

Table 1. below shows a selection of corporate bonds that are currently priced below face value (Data May 20, 2017).

Table 1. Corporate Bonds below Face Value

Bond Investing Strategies - Table showing corporate bonds from companies with bond price that is below face value for investors to buy

Investors can hold bonds that are not callable until maturity if they want to do so, however a lot of corporate bonds are callable which means the issuer can recall these bonds at their discretion (usually when interest rates drop).

Convertible Bonds Strategy

A popular strategy is to buy corporate bonds which are convertible into stock. These convertible bonds can be thought of as an option that pays interest.

Example: Avid Technology NASDAQ:AVID convertible bond with 2% yield, 2020 maturity and a strike price of $21.94 for conversation into common stock. The current common stock price is $5.25 (May 19, 2017).

When an investor buys a convertible bond they have the option of exchanging the bond for stock in the company at a predetermined stock price. The strategy is quite simple and merely involves buying a convertible bond and exercising it if the stock price is favorable. Should the stock price not reach the required price for conversion then the investor can simply hold the bond and collect the coupon payments.

If the bond is converted to stock, the investor can simply sell the stock for a capital gain or they can hold the stock.

If the investor holds the stock, a common strategy is to implement a stop-loss. If the stock price trades below the stop-loss level then the stock is sold. The advantage of using a stop-loss, rather than immediately selling the stock, is that stock price can continue to increase - especially when market conditions are bullish.

Investors generally select convertible bonds based on the likelihood of the stock price increasing above the bonds conversion price.

Bond Investing Strategies - picture of comparison cubes for stock investors depicting allocation of bonds for conservative, growth and aggressive investment portfolios

Fixed Allocation Rebalance

A popular diversification strategy is to allocate a fixed percentage of a portfolio to stocks and allocate the remaining to bonds. For example, a portfolio might be setup with 60% stocks and 40% bond funds.

After the portfolio is setup, market conditions will drive both the price of stocks and the price of bonds which can lead to the percentage proportions to change. The portfolio in one year's time might end up as 70% stocks and 30% bond funds, due to the increase in the price of stocks and the decline in the value of bonds.

While this is a desirable outcome with stock prices increasing, the original allocation for diversification was set at 60% stocks and 40% bonds. The idea with a fixed allocation portfolio is to maintain the original setup by selling stocks and buying additional bonds or bond fund shares when stocks represent an increased portion of the portfolio.

So for the example where stocks now represent 70%, the investor would sell 10% worth of stocks and buy additional bonds or bond funds.

As the proportion of stocks increases, the stock market is becoming more overpriced which is the typical result of a bull market. The strategy simply involves reducing the amount of stocks owned as the stock market advances higher. In effect the strategy locks in some open profit before the inevitable bear market comes along and at the same time buys more bonds which typically perform better during bear markets.

The rational behind the fixed allocation rebalance strategy is:

Allocation rebalance:

  • When stocks are expensive and bonds are cheap - sell some stocks to buy more bonds.
  • When stocks are cheap and bonds are expensive - sell some bonds to buy more stocks.

When selling a portion of stocks (say 10%), this means to sell 10% of the shares owned for each stock held in the portfolio. For example, if an investor owns 100 shares in company XYZ then sell 10 shares.

When buying say 10% more bonds, with a bond fund this as easy as buying 10% more shares in that bond fund. If there are more than one bond fund, then an additional 10% is purchased for each bond fund held.

Should the investor hold stock funds, then the same applies - for this example, sell 10% of the fund shares owned.

Re-evaluating the percentage proportions of stocks and bonds by their current value should be performed at least once a year.

A variation of the fixed allocation strategy is a variable allocation over time. The common reason for varying the allocation proportions is when using the investors' age to determine the allocation to bonds.

Example: A 40 year old investor starts a portfolio by allocating 40% to bonds and 60% to stocks.

In one year's time, the investor is now 41 years old and would now allocate 41% to bonds and 59% to stocks.

Thus if stocks increased to 70%, the investor would sell 11% of stocks to bring the allocation down to 59% and not to the original 60%.

Also bonds would be bought so that the portfolio now has 41% in bonds and not the original 40%.

Thus with a variable allocation over time, the portfolio is constantly rebalanced to a new allocation proportion. So for the investor's age example, the percentage in bonds is rebalanced every year to an increasing balanced level (which increases at the rate of 1% per year).

Value Stocks Strategy

This strategy is essentially a value stock investing strategy and was used extensively by the famous investor John Templeton.

As bull markets progress, it becomes increasing difficult to find good value stocks trading at a discount. Basically most of the good stocks are by now overvalued and the only stocks left trading at low valuations are the stocks that are fundamentally undesirable and have little to no future prospects.

The basis for the strategy is to reduce the number of shares owned in overvalued stocks as the bull market continues to climb higher. This locks in the open profits as these overvalued stocks are at a high risk of correction, especially when the inevitable bear market comes along.

The profits received are used to buy more good stocks which are undervalued. This process continues until there are no more good stocks available to buy which are undervalued. The investor then allocates their capital to bonds. Treasury bonds or Treasury bond funds are a good choice as these have a poor correlation with the performance of stocks.

A small selection of Treasury Bond mutual funds is provided below in Table 2.

Table 2. U.S. Treasury Bond Mutual Funds

Bond Investing Strategies - Table showing US Treasury bond mutual funds for investors to buy for their portfolio

As the bull market climbs higher, more shares are sold and the profits are used to buy more treasury bonds or bond funds (since there are no good undervalued stocks left).

Eventually the bear market arrives and stock prices begin correcting. As the bear market progresses, good quality stocks at undervalued prices begin to appear. This is where some bonds are sold and the capital used to buy these bargain priced quality stocks. The further the bear market declines, then the greater the number of bargain priced quality stocks that can be found.

At some point in the bear market decline, the investor will have sold all of their bonds to finance the purchase of their value stocks. The bear market may well continue, but the investor is now probably out of spare capital. Sooner or later the eventual bottom is reached and the next bull market cycle begins and the whole process is repeated again.

To summarize, the strategy starts to buy bonds as bull markets reach high levels, it then holds bonds through the early phase of bear markets and starts to sell bonds to buy stocks as the bear market heads towards its bottom.

Speculating with Bonds

Higher risk strategies for greater returns

Bond Investing Strategies - Speculating with Bonds; picture of a road sign with a green background and a white arrow pointing upwards and the word convertible bond written in white large scale font

The speculative strategies with bonds are generally only suited to experienced investors who can manage the higher risks involved. This is no different to speculating with stocks. These speculative bond strategies are popular with hedge funds and experienced investors.

Convertible Bond Hedge

The convertible bond hedge strategy was a popular tactic which the famous investor Benjamin Graham used. Benjamin called this strategy 'related hedges'.

The strategy is quite simple and combines the convertible bond strategy with a hedge. This involves buying a corporate bond which has the option to convert into stock and simultaneously short selling the stock (which is from the same company as the convertible bond).

Example 1: AMAG Pharmaceuticals NASDAQ:AMAG convertible bond with 2.5% coupon rate, 2019 maturity and a strike price of $27.09 for conversation into stock. The current stock price is $18.50 (May 19, 2017). Stock does not pay dividends.

Example 2: Avid Technology NASDAQ:AVID convertible bond with 2% yield, 2020 maturity and a strike price of $21.94 for conversation into stock. The current stock price is $5.25 (May 19, 2017). Stock does not pay dividends.

The strategy profits when the stock price falls and as such is a strategy which is best suited to bearish market conditions - especially bear markets. The Dow Theory is a useful indicator to determine the state of the market.

When the stock prices falls, it usually falls more than the bond price falls, especially when the stock price declines significantly. The strategy works well with overvalued stocks that are fundamentally sound.

Since the strategy involves short selling the stock, the short interest fee needs to be considered as well as the dividends. The strategy works best with low short interest fee stocks that pay little or no dividend - since the investor has to pay any dividend due with shorting the stock. Also the Bid-Ask spread for the convertible bond needs to be within reason (the lower the better). Large bond spreads can quickly turn a profitable trade into a losing trade.

Should the stock price fall sufficiently more than the bond price, the stock position is bought to cover the short stock and the convertible bond is sold. The profit is the difference between the short sale profit and the bond capital loss. From this profit any dividends paid are deducted and the short interest fee is deducted and any interest earned on the short sale proceeds is added and the coupon payments are added.

Should the stock price rise above the convertible price, then the bond is converted to common stock which covers the short sale and thus exits the trade. The loss is the difference between the short sale price and the convertible price. From this loss any dividends paid are added and the short interest fee is added and any interest earned on the short sale proceeds is subtracted and the coupon payments are subtracted.

Convertible bonds can have their strike prices well above the current stock price. As the above two examples show, the difference can be significant (especially with example 2).

The maximum loss is reduced when the short sold stock price is closer to the convertible bond strike price. Should the stock price essentially trade sideways, then the investor ends up holding the short stock and the convertible bond and the holding costs need to be considered. While the investor receives the coupon payments and any interest due on the short sale proceeds, the investor pays the short sell interest fee and any dividends due. The net result might be a positive figure meaning that the investor still profits from holding the position, but if the net result is negative then the position ends up costing money to keep the position and investors might consider a time limit after which the position is exited.

Bond Investing Strategies - Speculating with Bonds; picture of a car tachometer with the needle pointing to bankrupt and more writing saying in debt and broke and secure

Bankruptcy Bond Tactics

Buying corporate bonds of large companies in or close to bankruptcy was a common hedge fund strategy used by Benjamin Graham.

This is a very high risk strategy which can earn some nice capital gains for experienced investors and can also easily lose their entire invested capital.

The most common bankruptcy bonds are speculative grade corporate bonds with smaller companies and these are the highest risks. The risk reduces with larger companies as they have a higher probability in recovering from their financial woes.

Sometimes municipalities end up in bankruptcy and buying municipal bonds is a lower risk compared to corporate bonds as the recover rate is relatively high, since the bondholders are usually the only creditors.

The bonds of companies facing bankruptcy often trade for a fraction of their face value, however very few bankruptcy bonds will ever see the bond value return to its face value if reorganization was sufficiently successful. If the company is liquidated, then the recovery (the amount returned to bondholders) can range from zero up to around halve of the bonds face value. In other words, bondholders rarely see the face value amount returned.

To profit from buying bankrupt bonds requires buying a bond at a sufficient discount to what the investor thinks they will receive back once the bankruptcy process is completed. This is where the difficulty comes in - how much will be returned.

Some general guidelines are that companies with high intangible assets relative to their tangible assets are undesirable. This is because in bankruptcy especially liquidation, the only thing that has any value are items which can be sold at auction. Companies with a high portion of hard assets, especially real estate are desirable. Land is particularly good as these are normally recorded on the balance sheet statement at cost and are not adjusted to reflect any increase in land value.

Any investor considering buying bankruptcy bonds needs to be clear that there is a good chance that the entire amount paid will be lost, as there are plenty of bankruptcy cases where bondholders receive little or no recovery.

The strategy has the best chance for success when bonds are bought at sufficiently depressed prices with large companies that have balance sheets loaded with hard assets and moderate intangible assets. The maximum loss is limited to the amount paid for the bond and the realistic maximum recovery is around half the face value. Thus the profitability of the strategy is based largely on the price paid for the bond - the lower the better.

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