If you have been reading the Monday commentaries for the past few weeks, you may have noticed that they are painting a step-by-step story. We intend to pull all the parts together culminating in the upcoming Fixed Income Quarterly. So far we have discussed the difference between speculating and investing. Neither is “right” or “wrong”, they provide different risks with corresponding potential results. Most investors benefit from a combination of speculated outcome (growth assets such as stocks) and a known outcome (individual bonds).
We’ve also discussed that our known outcome is typically part of long term planning. It is not about the moment but about the long term certainty. It is a tradeoff of potential large growth for predictable income.
Last week we looked at cash flow for buy-and-hold investors. Regardless of interest rate movements during the holding period of an individual bond, the coupon is constant and maintains its known cash flow and income. In addition, price movement over the holding period is abated since the closer the bond gets to maturity, the price gravitates towards par.
Now let’s test this theory with two soon-to-mature bonds by comparing their price behavior over the last five years. The red line is a 1.75% coupon bond maturing April 18th. The blue line has a 4.75% coupon and matures April 16th. Over the depicted time period, both bonds had similar starting yields and maturities. The gray line shows a constant 10 year Treasury rate and its volatility during the five year holding period.
The takeaway is simple. Regardless of their very different coupons, settlement prices, price volatility over their holding period and changing interest rates, both bond prices shift toward par. Why does this occur? It occurs because at maturity, both bonds pay their face value off at par. The possibility for price appreciation or depreciation diminishes. Recall that total return includes: income + interest on cash flow + appreciation/depreciation. Since the possibility of appreciation/depreciation is gone, total return transforms to the equivalent of the bond’s yield. This explains why individual bonds have “known outcomes”. The only variable (price) becomes a constant (par) when a bond is held to maturity.
Assuming both of these bonds had similar yields on the same purchase date, both (barring default) would have very similar total returns (altered only by reinvestment of coupon cash flow) if held to maturity (appreciation/depreciation disappears and yield stays intact). Although the higher premium bond has more ground to cover as it gravitates towards par, it also provides more than 2.5 times the cash flow (4.75% coupon versus 1.75% coupon) bond for bond. More cash flow can be a benefit in a rising rate environment as an investor has more dollars to reinvest at higher rates. Individual bonds can provide investors with tailor fit cash flow coupled with their known outcome of income.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.