Our last article focused on the current investment climate and offered a strategy on how to maximize gains during this stock market slow down. We proposed that investors should consider creating a laddered portfolio of short-term bonds. It occurred to us that while the article was an interesting read, it offers no real proof as to why such a strategy will work. Due to a fortuitous chain of events (my studying bond valuation in Corporate Finance class), we wish to revisit our strategy and offer some concrete evidence for why it works.
To begin, investors must understand that how bonds work. First, prices rise as interest rates fall, and when interest rates rise bond prices fall. In other words, price and interest rates are inversely related. This occurs because of the time value of money. An investors reaps two gains on a bond: (1) the coupon payment; and (2) capital appreciation. As price and yields fluctuate, the yield to maturity on bonds changes, let us use an illustration:
We have a choice between two bonds, both paying a $40 semiannual coupon payment. One bond matures in 10 years the other in 2 years. The current Yield to Maturity is 8% and the bond sells for $1,000. Observe what happens to each bond as rates rise to 10% and fall to 6%.
Below is what happens when interest rates rise to 10%. You can use a simple business calculator to make the computations below.
Bond A Bond B
Periods: 4 Periods: 20
Rate: 10% Rate: 10%
Present Value: Present Value:
Payment: $40 Payment: $40
Future Value: $1,000 Future Value: $1,000
As rates increase the price falls, the amplitude of this drop is based on the length to maturity. Now observe what occurs when rates fall to 6%
Bond A Bond B
Periods: 4 Periods: 20
Rate: 6% Rate: 6%
Present Value: Present Value:
Payment: $40 Payment: $40
Future Value: $1,000 Future Value: $1,000
When rates fall to 6%, the price will rise accordingly. This price rise compensates investors for the fact that the bond pays a higher rate than the overall market.
Our strategy is based on Expectations Theory, which states: in equilibrium, investors should expect to earn the same return whether they invest in long-term Treasury bonds or a series of short-term Treasury bonds. Consider the following examples:
Take a look at the Yield Curve (this is a graphical display of Yields to Maturity and their respective times to maturity)
A 1 year Treasury bond offers a 4% Yield to Maturity and a 2 year offers a 4.5% Yield to Maturity. It is our assumption that interest rate will rise in the near term, which is based upon recent decisions of the Federal Reserve. In this type of environment observe what occurs:
Ceterus peribus, we would make a simple 8% buying a string of 1 year bonds. If we bought the two year bond our return over the same 2 year period would be a simple 9%.
We are assuming that rates will rise, let us say to 6% after one year. The new return for our string of one year bonds is 10%, whereas we only make a simple 9% on the 2 year bond.
Certainly, this is a very simplistic look at the bond market. An investor must understand that there are numerous factors that determine interest rates: maturity, liquidity, default, et al. Nevertheless, our analysis of the current yield curve, where it has been, and seems to be going, we believe that creating a string of short-term bonds will offer an investor an outstanding return in this investing environment.
*For more information on the yield curve go to the living yield curve at Fidelity Investments, the site also gives good explanations of the Yield Curve:
The Living Yield Curve
Watching the yield curve is pretty neat, you can pause it as well.
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