Bond Investments – Enhance Returns in Managed Health Care Sector by Rolling Down the Yield Curve
By Rom Badilla, CFA
November 13, 2012
Since the Presidential election, managed care health care stocks have been battered on concerns that profit margins will be squeezed. The re-election helped clarify the future of health care overhaul which should cover millions of uninsured people and will result in higher fees and coverage restrictions for the insurance providers. Cigna and Aetna have fallen 4 and 6 percent, respectively from the November 6 close to Monday. While the stocks in the sector have tanked, the bonds on the other hand have held in, highlighting the difference in risk between the safer vehicle in bonds and the highly volatile equities.
Having said this, here we will cover our best picks in the managed health care sector of the corporate bond market. Furthermore, we will illustrate a simple strategy for each bond that total return fund managers employ that can significantly enhance returns beyond a traditional buy and hold approach. In particular, the strategy captures both income and price appreciation by allowing time to pass and Rolling Down the Yield Curve (For more information, please review Enhance Bond Returns by Rolling Down the Yield Curve).
Cigna Corporation (CI) is a global health service organization and is one of the largest managed-care companies in the country with over 11 million clients. The company’s Health Care segment accounts for roughly seventy percent of revenue which totaled close to 22 billion in FY 2011. The remaining segments, International and Disability & Life account for the remaining portion of total revenues.
We will focus on their bond that pays a semi-annual coupon of 8.5% and matures on May 01, 2019 (CUSIP 125509BL2). The bond is a senior note and is straight bullet maturity with no embedded early call feature. This bond is rated BBB by Standard & Poor’s and Baa2 by Moody’s which falls under the Investment Grade part of the credit spectrum. In addition, the bond deal size is just over $250 million outstanding and this bond is actively traded. These senior notes are currently being offered at a dollar price of $133.00 which translates to a yield to maturity of 2.87%. Based off of our analysis, this is the steepest part of Cigna yield curve and offers a nice pickup in yield over shorter maturity Cigna bonds.
Comparatively, there is a 4-Year Cigna bond which yields significantly less. Cigna 2.75% Coupon Maturing November 15, 2016 (CUSIP 125509BR9) can be sold at a dollar price of $104.66 which is a yield to maturity of 1.55%. So by extending an additional two plus years provides an additional 132 basis points of yield.
As for the Cigna 8.5% May 01, 2019 at a dollar price of $133.00, an investor will “lock in” that annual return of 2.87% assuming the coupon payments are reinvested and it is held to maturity. All an investor has to do is wait and collect. If you take a total return approach by rolling down the yield curve, an investor can enhance return. This can be achieved by selling the bonds prior to maturity.
An investor will purchase that bond at the stated 2.87% yield and will hold the bond for a period of time. While held and collecting coupon, the bond’s maturity will shorten. So after two and half years in time, that original 6.5 Year will become a 4-Year bond. Assuming stable interest rates, the yield of that bond will “roll” downward toward
the aforementioned current 4-Year Cigna which is yielding 1.55%. This rolling will in turn, result in price appreciation.
To quantify this, we use horizon analysis shown below (Source: Bloomberg) to determine the gain.
As you can see we purchased the Cigna bond at a yield of 2.87% percent or a dollar price of $133.00. Assuming that rates are stable during our time horizon of 2.5 years or ending April 15, 2015, we plug in today’s 4-Year yield of 1.55%. Again we know that in two plus years our original 6.5 Year will become a 4-Year and hence assuming stable interest rates, we can use the aforementioned yield. This yield at this horizon date will correspond to a price of $127.13. This is the dollar price which we plan to monetize by selling in the open markets at our horizon date. Given our reinvestment rate of 0.29 percent for coupon payments earned during that time period, this profit results in a holding period return of 11.05% or 4.38% annualized gain. Now, when we compare this gain to a static Hold-to-Maturity strategy we can see the effectiveness of Rolling-Down the Yield Curve.
Keep in mind that the main assumption to this strategy is stable interest rates. As we all know, if rates rise, bond prices fall and this approach as described will not work. Having said this, all is not lost. If rates rise and the objective is to avoid a loss, all an investor has to do is hold the bond to maturity as principal will be paid back at par. Problem solved.
Cigna 8.5% Coupon Maturing May 1, 2019 (CUSIP 125509BL2)
- 6.5 Year Cigna bond can be bought at a price of $133.00 yielding 2.87% and should roll down the curve to the current 4.0 Year Cigna bond at 1.55%
- Rolling Down the Yield Curve strategy: 4.38% Annualized Return (2.5 Years Horizon)
- Buy and Hold to Maturity strategy: 2.87% Annualized Return (6.5 Years Horizon)
Aetna Inc. (AET) is another diversified managed-care company and is one of the largest in the country with 18 million members. The company has three main operating segments: Healthcare, Group Insurance, and Large Case Pensions. Last year, the company generated over 33 billion in revenues and sports a market capitalization greater than 15 billion. Aetna has a long-term contract with CVS Caremark to provide prescription drug benefits to its customer base.
The company has several bonds outstanding. We will focus on their 6-Year bond that pays a semi-annual coupon of 6.50% and matures on September 15, 2018 (CUSIP 008117AM5). The total deal size of this bond is $500 million. Standard & Poor’s rates these senior notes at A- while Moody’s provides a rating of Baa1 and is on negative watch for a possible downgrade. This bond is currently being offered at a dollar price of $125.86. This price translates to a yield to maturity of 1.81% which is one of the steepest parts of the Aetna yield curve. The 4-Year Aetna bond that pays a 6% Coupon Maturing on June 15, 2016 (CUSIP 00817YAE8) is yielding only 1.23% based off of the bid side price. Hence an investor can pick up an additional 58 basis points on a yield to maturity basis by extending the maturity only a couple of years.
To determine return from Rolling Down the Yield Curve strategy, see the horizon analysis in the graphic (Source: Bloomberg) below.
Aetna 6.5% Coupon Maturing September 15, 2018 (CUSIP 008117AM5)
- 6.0 Year Aetna bond can be bought at a price of $125.86.00 yielding 1.81% and should roll down the curve to the current 4.0 Year Aetna bond at 1.23%
- Rolling Down the Yield Curve strategy: 2.47% Annualized Return (2+ Years Horizon)
- Buy and Hold to Maturity strategy: 1.81% Annualized Return (6.0 Years Horizon)
All of the aforementioned bonds were highlighted by finding the best yield given the dollar price. Some bonds yielded higher but at a cost of a higher dollar premium.
Furthermore, keep in mind that corporate bonds trade over-the-counter. So, prices and yields can vary depending on the broker you use. The best suggestion is to use a broker that offers the most visibility and price transparency for the corporate bond market. This can be achieved by comparing the price to buy and the sale price (aka bid-ask spread). The closer the differential usually means the better the liquidity.
Information and market quotes on the bond investments are provided by Trade Monster’s Bond Trading Center (unless noted otherwise).
As always, every bond investor should perform their own due diligence when making their investment decisions.
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The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.