HJ Sims

Fixed Income Strategies in a Low Yield Market

Back in late 2008 it was easier to find value in fixed income securities. In the November-December 2008 period yields were at twenty year highs, and every other asset class appeared to carry much too much risk for many investors. Fast forward to early 2012 and stocks are still volatile, the economy is still precarious and value seems harder to find. After a spike in yields in early 2011, average yields on high-grade tax-backed municipal bonds are lower than at any time since at least 1970, and yields on revenue bonds are nearly a full percentage point lower than one year ago.

At HJ Sims our job is to peel back the onion and help investors prepare for changing market conditions, as well as guide them in selecting investments that match their investment objective and risk tolerances with an eye on changing market conditions and generating income.

Inaction is the one strategy we don’t often suggest, since it is the most costly to you and your portfolio no matter what happens. No matter in what direction interest rates move, up or down, inaction causes your portfolio greater harm because your money is idle. Staying fully invested in bonds also reinforces the power of compounding interest, where both your original investment, as well as your interest earnings, are working to grow your income.

For investors who think rates will rise, we can suggest several strategies. For example, you could focus on short duration bonds, five years or less, and weather the storm until rates move higher. Our traders consistently identify short-term, income-generating municipal bond opportunities that provide substantially higher short term yields compared to CD rates, and the income is still tax free. A recent item that Sims’ traders identified in the market was an A3/A- rated Brazos River Authority bond issued for Centerpoint Energy. Bondholders enjoy first mortgage backing, the coupon is 4.25% with a short maturity due 12/1/17 The bonds are callable 6/1/14 at par, and with a price of 104, investors get a 2.25% yield to 2014 if the bonds are called and a 3.38% yield through 2017 if the bonds are not called early.

You could also buy cushion or “kicker” bonds: premium bonds with above market coupons and short term calls. In this scenario, if rates move higher you have locked in a better income producing bond than had you purchased par bonds, and as rates increase, the likelihood of an early call decreases. If rates move lower, you have earned a higher short-term rate than had you purchased a straight bullet maturity. If you choose this strategy, we would suggest looking for bonds that have already been refunded once, because the borrower would need cash to call them in early instead of refinancing them. Sims recently brought these bonds into our inventory: Puerto Rico Muni Finance Agency Unlimited Tax G.O. bonds, rated BAA1/BBB-. The bonds are backed by the full faith and credit of Puerto Rico’s towns and cities that borrowed from this authority; in addition, there is a moral obligation pledge of the Puerto Rico Commonwealth itself. With a 5.25% coupon and a final maturity in 2024, the bonds earn 3.10% through the possibility of an early redemption in 2015; Commonwealth G.O. bonds due in 2015 yielded only 2.25% in January 2012. If the bonds are not called, investors would see their yield climb until the final maturity, for a total annual yield of 4.50%; this is comparable to only a 4.00% yield on Puerto Rico G.O. bonds due in 2024.

For those investors who anticipate that interest rates will continue to move lower, we would recommend investing in non-callable bonds, preferably with premium coupons. Non-callable bonds have extra value in declining interest rate environments because your investment income is locked in barring a negative credit event. Non-callable bonds are difficult to find and their scarcity factor increases the price you will pay in exchange for this income certainty.

For the investor who is on a fixed income budget we understand your fear. As rates have dropped some of your bonds may have been called in and you have had to replace them with lower coupons. We would suggest blending your replacements with maximum maturity bonds, cushion bonds, and some non-callable, short duration bonds. This combination strategy should give you the peace of mind that no what matter happens to interest rates, you will own a diversified portfolio of bonds and as individual bonds are called or mature your portfolio will allow you to re-enter the market at potentially better terms as market conditions change.

Another long-term strategy might involve purchasing “zero-coupon” or capital appreciation bonds. These bonds are structured like the old-time U.S. Savings bonds, which don’t pay regular interest, but increase in value the longer you hold them, with full payment of the par amount at final maturity date. These bonds are only a small portion of the entire municipal bond market, and their values fluctuate more than traditional coupon bonds; because of this volatility, prices on these bonds may be more attractive than traditional coupon bonds if you have a long-term perspective and don’t need to liquidate in the short-term. New Jersey Transit “zero coupon” bonds due in 2039 currently yield 5.45%; this is well above the return on traditional NJ Transit term bonds due in 2039 currently yielding about 3.2%.

You might want to consider longer maturity bonds for the higher yields that go with them. Although gross yields are down, the yield curve is much steeper than a year ago. AAA rated bonds with a 25 year maturity now offer yields that are more than 16 times the yield offered on a one year bond. A year ago, that spread between a one year bond and a 25 year bond was only 13 times the yield. Sims regularly brings in bonds for sale with maturities of 25 years, 30 years, and longer.

Another strategy takes into account the yield spread between “A” rated bonds and “Baa” rated bonds. A year ago, the yield difference between “A” rated bonds and “Baa” rated bonds was only 0.61%, or a 10.9% difference between “A” and “Baa”. That yield differential has widened in 2012. As reported on January 19 by The Bond Buyer, the yield differential between these two categories was 0.84%, or a 22% yield differential for bonds in these two rating categories. Sims is a specialist in higher yielding bonds; we seek out quality in lower rated credits that are still deemed to be credit-safe. Puerto Rico bonds, because of their higher than average yields and triple-tax-exemption in all states, have been favored in the past by Sims’ traders and financial advisors.

The last piece of advice has to do with credit risk. Some investors step out of their comfort zone in search of higher coupons when rates drop and current income is dwindling. Be sure that you understand the additional risks you are contemplating and that your municipal bond advisor has done his homework. Again, be honest with yourself and your advisor. There are plenty of good lower and non-rated bonds out there, but they are not for everyone. Sims has decades of experience in judging credit risk. In recent years, we have been able to cull out bonds with strong creditworthiness after the bonds lost their previously high ratings based on bond insurance backing. At HJ Sims, underlying credit risk is always considered on bonds that have third-party credit enhancement. Perhaps it’s time to review the credit risk in your portfolio and diversify.

To sum up, here are seven strategies that may work for you, depending on your own individual needs:

1. Short-term municipal bonds that yield more than comparable certificates of deposit, if you are uncertain about the future direction of interest rates;
2. Cushion bonds that have high coupons and early call dates, if you believe rates will rise in the future;
3. Non-callable bonds, if you fear that rates will continue to drop;
4. Zero coupon bonds, if you are interested in current value in the market and can invest for the long-term;
5. Consider longer maturity bonds for the higher yields available in today’s yield curve;
6. Consider high-quality “Baa” rated debt to take advantage of the wider yield spread between “A” and “Baa” rated bonds; and
7. Review credit quality in your bond portfolio with an eye to diversifying and improving overall creditworthiness.

In retirement, most people’s expenses tend to be predictable. Stock market investment returns are notoriously variable and unstable, while bonds provide fixed income. Fixed rate tax-free bonds are an excellent, steady investment to fund retirement expenses. Sims’ advisors have specialized in maximizing investors’ fixed income from bonds. We have guided investors just like you through 77 years of market cycles, building client portfolios designed to meet clients’ unique needs and, most importantly, generate consistent income. Let our experience and expertise put your portfolio to work providing you steady, stable income.

This article was a collaboration of six of Sims’ senior professionals: Dick Larkin, Bill Sims, Peter Polakoff, Howard Burstein, Kim Stevenson, Artie Wunder & Gayl Mileszko. Collectively, they represent over 200 years of experience with municipal securities, averaging over 30 years each.