Bonds: A Lesson in Corporate Finance

By: Steve Rubis

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.

The Fork in the Stock Market Road: The Road to Nowhere

By: Steve Rubis



Our last article recommended that investors hold their positions, at this time we would like to issue an emphatic sell for all stocks. There are numerous stocks with very strong fundamentals, yet all they do is go down in price. Investors must take the following to heart: there is a time for all things. The time to buy stocks has passed with the climax occurring in May 2006. At this time, the best strategy is to create a laddered portfolio of short term government bonds.

Your editor has sold all stock positions at this time. We feel that both our positions in Sierra Wireless and Elan Pharmaceuticals had room to go higher. The problem is that when the entire market has gone down 1000 points in one month, you have to heed the obvious signs. Broker rates are at 6.75% showing that any type of rally will fall short. The major culprit of this precipitous drop is Fed Chairman Ben Bernanke and his raising rate strategy. It seems that he has taken rates higher too quickly.

The problem with raising interest rates so fast has hurt both the stock market and the real estate market. Home builder’s stock prices have been ravaged over the last month. An especially telling sign are the oil stocks. These stocks have tanked, to put it mildly, and there is no reason to believe that the fundamentals of this sector have changed. Investors must realize that higher rates will cut profit margins and make corporation’s cost of capital increase. When this metric increases it becomes harder to generate shareholder value.

Since higher rates will hurt stocks, we believe that they best strategy is to purchase short-term bonds. An astute investor should create a laddered portfolio of short-term bonds maturing in as quickly as one month to one year. The Fed will most likely continue to raise rates; this continuous rise will ultimately create an inverted yield curve. Currently, the flat yield curve illustrates the market’s uncertainty. Short-term rates will have to rise in order to induce long term bond investors to switch maturity. We believe that with a laddered portfolio, an investor can eliminate reinvestment risk. As your staggered maturity dates come due, you will be able to purchase more bonds because prices will have dropped and rates will have gone up. You receive a double bonus, a higher coupon rate and at the same time the difference between purchase price and maturity value.

It was easy and entertaining to listen to people like Jim Cramer who gives advice on his show Mad Money. The problem is that people like Cramer only advocate stock investing. Such a strategy is equivalent with financial suicide. Benjamin Graham, one of the most conservative and most successful investors, advocates a position of both stocks and bonds, with each portion ranging from 25 to 75% of the portfolio. With this in mind, we think that most investors should be allocated to 75% or higher in bonds. As the market goes lower, it will continue to follow the path of least resistance – stocks will follow suit. Remember a rising tide lifts all ships, but at the same time as the tide falls so will everything in its wake.