Bond Strategies In A Rising Interest Rate Environment

BF: Good morning everyone this is Brian Fricke. BT are you there? Yes. Let’s get going. Do you have any announcements?

BT: Just real quick. Everybody will be on the call and muted. So we won’t have any background noise for now. Later on in the question and answer period, the phone will be unmuted and at that point any noise behind you will be heard by everyone. So if you want to mute yourself later just hit Star 6 and that will mute you personally. I’ll recover that again before we start. It’s 9:01am so let’s get going.

BF: Today’s topic is Bond’s Strategies in a Rising Interest Rate Environment. It seems like to me we’ve been getting more and more calls and conversations about the concern over bonds and how they are going to perform when, not if, but when interest rates start to go up. So I thought today’s topic will be somewhat timely. I’m going to share with you our general strategy. A couple of ideas on how to make money in a rising interest rate environment, as well as industry tricks and traps to suck money out of your accounts and help fund some of those fat cat Wall Street bonuses that you need to know about so you don’t become an unwilling participant in funding Wall Street bonuses. So let’s jump into it. Here is our strategy and if you have questions about it feel free we don’t claim to know everything there is to know. We are happy to explain our strategies and details. But in general terms, when we put bonds into someone’s investment account, we are buying an individual bond and we intend to hold that bond until it matures or it’s called by the issuer. And if we are paying face value for the bond then we are going to get all of our money back when the bond is called and matured. And while we hold the bond we get the stated interested rate or the coupon interest rate that the bond is suppose to be paying. Now the bond value one month to the next will change either up or down depending on interest rates; just think of a teeter-totter. So you’ve got two people sitting at the end of the teeter-totter and one person is named “interest rate” and the other person their name is “bond.” Well if interest rate is moving up on the teeter-totter then the bond is going down. So if interest rates go up the market value of the bond goes down. The flip side of course is if the interest rates go down the market value of the bond goes up. So I think most of us would think hmmm, rates can’t go much lower so the next move in interest rates is going to be up, meaning bond values are going to go down. For most of our clients and accounts we are not concerned with that simple because if we hold the bond until it comes due, we get all our money back; we don’t lose any money.

Now if you sell the bond before it comes due or it matures, then obviously you run the risk or opportunity of either making money or losing money when you sell the bond. So for that reason it is important to understand what your maturity or call provisions are on the bond so that if you need money from your account, from the bond portion of the holdings that you’ve got money coming due, you know kinda sorta timed to when you’re going to need cash flow or money from that part of your account. So that in a nutshell is why we don’t get too concerned about a rising rate environment simply because we buy the bond, hold it to maturity and then we get our money back. Very similar to buying a CD, holding it to maturity; you get your interest plus your money back.

Now, what do we do when interest rates go up? Well there are two general types of investment strategies. When it comes to buying bonds we always advise whenever possible to buy the individual bond not a bond mutual fund. The reason for that is the bond mutual fund, there is no maturity date. So you can’t buy a bond fund with the idea you are going to hold it to maturity because it never matures. Therefore owning a bond fund long enough is a guaranteed way of watching your principle erode in value. It’s very tough to make money net in a bond mutual fund. If you catch an interest rate cycle properly, then you can make money with a bond fund but just as a long term holding it is very difficult to do. Whenever possible we try to avoid the bond mutual fund. That’s when we want to own bonds to generate income and add a level of stability in an investment fund. When it comes to making money in a rising interest rate environment, we actually intend to own bond funds. Two different types. The first one is generally referred to as a floating rate note fund. It’s a mutual fund that will buy short-term commercial paper, diversified in a fund. The interest rates on these short-term notes are usually tied to an index like Lebore (?) London Inner Bank Offer Rate, resetting every 90-120 days. So in a rising rate environment, the yield on the fund tends to follow increasing interest rates. The other type of fund that is out there is what is referred to as an inverse fund or a short fund. These are mutual funds that are engineered if you will, to short the bond market or go inverse (opposite direction of the bond market) so when bonds are losing value, these funds go up in value. So those are our strategies to combat a rising interest rate environment where we are still going to earn competitive yields or returns in our fixed income, fixed interest rates portfolio or that piece of the investment account earmarked for fixed interest rate type of account.

The other thing I wanted to share with you is some industry tricks, tactics that are used. The first is, understand this. Bonds, the buying and selling of bonds, is totally different to the buying and selling of stock. A lot of people don’t realize this. When we go to buy an XYZ stock, we can buy it from a multitude of places, internet broker, discount broker, full service broker, etc…Pretty much the price is known. You’re paying the same price for the stock or fund regardless of where you buy it. The difference is the level of commission you pay whether you are using a discount broker or full service broker. The share price for a stock is pretty transparent. This is not the case when it comes to bonds. Bonds typically are bought by the brokerage firms, held in their inventory, marked up and then resold to their customers. And this is whether we are talking about discount brokers like Schwab, Fidelity, TD Ameritrade or the full service brokers; Merrill Lynch, Morgan Stanley, UBS. It’s just wide spread common industry practice. So if you are buying bonds from a broker and the broker tells you there’s a half percent or quarter percent commission, don’t take that to mean that’s the only money the brokerage firm is making. They could very easily have a 2,3,4 % profit markup by selling you the bond. It pays to shop around and we do this all the time. We identify a bond that we want to own and we will check with multiple sources to make sure that we are getting the best prices because unfortunately there is no master clearing bureau if you will that allows us to see bonds trade quickly, easily and transparent. We’ve had instances where we’ve had a swing of as much as 2 to 3 % swing in pricing just by where we are buying bonds from one broker to the next.

The other thing I want to caution you against and share this with friends and relatives that are important to you. In a low interest rate environment like this, lots of people we are seeing have been tempted to put money into annuities. That very well may turn out to be not a good move in the long-term perspective. What I mean by that is typically when you put money in a annuity, your money is going to be subject to early withdrawal penalties. So the annuity company might offer a very attractive teaser or first year rate, but when it comes time to reset or renew your interest rate, it’s very common they will renew at below market rates because they have to make up for the teaser rate. A lot of people feel stuck or end up being stuck because the penalty to get out is so severe they end up being stuck with what becomes at best a mediocre or sub par performing annuity. So in an environment like we are in now, I would be very leery of annuities in general. Especially those that have long withdrawal penalties surrender charges.

One other aspect that we get questions about, bear in mind that bonds have a lot of detailed information tied to each individual issue. Very difficult if not impossible for the brokerage company to provide all of the details about each individual bond on your monthly brokerage statement. Bear that in mind if you have questions you need to check back with the brokerage firm or if you are working with us, give us a call if you have concerns or questions about an individual bond. One of which is you may have heard of so-called “Build America” bond. And we’ve been buying these bonds for certain client accounts for quite some type. They are also referred to as taxable municipal bonds. So it’s very hard to tell. They are not designated on most brokerage statements whether you have a tax-free or now a taxable municipal bond. It use to be if you had a municipal bond, you knew it was tax free. Well now if you have a municipal bond you have to ask yourself if it’s taxable or tax-free. One easy way to tell is if the interest rate seems abnormally high, then you probably have a “Build America” taxable bond because tax free bonds we all know pay lower interest rates because you don’t have the income tax hit.

BT, with that let’s go ahead and open it up for any questions. Why don’t you tell everybody how that works and we’ll start answering questions.

BT: All right. What I will do next is unmute the lines and we will be able to hear everything on your end of the phone line so everyone will hear any background noise. Hit *6 and that will mute your individual line. So let’s open it up for questions. We have about 15 minutes left.

Any questions?

BT: Just a comment about the Build America Bonds while we are waiting. The BAB program was set to expire shortly. The success of the program has caused municipalities to encourage the federal government to continue the program. Basically the US government has been on the hook for 35% of the interest payments for these BAB. If they do extend the program, it’s been speculated that they will lower the interest rate exposure or the interest exposure to the government down to about 28% of the next pool of bonds they would sponsor. So we’ll have news on that shortly but most likely it will be a slightly smaller degree of coverage if you will from the federal government side. So we’ll keep you informed on that program.

CHERYL: What is the interest rate personally that you can get on the tax exempt part? Do they have tax exempt America Bonds?

BT: Generally speaking they are taxable so the Build America program we are seeing rates in the 5-6% range just depending.

CHERYL: What length are they?

BT: It depends on the municipality that’s putting them out there. Usually they are at least 10 years. Often times they are 15-20 years for maturity. Usually there is a call provision in those which means they are going to back it back early if they have the chance. But it’s usually 10-20 years.

BF: That brings up a question we get all the time. My goodness, rates are going up. Why on earth would I want to lock in a bond for 10-20 years? So one of the things we do and if you’re not working with us, you need to be doing this yourself or whomever you are working with. On a monthly bases, which is what we do. Some of you may remember years ago, you could buy a CD at 14, 16, 18% interest. Ahhh, the good ole days!! And you may recall it was quite common for people to go to the bank, cash in a CD prior to maturity, pay the early withdrawal penalty and go buy a CD that was paying a higher interest rate. When all the dust settled and you did the math, you actually made money by doing just that. So we look at that with all of our bond holdings on a monthly basis. And I would say collectively we’ve got probably $30-$40 million dollars invested in bonds right now. And on a monthly basis we look at every single bond issue. Does it make sense to close that position out and reinvest the money in a different issue whether it’s for a profit or a loss with the idea are we going to be able to create a bigger income profit opportunity by doing that transaction or transfer if you will. And you really should be doing that on a monthly basis regardless of what the interest rate environment is doing to make sure you are maximizing your bond holdings.

BT: We find opportunities from time to time where we can take profit on a position or bond. An example would be we held a Pitney Bowes bond for a couple of years. In December we sold it for more than a 10% gain so it appreciated while we held it. We had bought it slightly below the par. Which is face value. So we sold it for a 10% gain and was able to find another bond that had a slightly higher interest yield and it made sense to take the opportunity to earn the profit.

BF: Any other questions? Shy group this morning.

Pat: Just wanted to say that this is a little more sophisticated which could be the problem. Anyway wanted to let you know how much I enjoy the program and I listen every week so please keep it up.

BF: Pat brought up a good point. Bonds can be much more complicated and the bond market itself can be as volatile if not more volatile than the stock market. So you really need to know and understand what you are doing when it comes to buying individual bonds which is why naturally a lot of people default to bond mutual funds and in a falling interest rate environment, bond mutual funds perform quite nicely. Our concern is in a rising interest rate environment a bond mutual fund will come down in share price. Be very leery if you have a bond mutual fund today, you want to have a strategy to protect yourself against loss in a rising interest rate market.

The other thing I’ll share with you, and this may stir the pot a little bit, everybody feels the interest rates are going up. It’s just a matter of when and how high and how fast. Here is an interesting tidbit. The 10-year treasury note; the average long-term yield is usually around 4%. Well the yield today on a 10-year treasury note is 3.65% give or take. So we are not too far below the long-term average yield wise anyway. I think the same thing holds true, I don’t remember the rate off hand BT, but I think the 30-year treasury there isn’t that big of a difference rate wise either is there?

BT: No. In fact the yield curve. And when I say yield curve I mean….

BF: The short term, mid term, long term. So in a normal interest rate environment you expect short-term rates to be lower than mid term rates, which should be lower than long term rates. And so then you’ve just the mountain if you will. How steep is that mountain. So what it is looking like right now is the long-term rates….

BT: And just so you know the 20-year treasury is about 4.43%

BF: There you go.

BT: The 30 year is actually a theoretical number at this point because they aren’t selling 30-year bonds, but the 30-year is about the same not much difference.

BF: When it comes to mortgages, home mortgages, most of the mortgage interest rates are priced more closely to believe it or not the 10 year bond. Bottom line is it doesn’t seem like we are too far out of whack. I can tell you our supply and demand system of seeing strength in certain areas of the market whether it’s stocks bonds, commodities, currencies, etc… certain sectors of the market; large cap or small cap, international, we use the same research to track interest rate and we’re seeing no signs right now of significant increases of interest rates. A little bit of an up tick here recently but nothing to start sending off warning bells. To that end we think people who are making decisions on investments today assuming we are going to be in a high interest rate environment and especially a hyper interest rate environment, they are going to have to be very patient for now to see profits from those types of investment choices. Which means we think it’s too early to be making those types of moves just yet.

BT: 5 minutes left.

BF: Any last minute questions or comments?

CHERYL: I’ve been thinking about coming to get financial advice. How do you charge for your services?

BF: This would probably make for a good topic. We are what are known as a fee only financial advisor. Clients pay us a fee that we agree on ahead of time. And then in return we look for the lowest cost in investment options appropriately for each individual client. The bottom line is, our clients don’t have to be worried or concerned about a recommendation and if it’s going to add money or put money into our pocket because it doesn’t. They are just getting unbiased, independent third party advice on a fee basis. So if you want to dig into that deeper, I encourage you to call the office and we can follow through on that.

Thank you for joining us this week. We’ll have another call next Tuesday at 9am. If you have a topic or concern you would like to hear, please let us know. Send an email or call the office. Tell you friends about the calls. If anyone misses a call, we do post the calls on the website.

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