Fixed Income Portfolio Management 102

Bond Ladders

One very popular and effective way to create a bond portfolio is to create a bond ladder.  A bond ladder consists of several different bonds with differing maturity dates. For example, if one had $200,000 to invest, they could buy $40,000 in bonds that mature in 2 years, 4 years, 6 years, 8 years, and 10 years.  This would result in a portfolio that has an average maturity of 6 years.  Another possibility is to purchase $20,000 in bonds that mature each year for the next ten years, which would create a portfolio with an average maturity of 5.5 years.

Each separate bond maturity is a “rung” in the ladder.  The bonds could be treasuries, agencies, municipals, or corporate bonds.  For bonds that are not treasuries, the ladder would most likely be invested in bonds from different issuers to diversify in order hedge against default risk.

Creating a bond ladder provides investors with a number of advantages:

  • Provides a steady and predictable stream of income.
  • The regular maturity intervals provides ongoing liquidity.
  • Because the periodic maturities allow the portfolio to purchase new bonds on a regular basis, the reinvestment risk is significantly reduced.  If interest rates rise, the maturing capital is reinvested at higher rates.  If interest rates fall, maturing capital is reinvested at lower rates, but the longer bonds in the portfolio continue to earn higher rates.
  • Having the bonds mature at regular intervals also provides a hedge against interest rate risk.
  • Because it is unlikely that all of the bonds in the portfolio are likely to be called at once, the ladder provides protection against early redemption or call risk.

If an investor knows that they will need access to funds in the future, a bond ladder can be created that matches their funding requirements.

Bond Swapping

A bond swap is the simultaneous sale of a bond for the portfolio and purchase of another bond from the sale proceeds.  An investor will execute a swap in order to take advantage of a market opportunity, or to adjust their portfolio for a change in investment objective or financial status.  Typical strategies for executing a swap include:

  • Increasing Yield
  • Increasing Quality
  • Increasing Diversification
  • Benefit from Changes in Interest Rates
  • Call Protection
  • Lower Taxes

Let’s take a look at how each objective is achieved.

Increasing Yield

Bond investors will often execute a swap to increase the yield that their portfolio is earning.   An increase in yield is often achieved by swapping to a bond with a longer maturity (assuming a positive sloping yield curve), a lower credit rating, or both.  It is important to remain cognizant of the fact that the added yield does not come for free- increasing the maturity also increases the portfolio’s interest rate risk, and decreasing the credit rating increases the credit risk.

Often the investor will enter into such a swap based on their perceptions of relative value.  It is not unusual for identical bonds with the same credit rating to trade at different yields due to the market’s current perception of differences in an industry or company’s business outlook.  For example, the prospect of high oil prices may cause investors to be concerned with the earnings impact this would have for heavy users of fuel, such as airlines; or a particular company may be considered to having a weaker product offering.  If an investor does not share the market’s view, or if they think the situation is only temporary, they may take advantage of the price discrepancy by buying the cheaper bond.

Bonds that carry credit risk will yield more than treasuries.  The difference in yield is known as the credit spread. Credit spreads change over time depending on the market’s perception of where the economy is in the business cycle. If investors feel that the economy is weakening, they will sell riskier assets and buy safer investments (this is known as a flight to quality). When this happens, credit spreads widen.  Conversely, when the investors are optimistic about the economy, they are more willing to purchase riskier assets in order to increase their return, and the credit spread will narrow.  An investor that believes the market has overreacted, and that the credit spread is exceedingly large, may take advantage of the situation by swapping into a bond with a lower credit rating.

Increasing Quality

A quality swap is a swap that is executed by selling a lower rated bond and purchasing a higher rated security.  It is essentially the opposite of a yield swap and is the result of the investor’s negative perception of the economic prospects for the issuer of a specific bond in their portfolio, the issuer’s industry, or the economy in general (they feel that the credit spread is too narrow).

Increasing Diversification

An investor may decide that their portfolio is too concentrated in a specific issuer, industry, or country.  The investor will sell some of the concentrated position and invest the proceeds in the bond of another issuer that provides greater diversification.  The concentrated position may result from a merger or other corporate restructuring, or some event may alter the investors comfort level with their exposure to the issuer, industry, or country.

Investors may also execute diversification swaps because they feel general economic or market conditions warrant increased diversification to mitigate market risk.

Changes in Interest Rates

Investors may execute swaps based on their belief that the level of overall interest rates are likely to change.  If the investor believes that rates are likely to rise, they can swap into floating-rate, shorter term, and/or premium bonds to reduce their portfolio’s exposure to interest rate risk. If the investor believes that rates are likely to fall, they can swap into zero coupon, longer term, and/or discount bonds to try to maximize their exposure to the expected rate change.

It is important to note that interest rate swaps are speculative in nature as the anticipated rate change may not occur, or rates may change in the opposite direction.  Also, changes in rates do not impact all maturities equally, so the swaps may not provide the desired effect.

Call Protection

An investor may choose to execute a bond swap to increase the call protection in their portfolio.  Call protection swaps generally occur in a falling rate environment when it is more likely that bonds may be called.  In this case, the investor will swap out of bonds with little or no call protection to bonds that are not callable in the near future, or into bullets.

Lower Taxes

Tax swapping is the most common form of bond swapping.  Investors will often swap out of a bond that is trading below par (or the price the investor paid for it) in order to offset a capital gain realized in the sale of another asset.

It is important to note that the IRS does not recognize a tax loss resulting from the sale and repurchase of the same or “substantially identical” security within 30 days before or after the sale date (known as a wash sale). The IRS has not explicitly defined “substantially identical,” but it is generally believed that the securities would not be considered substantially identical if the securities have different issuers, or there are substantial differences in the coupon rate or maturity.

Investors that experience an increase in their tax rate will often swap from taxable bonds to tax-free municipal bonds.  Some municipal bonds are subject to the Alternative Minimum Tax (AMT), while others are not.  Bonds that are subject to AMT will generally yield more than an equivalent non-AMT bond, therefore investors that are not subject to AMT can often improve their yield by swapping into AMT bonds.  Investors subject to AMT can save taxes by swapping into non-AMT bonds if the tax savings more than offsets the lower yield.

Tax laws change frequently and the treatment of capital gains is particularly complicated, so investors should always consult with a competent tax advisor before engaging in tax swaps.