Bond Market Commentary
Object of the game (for buy-and-hold investors)
By Doug Drabik
June 26, 2017
For growth seeking, risk taking investors… stop reading right here. This commentary applies to the buy-and-hold investors pursing steady cash flow, predictable income and the means to protect hard-earned wealth.
In baseball, the object of the game is to score more runs than the opposing team. Scores may be accumulated very differently from game to game. It is possible to score 1 run in every inning yet lose to an opponent that only scores in 1 inning but accumulates 10 runs. It’s possible to put on a show of 10 home runs in a game yet lose to a team that bunts and walks 11 runs across the plate. All that matters in the end is the object of the game: accumulate more runs (in any manner) after 9 innings than your opponent.
In the fixed income world, the object of the “game” is to optimize return within the risk parameters of the investor. Large coupons may appeal to some investors while others may be enticed by discounted prices. Too often cash flow and income are comingled terms clouding the real objective of optimizing return. For many investors, the risk parameters include steady income and the protection of capital. For this reason, many are buy-and-hold investors. Although there are many different ways to “play the game”, buy-and-hold investors are concerned with steady coupon income as the total return components of appreciation/depreciation are rendered ineffective when holding securities to maturity. If this is the case, yield-to-maturity and yield-to-worst become more important bond characteristics and should overshadow other structural characteristics such as coupon and price. Holding a bond to maturity negates the pricing advantages or disadvantages experienced during the holding period as bonds eventually gravitate toward par while approaching maturity.
Often there is a misconception that paying a premium and then receiving par at maturity is penalizing an investor. This simply is not so. A par bond with a 3.00% coupon and ten year maturity yields 3.00%. A 5.00% coupon premium bond with a ten year maturity and 3.00% yield also yields 3.00%. Given that both purchases put the same amount of cash to work on the purchase date, both will net virtually the same net money over the 10 year period. Although less face amount of the premium bond can be purchased with the same dollars, the additional coupon flow offsets the difference over the holding period. The same holds for a discount bond held-to-maturity. The apparent added benefit of getting par dollars back on a discount purchase is offset by the lesser coupon flow accumulated during the holding period. The take-away is that for buy-and-hold investors, whether the price paid is at a premium, discount or par ultimately doesn’t matter thus revealing that yield should be a much more coveted characteristic than coupon or price.
The assets suitable for fixed income have seemingly been tougher to allocate as interest rates decline, supply is challenging and the temptation to hold an unbalanced portfolio lingers with a screaming bull equity market. The economic discipline may have gotten harder but that discipline is what stands between investing and gambling. The purpose behind fixed income allocation is to protect the hard earned wealth accumulated through hard work. The object of the game is not altered by the conditional changes that occur during play. Buy-and-hold investors who stay focused on the end-game benefit from long-term characteristics that fit within risk parameters. Structure and bond characteristics remain important, but yield (income) typically trumps other features, in particular for the buy-and-hold investor.
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.