Fixed Income is often poorly understood by equity and retail investors. Sure, investors analyze every word the Fed says, discuss market interest rate expectations, and, my personal favorite, often ask themselves “what is the bond market telling us?” However, beyond these high level observations, the important nuances of fixed income investing are often misunderstood and underappreciated. With the 2-year Treasury bond now around 1.9% and the 10-year Treasury bond just above 2.1%, we thought it was an opportune time to remind investors of the common potential pitfalls of fixed income investing.
I like to refer to the first common mistake of fixed income investing as, “Don’t be deceived by the sticker price.” Many investors often focus on the coupon rate on a bond or preferred. However, unless you are buying the security at par (generally $1,000 for bonds), the yield earned will differ from its coupon rate. The yield is the expected economic return of a fixed income investment, whereas the coupon is simply the annual interest rate payment from the borrower to the bondholder. For example, a 5% coupon bond maturing in 10 years purchased at $110 only has a yield of ~3.8%. While you may receive $5 per year for the next 10 years, you will only receive $100 at maturity versus the $110 you paid. The $10 difference the payment the buyer is making for the ‘above market’ coupons. An even more extreme example is when a 5% bond matures in only 1 year and you pay $102.5. You will earn less than 2.5%, but some investors may think they are getting a 5% yield. This misperception is true as well on bonds purchased at a discount. For example a 1-year bond with a 3% coupon purchase at $98 will yield just over 5% because the investor will receive $3 in interest payments and then $100 at maturity.
A second mistake is the belief that are higher yields are always better. Higher yields are great, but at what cost and for how much more risk? While a 7% yield may sound attractive when the 10-year Treasury bond yields around 2.1% (as it does today), most bonds and preferreds yielding 7% likely embody significantly more risk. Without a doubt, some securities currently yielding 7% are attractive, but choosing the correct ones is of utmost importance and requires significant research. Even amongst two bonds with similar yields and ratings, one company may have significantly more commodity price, leverage, or business risk than another. Blindly buying a large basket of bonds yielding 7% likely entails significantly more risk than the investor appreciates. You must very carefully pick your spots to find incremental yield in such a low interest rate environment.
A third mistake arises when investors underappreciate the substantial tradeoffs of owning short-term securities versus long-term securities. Many high quality companies issue 30 year bonds which typically offer higher yields than their 5 year bonds. Since corporate yield is the sum of a risk-free interest rate (think: Treasury bond) plus the company’s credit spread, two factors lie behind the difference. The first difference is the spread between the long-term and short-term interest rates which is driven by current and expected inflation, economic growth, and Fed actions. Currently, the Treasury bond curve is relatively flat so investors are only getting ~0.66% extra yield from owning a 5-year Treasury bond versus a 30-year. This spread is not overly compelling on an absolute basis and is well below the past ten year average of ~1.62%. The second difference is the incremental credit spread investors demand for a 30-year loan versus a 5-year loan. A credit spread is the additional yield investors require above the corresponding Treasury bond in order to lend to a Corporation. The riskier the Corporation is perceived to be, the higher the credit spread investors demand. As you can see in the chart below, credit spreads are relatively tight by historical standards so you’re not getting paid very much extra, by historical standards, to take 25 extra years of business risk. While some companies are expected to improve their balance sheet and experience strong business growth, the past 20 years highlight just how many companies will likely complete large debt-financed acquisitions or become secularly challenged over such a long time horizon. The likelihood of an industry undergoing transformative change in the next 30 years is significantly more likely than over the next 5 years. Admittedly, longer-dated bonds do offer more price appreciation when interest rates decline or a business dramatically improves, but once again you must choose very wisely.
Source: ICE Benchmark Administration Limited (IBA), retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2, May 30, 2019.
The fourth mistake, which is more common in the low interest rate environments of the past decade, occurs when investors think of preferred shares as the simple, safe answer to generating higher yield. The three major risks of preferreds are duration risk, credit spread risk, and call risk. Preferreds generally have no maturity date, so if interest rates increase dramatically the Company will simply never redeem the preferreds. For example, if you spend $100 to buy a 5% coupon preferred now, but in the future comparable securities yield 6%, the preferred will trade down to approximately $83.3 so that the security will yield 6%. The same math applies to credit spread risk. If investors in the future demand an additional 1% credit spread for similar preferreds, the security you’ve purchased will trade down dramatically to incentivize new investors to buy such a security. The third, often ignored, risk of preferreds is “call risk,” which arises when—as often is the case—the issuer has the right to redeem the securities 5 or 10 years after issuance. The company will only do so if the redemption is beneficial to itself, not the investor. Currently, some preferreds are trading well above their current potential redemption price so if they are called, the investor takes an immediate hit on the value of those securities. While these securities may not be expected to be called, it is a risk investors should take consciously and carefully. This also goes back to pitfall one in which some investors just look at the coupon rather than the yield if the preferred were, indeed, called.
The fifth common mistake surfaces when investors forget that a company’s fixed income story and its equity story are often not the same. Investors often fail to recognize that some companies’ risk/reward profile makes them interesting equity holdings, but weak fixed income investments. Furthermore, actions that are good for the stock may be detrimental to the bonds/preferreds. For example a debt-financed repurchase of shares provides no benefit to fixed-income investors, but will likely be lauded by the equity market. A fixed income investor generally wants the Company to generate large amounts of excess free cash flow that can be used to repay debt. While equity investors typically want to see growth or significant cash flow returned to shareholders. It is important to remember that the appeal of a stock may not coincide with the attractiveness of a company’s fixed income instruments.
When choosing fixed income investments, investors must remain keenly aware of the five pitfalls discussed here. We recognize there are various tradeoffs, but consciously evaluating the risks versus the rewards associated with each of these pitfalls can be a true differentiator. A 7% yield sounds great in a 2% interest rate world, but when challenging times come the 7% yielding securities could quickly become 8%, 9%, or even 10% yielding securities—and that means the prices of those securities could drop materially. The investor who ignores risks and excessively focuses on maximizing returns may outperform for months or even years, but will eventually get very hurt upon a downturn. For these reasons, we carefully choose individual securities so we can remain keenly aware of the potential pitfalls while consciously analyzing the risk/reward associated with each security.