Bingham Robert

The extraordinary measures taken by the United States Federal Reserve to stimulate employment growth has resulted in substantial price appreciation of bonds during the last 4 years. Investors who owned bonds have seen appreciation of their holdings across market sectors including high-yield, high-grade corporate, government and municipal issuers.

But experienced bond investors are becoming increasingly concerned about the impact rising interest rates will have on their bond portfolios when the Federal Reserve decides stimulus measures are no longer warranted. While the Fed has announced that we will see additional Fed intervention in the bond market for the foreseeable future, at some point they will step away from the market and bond prices should fall.

How bad could it be? Consider that in 2011, the ten year Treasury bond started the year with interest rates near 4%. By year end, rates had fallen to 1.86%. Accordingly, the ten year Treasury appreciated by 17%. In a reversal, it would be reasonable to expect long term bonds to decline by 17% or more.

So what can bond investors due to protect themselves? There are a variety of fixed income tactics that can be employed:

1. Avoid bond mutual funds and buy individual bonds with laddered maturities. When interest rates rise, most bond prices fall. Owners of individual bonds can expect their principal to be returned to them through interest payments and bond redemptions; bond mutual fund holders have no such assurance. As rates rise, mutual fund prices will fall, and investors will need to sell fund shares at depressed prices to obtain liquidity.

2. Buy premium bonds with high coupons priced to a short call date.  "Kickers" are a conservative way to generate above market income, while protecting investors from major price adjustments if rates rise modestly. The bonds' prices are generally less volatile than the market because they will probably come due before maturity due to the short call date and high coupon.

3. Invest in variable rate bonds which pay interest tied to a recognized index like US $ LIBOR . Currently, many of these issues  have coupons that are near zero percent. So, like the “Zero Coupon Bonds” that they currently resemble, they trade at a discount to par. But when rates rise, they will pay more interest and begin to resemble bonds with regular coupons. Prices are likely to rise to par value when this happens. There are a limited number of these bonds outstanding. So when they are in demand (and in a rising rate environment, they should be in great demand), they should move higher in price.  So in the worst case, you own a discounted bond which over its life should appreciate to par and earn an attractive return. But when rates rise, the bonds should appreciate quickly, which will help to offset the principal losses of the fixed coupon instruments in a bond portfolio.

Example: GE Capital has bonds available in $1000 par increments which mature in 2036 and pay Quarterly US $ LIBOR + .48% . (LIBOR is currently .4345%.) The bonds trade at a price of 76 or $760 per $1000 par and pay a coupon of .9145% or $91.45 per thousand (a/o 10-8-12). If Quarterly US $ LIBOR were to rise from .4345% to 5%, they would pay 5.48%. Over the same term, we would expect the bonds to trade higher to around par, giving investors capital appreciation of 24 points or around 32%.

4. Buy short term, “junk bond issues” which mature in 3 to 5 years. There are many well-managed companies, particularly in the “mid-cap” universe, which offer good yields. These are “junk” issuers, but many have reasonable financial characteristics, limited annual redemptions to refinance, and yield attractive returns. Clearly, investors need to diversify their portfolio holdings; but it is worth the effort. Investors can earn an additional +/- 2 percentage points of return by taking risk that can be, for the most part, diversified out of a portfolio.

Buying individual bonds and implementing these strategies in parallel with other traditional fixed income portfolio tactics can generate good return and cash flow, provide protection from rising rates and reduce risk by adding additional sector and industry diversification. And most importantly, they should  help you to survive the bond bear market which is likely to unfold over the next ten years.

Robert Bingham is the founder, President and Chief Investment Officer of SKY Investment Group, a privately-held investment management firm based in Hartford Connecticut. The firm provides direct-instrument equity and fixed income portfolio management to private clients and their families. Mr. Bingham holds a joint BA in Mathematics and Economics from Middlebury College. He is a Chartered Financial Analyst and a member of the New York Society of Security Analysts. He has been managing assets for private clients and their families for 26 years. For further information on SKY, visit their website at www.skyig.com.

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