A great many investors are aware of only one way to manage their bonds: buy them and hold them until they mature, reinvesting the redeemed funds in more bonds to hold until they mature. Not surprisingly, this is called a buy-and-hold strategy, and it’s considered a form of passive management.
But there is another way to approach a bond portfolio. It’s called active management, and it routinely involves selling bonds before they mature. Before considering active management, however, it’s important to understand some bond fundamentals.
Bond Income Versus Capital Gains
Everybody knows that bonds generate income in the form of interest payments. But many people don’t realize that bonds can also generate capital gains in the secondary market — the market where investors buy and sell existing bonds.
Interest rates are the result of the prices investors are willing to pay to receive the fixed income streams from existing bonds. Whenever potential buyers of existing bonds decide the bonds’ annual income isn’t enough relative to the bond’s price, they’ll bid bond prices lower. As a result, the bonds’ current yield, their effective interest rate, will rise. The result is that at any time, the market value of any given bond could be higher or lower than its face value, original price, or previous transaction price.
Individual bond prices can also change as a result of changes in their credit ratings. If a major bond agency reduces the rating of a bond, its price will normally go down; if the rating goes higher, the price will ordinarily go up. In either case, the price is bound to be different from its price when you bought it.
Selling to Capture Premiums or Higher Yield
Bonds with prices higher than their face value — something that often happens when interest rates have been falling for some time — are called premium bonds. If you’re holding a premium bond to maturity, one thing is certain: no matter what happens to interest rates in the future, you’re never going to benefit from this temporary increase in your bond’s market value — unless you sell it. So in the right circumstances, it can make sense to sell a premium bond.
In certain circumstances, it can make sense to sell a bond that’s fallen to a lower price than it was purchased for. Why? First, selling a bond at a loss generates a potential tax advantage — a capital loss that, come tax time, can be used to offset capital gains taken elsewhere. Second, in a market in which bond prices are falling, bond interest rates are rising. So investors can increase their net income if they sell a lower-yielding bond to purchase a higher-yielding bond.
Using the Yield Curve
Professionals know that the bond markets are more inefficient than the stock markets. One of the results is that anomalies frequently occur in what’s known as the yield curve, the line on a graph that shows yield by maturity.
In theory, there is a gradual and proportional relationship between time to maturity and yield. On a normal yield curve, the line rises a bit steeply from left to right over the first few years, and then begins to flatten out, with yields continuing to rise as the maturity gets longer.
In practice, abnormal relationships can emerge, where the yield for a slightly shorter maturity is higher than the yield for some longer maturity (an inverted yield curve). In this case, a premium may have developed for the longer maturity that could disappear once the market becomes fully aware of it. In such cases, active managers may decide to sell the longer maturity and buy the shorter one to book that capital gain.
Have some of your bonds become premium bonds, and could you benefit from selling them? Or have the prices of some of your bonds sunk below what you paid for them? Are there bonds on the market that could increase your income? Please call if you’d like to review your bond portfolio.
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This newsletter was prepared by Integrated Concepts Group, Inc. The opinions expressed in this newsletter are for general information only and are not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. The views expressed are those of the author and may not necessarily reflect those held by PlanMember Securities Corporation. Material presented is believed to be from a reliable sources and PSEC makes no representation as to it accuracy or completeness.