In case you hadn’t heard, The Federal Reserve System recently lowered interest rates.
But what does that mean for investors?
To help you better understand what this means and how it may impact you, I brought Jason Stuck on to the Retire Right podcast to talk a little bit about municipal bonds, what they are, and how they work.
Jason is the Managing Director and Head of Portfolio Management at Northern Capital, where he oversees the management and implementation of client strategies. Jason also advises investment advisors and money managers on portfolio construction, rebalancing, security selection, and risk management strategies.
Through his expertise, Jason brought some clarity around the subject of municipals bonds, along with some great insight for investors. Read on for some highlights from what he had to share!
Bonds are a loan between a lender (an investor) and borrower (companies, municipalities, states, etc.) which includes an end date when the principal of the loan is due to be paid to the lender. Bonds also typically come with variable or fixed interest payments by the borrower.
Coupons are essentially a guarantee that the borrower is going to pay the investor semiannual interest payments. For example, if a municipality is issuing a new 10-year bond at par with the coupon at 5 percent, the investor will get 5 percent interest and the 10-year return would be 5 percent.
Callability is when the issuer gives themselves the option to take the bond away at any given time, which is usually specified within the bond.
For example, you can have a 15-year maturity bond (meaning the bond matures in 15 years), but the issuer has the option to take it away from the investor in 10 years at a specific price that’s agreed upon at issuance. When that happens in an environment like the one we’re in now, when investors get their money back, they have reinvestment risks —where they have to go back into the market and buy a new bond when bond yields are less favorable.
Duration is something that is typically used to measure the risk of a bond. However, as interest rates change, the duration of bonds or even portfolios can shift pretty dramatically if there are call features.
So what Jason and his team tend to look at for risk is the total return equation, with the change in price as their risk metric. By looking at the bond today, what the purchase price is, and what the potential price is a year from now, or three years from now, they can then use the ending price duration as a good metric to try to measure the risk in a portfolio. Then, based on the duration, you can gear what would happen to the portfolio if interest rates were to fall or rise.
It’s also important to note that shorter durations have less of a tendency to move with interest rate movements and are less sensitive. On the other hand, longer duration portfolios tend to have more interest rate risk, meaning it's going to respond in a greater capacity to interest rate movements.
Maturity is essentially the expiration of a bond, when it’s fully paid off. When this happens, the principals are returned to the investor, who then have to go out and find new bonds.
The Current Climate of Bonds
In the last 30 years, interest rates have dropped, which has been good for the bond market. It’s also great for people who already own bonds because the price on their current bond is going to go up.
It only becomes a problem when you then have to go out into the market and invest new money. Right now, interest rates are lower, making prices much higher. So, the same bond that you would be buying in the secondary market to get 5 percent, you would have to buy above par or at a premium.
For example, if you are buying a $100,000 bond, you have to give $130,000, and then ten years from now you will get back $100,000. That means you’re going to lose $30,000 over 10 years — but you’re making 5 percent interest.
There’s also a lot of buzz right now due to an inverted yield curve. If you think of a typical yield curve, it's typically an upward slope. If you buy a two-year bond compared to a 30-year bond, you could expect to get more yield by buying the longer bond because of factors like expected inflation in the future or expected risk with longer bonds. Right now, we have an inverted yield curve, which means the longer bonds are yielding less than the short maturity bonds. Therefore, you can actually make more money by investing in a short-term bond than you can with a long-term bond.
So, why would anyone buy long-term bonds?
According to Jason, it depends on where you think interest rates are headed or how you want to position your portfolio. If you buy short bonds, you're going to, in most cases, receive more yield or more income. The problem is, you won't hold the bonds for very long, and then you'll be subject to reinvestment risk.
According to Jason, investors could also be scared of premium bonds when they consider the premium versus the principal. However, one reason why you would buy premium bonds is that you’re going to get more cash flow now. That 5 percent coupon is going to provide more income, which is important to people in retirement. You also get to receive that coupon now, which is valuable if and when interest rates rise.
Bond Buying Strategies
One strategy for buying bonds is to buy a bond latter. With this, you're buying each maturity in sequence. For example, if you want to buy a 10-year ladder, you would buy 10 percent of the 1-year maturity, 10 percent of the 2-year maturity, and so on, all the way out to 10 years. Then, when the one-year bond matures, you buy a new 10-year bond.
This strategy tries to capture some or as much yield as possible, given the current state of affairs, or to provide some kind of defense if the investor is concerned about interest rates rising.
According to Jason, another strategy you can pursue is what's called a barbell strategy. With this strategy, you buy some shorter bonds and some longer bonds, avoiding the middle part of the curve (which are about three to six-year maturities.) The short-term bonds will provide some liquidity while the longer bonds will give you some yield in case yields go to zero.
If you’d like to learn more about municipal bonds, be sure to listen to the full episode with Jason, and feel free to give us a call at (631) 293-2806.