9.4: Some Final Aspects of Bond Investing

Video - Audio - YouTube (Material for this section starts on slide 32.)

We will finish our coverage of bonds with some final aspects of bond investing.

Reinvestment Risk

Reinvestment risk is the uncertainty about the future value of an investor’s bond investments that result from the need to reinvest bond interest payments and redemptions at yields not known in advance. Changing interest rates don’t only affect the price of your bonds. They also affect your future income as you need to reinvest the interest income and bond repayments. If interest rates have fallen, although bond prices will have risen, your income level will fall as you reinvest your income and bond repayments. Likewise, if interest rates have risen, although bond prices will have fallen, your future income level will rise from reinvesting in higher paying bonds. This exact scenario is playing itself out of this writing in April 2022. Interest rates are rising, bond prices are falling. No doubt many bond investors are alarmed that the values of their bonds are falling. However, newly issued bonds will be paying higher interest rates. This is yet another example of why it is important for prudent, patient investors to keep a long-term perspective, no matter what the investment alternative.

Duration and Immunization

Duration is a measure of a bond price’s sensitivity to changes in interest rates and bond yields. Duration captures both price and reinvestment risk. It is used to indicate how a bond will react in different interest rate environments. The duration of a bond changes as it approaches its maturity date and current interest rates change. In general, the longer a bond’s maturity, the longer its duration and the higher a bond’s nominal rate and yield-to-maturity, the shorter its duration. Theoretically, the shorter the duration, the less potential price volatility the bond will exhibit from interest rate changes. The longer the duration, the most potential price volatility the bond will exhibit.

Investors who have a specified time horizon can use bond immunization to increase the probability of successfully achieving their desired goal. The goal is to keep the average duration of your bond investments equal to your time horizon. An investor would thus be more protected against interest-rate induced price swings. The problem with this strategy is that it requires constant rebalancing of your bond portfolio since durations of bonds change as interest rates change and bonds get closer to maturity. Only bond investors with very large bond portfolios would easily be able to implement this strategy. Hence, this strategy is mostly used by pension funds, bond mutual fund managers, life insurance companies, and other institutional investors with very large bond portfolios.

Bond Investment Strategies

There are three major types of bond investment strategies. The most common is the Income Strategy where investors purchase the bonds simply for the interest income they produce and typically hold the bonds until maturity. The Capital Gains Strategy entails speculating that interest rates will fall and capitalizing on the general increase in bond prices. Another form of the Capital Gains Strategy involves researching, identifying, and purchasing distressed, high-yield “junk” bonds in anticipation of the bonds increasing in credit quality and prices. The final strategy is the Total Return strategy. Investors purchase bonds for both the income and the possibility of capital gains. You will notice that there are many bond mutual funds that have the term “Total Return” in their name.

Which of these would be the easiest to implement? Which would be the hardest? The Income Strategy is the easiest method since the investor is unconcerned with the direction of interest rates and will typically keep mostly high-quality bonds in a portfolio. The Capital Gains Strategy is the most difficult as speculating on interest rates and the rehabilitation of junk bond issuers is not easily done. In fact, there are many professionals being paid tremendous sums of money to inaccurately predict the future of interest rates. (Can you imagine how much money they could make if they could accurately predict the future of interest rates?) Last, the Total Return strategy, being a mixture of the first two, sits somewhere in between.

Bond Laddering

A common method of diversifying a bond portfolio is bond laddering. This strategy involves purchasing bonds with staggering maturities. An investor, or more likely a pension fund manager or bond mutual fund manager, will purchase some bonds with short-term maturities, some with intermediate-term maturities and some with long-term maturities. Thus, the investor owns some higher-paying long-term bonds with the accompanying interest rate risk while also protecting the total portfolio with some lower-paying intermediate-term and short-term that carry much less interest-rate induced rate.

Here are interest rates as of October 25, 2021:

	Interest Rate	Maturity Date	Maturity (years)
3-month Treasury	0.04%	Jan 2022	0.25
6-month Treasury	0.06%	Apr 2022	0.5
2-year Treasury	0.47%	Oct 2023	2
2-year A Corporate	1.01%	Oct 2023	2
5-year Treasury	1.17%	Oct 2026	5
5-year A Corporate	1.73%	Oct 2026	5
10-year Treasury	1.63%	Oct 2031	10
10-year A Corporate	2.74%	Oct 2031	10
20-year A Corporate	3.52%	Oct 2041	20
30-year Treasury	2.08%	Oct 2051	30
30-year A Corporate	3.99%	Oct 2051	30

Data as of October 25, 2021 Source: Fidelity https://fixedincome.fidelity.com/ftgw/fi/FILanding

What a difference less than six months can make. Here are interest rates as of April 1, 2022:

	Interest Rate	Maturity Date	Maturity (years)
3-month Treasury	0.75%	Jul 2022	0.25
6-month Treasury	1.22%	Oct 2022	0.5
2-year Treasury	2.49%	Apr 2024	2
2-year A Corporate	2.97%	Apr 2024	2
5-year Treasury	2.59%	Apr 2027	5
5-year A Corporate	3.81%	Apr 2027	5
10-year Treasury	2.39%	Apr 2032	10
10-year A Corporate	3.95%	Apr 2032	10
20-year A Corporate	4.51%	Apr 2042	20
30-year Treasury	2.45%	Apr 2052	30
30-year A Corporate	4.78%	Apr 2052	30

Data as of April 1, 2022 Source: Fidelity https://fixedincome.fidelity.com/ftgw/fi/FILanding

Since then, through 2022 until to the time of this writing in May 2023, the Federal Reserve Bank has been ratcheting up short-term interest rates to curtail inflation. Below are the rates as of May 15, 2023. Notice the inversion of several rates. (Example: The three-month Treasury bill is paying 5.28% and the 10-year Treasury note is paying 3.51%. Recall the dreaded inverted bond yield curve!)

	Interest Rate	Maturity Date	Maturity (years)
3-month Treasury	5.28%	Jul 2023	0.25
6-month Treasury	5.19%	Oct 2023	0.5
2-year Treasury	4.07%	Apr 2025	2
2-year A Corporate	4.44%	Apr 2025	2
5-year Treasury	3.50%	Apr 2028	5
5-year A Corporate	6.47%	Apr 2028	5
10-year Treasury	3.51%	Apr 2033	10
10-year A Corporate	7.25%	Apr 2033	10
20-year A Corporate	5.80%	Apr 2043	20
30-year Treasury	3.85%	Apr 2053	30
30-year A Corporate	6.01%	Apr 2053	30

Data as of May 15, 2023 Source: Fidelity https://fixedincome.fidelity.com/ftgw/fi/FILanding

We always knew that someday, interest rates would begin to rise back to historical norms. It is unlikely that anyone would have thought the rise would begin because of the shutting down of the global economy because of a global pandemic with the subsequent supply/demand imbalances causing global inflation and then compounding the misery by Russia invading Ukraine. (What’s next? China invading Taiwan?) Is a recession coming? Stay tuned!