Favorable Current Strategy - Yield and Duration

Doug Drabik discusses fixed income market conditions and offers insight for bond investors.

The NCAA basketball tournament headlines the idea that their tournament is March madness. For those basketball fans out there, you know too well that this year is living up to the self-proclaimed mantra. It is very fitting in a year when the financial markets parallel this madness in March. The 10-year Treasury has experienced a price swing of 6.5 points or 79 basis points in yield during March (a low of 3.29% and high of 4.08%). The 2-year Treasury bedlam moved rates in a range between 3.58% to 5.08%.

Just like the tournament, the market pandemonium is eye-catching. When we see a firetruck go by we know nothing good is happening yet sometimes there’s an inkling to follow it and observe the danger it’s headed to. Curiosity can be gripping. The financial market volatility is also an attention-grabber. For investors utilizing fixed income as an asset allocation to protect principal (offset customary volatile growth assets such as stocks) and provide cash flow and income, the volatility has had zero effect on bonds held to maturity other than make your statement price look like it’s hooked up to an EKG monitor. Cash flow has been unaltered, income constant and the future date when face value is returned unmoved.

When prices experience volatility, then cash flow and income properties tend to get muddled. A bond’s coupon reflects its cash flow, not its income. In other words, a bond with a 1% coupon can generate the same income as a bond with a 4% coupon. This is because the price of a bond matters. If you pay $100 (par) for each of these bonds, you are getting more out of the 4% than the 1% coupon bond. If you pay $100 (par) for the 4% coupon bond versus $80 for the 1% coupon bond, the comparison is less obvious. The 1% coupon bond priced at a discount will benefit from the coupon plus the par dollars received at maturity after only paying 80 cents on the dollar. If you wish to compare which bond will provide more income, compare the yield to worst/maturity on each bond. This will tell you which bond is earning you more on your investment.

The coupon will help to determine how that money will come back to you. Higher coupons will produce more periodic cash flow. Premium bonds (bonds priced above par) provide more cash flow (higher coupons) which represents the return of income plus some of the premium paid. A deep discount bond can provide the same or more income with less periodic cash flow but a higher payout at maturity.