In my view, sticking to the common myth that bonds should be bought and then stored in a safety deposit box is a foolish way to invest. Bonds are investment instruments that must be traded like you would trade a stock.
To most of you, a bond is a secure, mostly stagnant investment that provides a fixed annual income and can be redeemed at maturity for the same amount of dollars used to purchase it when issued.
But there are plenty of conservative opportunities, with all kinds of bonds, to attain capital gains or to increase total returns from income plus appreciation.
A straight bond almost always reflect the cost of money, which is reflected by the interest rate. Capital gain opportunities result from changes in interest rates.
Nowadays, with the extreme volatility in interest rates, bonds should be bought for trading, not holding, unless you are willing to swap the ultimate security for interim paper losses or actual profits.
As a rule of thumb:
(1) buy short-term, high-coupon bonds when there is a probability of higher interest rates
(2) buy long-term, low-coupon bonds when there is good reason to anticipate a decline in interest rates in the next six to twelve months.
Since you are giving up some current income when you buy discount bonds, always look for a higher-than-current yield.
It pays to know the history of certain bonds before you buy them. For instance, U.S. Steel Corp had long faced financial crises, which caused chaotic conditions for the bond holders. Prices were all over the board. A 4 3/8’s U.S. Steel bond, issued at $1,000, sold at 55 when the interest rate was 8%. When the cost of money went below 7%, its value moved up to about 59. But, later, when interest rates soared to over 18%, its price fell to 39. When they started to fall again, the price jumped to about 66.
Discount bonds are excellent investments for a Subchapter S corporation (basically a family holding company in the U.S. where profits are funneled through the corporation to the individual shareholder).
Discount bond investments can earn tax-deferred or tax-free income for shareholders because only 40% of long-term capital gains are taxable to an individual. Hence, the result is to convert part of the investment income into tax-exempt income.
They are excellent for offshore corporations and trusts that pay little or no tax on income.
Recommended reading includes these books by “Dean of Bond Street,” Sidney Homer:
(1) History of Interest Rates
(2) Great American Bond Market
(3) Inside the Yield Book: Tools for Bond Market Strategy
(4) Price of Money, 1946-1969: An Analytical Study of U. S. & Foreign Interest Rates.
In his books, mostly written in the 1970’s, Homer advised investors to recognize the value of reinvesting bond interest. Over a 20-year period, he pointed out that more than half the total return of a bond comes from interest on interest.
This is the magic of compounding interest.
So, to build capital and boost your income over the years, always reinvest the semi-annual interest into more bonds. If your coupon income is relatively small, Homer would advise you to hold the money in a savings account until you can add savings and buy more bonds. Today, of course, you would put that money into a money market fund.
In his 1977 “Inside the Yield Book”, Homer explains that all bonds do not act the same when there is a change in interest rates.
Other things being equal, the volatility of bonds is greater (i) the longer the maturity, (ii) the lower the coupon and/or (iii) the higher the starting yield. Thus, 20-year 8’s are more volatile than 30-year 12’s; 15-year 10’s are almost as volatile as 30-year 12’s, etc.
If you have substantial holdings in bonds, it will pay you to ask your broker to discuss your portfolio with an experienced bond analyst and/or trader. Not being a bond specialist myself, that’s would I would do.
Guidelines for finding profits in the bond market:
(1) If you anticipate higher interest rates, buy short-term bonds. If you’re right, reinvest the redemption proceeds in high-yielding long-terms.
(2) Be cautious about locking in high yields unless you are happy with income alone. Over a period of years, the prices of these bonds can swing widely and their total returns will always run behind inflation.
(3) If you anticipate lower interest rates, buy low-coupon long-term bonds and sell when you have an adequate capital gain. The percentage gains would be higher if you used margin.
(4) With bonds, don’t worry about “wash” sales, i.e., selling and buying back similar securities within 30 days (see notes on taxes). With stocks, these losses are not tax deductible but with bonds, there are no such limitations.
(5) Beware of maintenance fees if you leave the bonds with your bank as custodian. Typically, the charge will be about $5.00 per month. This will lower your net rate of return considerably because $60 a year is quite a dent in the $600-a-year interest on ten 6%-coupon bonds.
Buying bonds on margin
Most broker-dealers limit margin accounts with bonds, which is usually about 33% for long positions and 50% for short selling. But banks are more liberal and will lend up to 80% on quality corporate bonds and over 90% on U.S. government securities. So check with your broker as their policy.
A few years ago when the cost of money was higher and the interest rate on bonds higher than that of a loan, it was usually not profitable to buy bonds on margin. But in today’s market environment (4Q03), with rates at historic lows, the income from the bond pays the loan cost.
If, as and when interest rates grow in future and the price of bonds start to fall, you could sell for a low-taxed, long-term capital gain. Or, if you a speculator, you could sell short today and cover your position at a profit in the future. Such speculations only work well in periods of low interest.
For high tax payers: 45% annual rate of return
If in a high-tax jurisdiction you pay taxes at a 70% rate and are willing to borrow heavily, bonds bought at the right time can provide after-tax returns of over 45%. This is possible because of a combination of deductions for interest and low 3% to 8% margins on the loan. The benefits may even be worthwhile at a somewhat lower tax bracket.
Mr. Smith, in the 70% tax bracket, bought $1 million 7%-coupon bonds, due in 13 months, at 94.4375 ($944,375). He put up $29,540 in cash and arranged a fixed-interest loan for the balance. (For tax purposes in his jurisdiction, everything had to be over one year). His interest payments were $44,710. In the 70% tax bracket, this meant an after-tax expense of $13,414. His total investment was $42,954. When the bonds are paid off at par, the capital gain will be $45,625. Since his capital gains will be taxed at a 28% rate (40% at 70%), the after-tax net will be $19,437. On the investment base of $42,954, that’s a net return of 45.25%.
The danger here, of course, is that the price of the bonds drop during the remaining 13 months of this bond, so that Mr. Smith will have to come up with more cash on the margin loan. With such a short maturity this is not likely but if it should happen, it could be expensive.
Every rise of 1% in the cost of money would mean an extra $10,000 in margin. So, before you try such a deal, be sure to check with your tax adviser and be confident that interest rates are likely to rise in the interim.
By Bill Cara
Source: Trader Wizard
Photo credit: Gamma Man via Visual Hunt / CC BY
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