If your clients are like most in- vestors, the recent rise in interest rates may make them wonder if now is the right time to invest in the bond market, or if they should wait in the event that rates rise even higher. According to the Investment Company Institute, as of August 27, 2003, there was approximately $2.18 trillion sitting idle in money market funds, and many of those funds had yields of less than 1%.
Why? Arguably, investors could be waiting for the right time to jump back into the equity markets or for interest rates to move up before investing in bonds. Of course, by waiting, they run the risk that rates may fall and the opportunity to lock in current levels may be lost. Alternately, rates might in fact rise, but not enough to offset the income sacrificed during the waiting period.
In helping your clients plan their investments, be aware that waiting can be very costly to their investment goals. Having said that, we will consider the cost of waiting as it applies to the bond side of the equation. Then we will explore several investment strategies that can accommodate the needs of investors regardless of the eventual direction of interest rates, such as laddering a portfolio, step-up, and floating-rate investments.
Let’s use the following two scenarios. Assume that two investors each have $50,000 in a money market account and both have a 10-year investment horizon. Investor A is uncertain as to the direction of interest rates but decides to invest $50,000 in a triple-A rated 10-year bond yielding 4.50%. The total income generated is $22,500.
Investor B is also uncertain and chooses to remain in the money market fund that is yielding 0.75% in anticipation of interest rates rising. Let’s say that after two years, rates do rise 50 basis points. Investor B takes the entire $50,000 and purchases an eight-year triple-A bond yielding 5%. The total income generated is $20,750.
Even though Investor B eventually buys a bond with a yield that is 50 basis points higher than Investor A’s, the cost of waiting to Investor B is $1,750 in total income ($20,750 compared to $22,500).
If interest rates had fallen, the loss of potential interest income would have been even greater. On the other hand, if rates had risen considerably within a short period of time, there may have been validity to waiting to lock in a longer-term rate.
Alternative #1: The Bond Ladder
A great way to put money to work in the bond market, yet hedge against interest rate fluctuations, is to build a bond ladder. A ladder involves allocating a certain dollar amount into different maturities over a specified time period. Having a portion of money mature, or “roll-off,” periodically allows the investor to reinvest in additional bonds, which can extend the final maturity of the investment. For example, an investor with $50,000 to invest could take advantage of various coupon rates and maturities by placing $10,000 in bonds that mature in years two, four, six, eight, and ten. As each bond matures, a new 10-year bond is purchased to maintain the ladder. A ladder generates more income than a money market investment, yet provides the opportunity to benefit from future interest rate increases as bonds mature and funds are reinvested.
Alternative #2: Callable Step-Ups
The callable step-up investment is another strategy that is gaining investor attention. As the name implies, callable step-ups do not pay a constant rate of interest over the life of the instrument; rather, they pay a predetermined schedule of coupon rates. The rates begin somewhat below that of similar fixed-income investments and gradually increase, or “step up,” over a specified timeframe. The coupon may step up only once or as often as annually until the investment is called by the issuer or it matures, whichever occurs first. Step-ups are sold at par, and most have final maturities of fifteen years or less.
Typically, a step-up also becomes callable on the first date that the coupon resets and is callable either semi-annually or at any time thereafter. Investors can choose step-ups that are issued by Government Sponsored Enterprises (GSEs), such as Freddie Mac and Fannie Mae. Banks also issue Certificates of Deposit (CDs) as step-ups, and CDs enjoy certain benefits such as FDIC insurance and possibly a survivor’s option, which allows the estate to redeem the certificate in the event of the owner’s death.
Callable step-ups may attract investors because they may provide a greater overall weighted average coupon than comparable fixed-rate investments. That is so because even though the coupon paid on a step-up is initially somewhat lower than the rate available on a comparable fixed-rate investment, the step-up eventually increases to a level that is considerably higher than the fixed-rate, if it is not first called by the issuer. The step-up investor chooses to sacrifice some interest income in the early years in exchange for the potential to receive a higher yield over the life of the investment.
Callable step-up investments generally attract investors who are expecting interest rates to rise, but who are also seeking protection if rates rise more than expected. In this scenario, the increasing coupons may keep pace with rising market rates, which can help to offset unfavorable price movements.
Alternative #3: Floating-Rate Investments
Another choice for investors who believe that interest rates may rise is a floating-rate investment that keeps pace with rising interest rates. A floater is a bond with an interest payment that “floats” or adjusts periodically based upon the rate of an underlying index such as LIBOR (London Interbank Offered Rate) or the T-bill rate. Because a floater’s interest payment changes from time to time, based upon changes in market rates, it is well suited to keep pace with rising rates.
Another benefit is that a floater’s market price is less sensitive to changes in the interest rate environment compared to fixed-rate bonds. It is important to note that since short-term rates are usually lower than long-term rates, the initial coupon of a floater is typically lower than that of a fixed-rate note of the same maturity.
Floating-rate investments may have a stipulation by which the coupon can move up or down, within a certain collar or range. A cap can limit the potential return to the investor, while a floor protects the investors on the downside. For example, a floating-rate structure issued with an interest rate equal to the three-month Treasury bill plus 40 basis points may have a cap of 3% and a floor of 1%.
Putting It Together
Each of the bond strategies mentioned might be appropriate for investors who are unsure as to the direction of interest rates. While no one can control the direction of rates, depending on their investing goals and time horizons, investors may not want to risk the costs of waiting on the sidelines. Further, a portfolio that is properly diversified among asset classes helps to reduce overall portfolio risk.