Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.
Ask yourself why you are investing in fixed income. Not why do most people invest in fixed income or how do most people utilize fixed income in their portfolio, but why are YOU investing in fixed income? Identifying the why will guide you to what characteristics to seek when buying bonds. Is a high level of cash flow a priority? You will likely want to focus on higher coupon bonds that will provide the cash flow you seek. Is eliminating credit risk of utmost importance? Look to a product with government backing like a US Treasuries or FDIC-insured CDs. In the current corporate bond landscape, for investors whose “why” isn’t to maximize current cash flow, an opportunity has presented itself that hasn’t been readily available in recent memory: buying corporate bonds at a deeply discounted prices.
Why is this opportunity available? Over the course of most of 2019 through 2021, interest rates were at very low levels by historical standards. As a result of the low yield environment, most of the bonds issued in this timeframe were issued with very low coupons. Last year, yields rose dramatically which is how we arrived at where we are today, where yields available are at levels we haven’t seen in 10-15 years across some parts of the market. Bond math 101 tells us that as yields rise, prices fall. This happens because a bond with a fixed low coupon will have to be sold at a lower price in order to compete with newly issued bonds that have higher coupons. Most of the low-coupon bonds that were issued over the past few years are now selling at discounted prices.
Why might deeply discounted bonds be appealing? And to whom?
- They require a smaller principal outlay relative to face value. If a bond is priced at 80, purchasing $100,000 in face value (maturity value) will only cost ~$80,000.
- The maturity value is known, so barring a default, there is a known appreciation value at the time of purchase. While the price of the bond will fluctuate based on market conditions, it will gravitate towards par over time.
- A low coupon reduces the probability that a bond will get called. Many intermediate and long maturity bonds were issued with low coupons and near-term call dates over the past few years. Purchasing these low-coupon/deep-discount bonds lessens the probability of a call (and corresponding reinvestment risk) compared with higher coupon bonds with similar call dates.
- Given the rapid rise in yields, deep discount bonds are prevalent. Casting as wide a net as possible when searching for investment opportunities increases the likelihood of finding unique pockets of value.