Interest

Interest

Published On: March 23, 2022

Written by: Ben Atwater and Matt Malick

Although income is always an important topic, we think its importance is now heightened given recent market volatility and retirees’ ongoing need to fund their lifestyles despite the market woes. Over the last few weeks, we discussed our broader portfolio income strategy, then we honed in on dividends and, today, we will better illuminate interest.

In the context of the portfolios we manage, we primarily see two kinds of income – dividends and interest. While a dividend is a payment companies make to equity investors, interest is a payment bond issuers make to fixed income investors. In most cases, dividends are discretionary while interest is contractual. If an issuer does not pay interest, then they are in default. As such, interest is higher in a company’s capital structure and more secure than its dividends.

In our investment philosophy statement, we cite our two goals for fixed income investing: safety of principal and a steady stream of income.

We strive for a “safety first” strategy in our fixed income investing. In stressful and volatile markets, like the one we are now experiencing, having a safe allocation in your portfolio is vital.

Of course, nothing is completely safe and all capital market investing involves risk. Bonds do face a variety of risks, including interest rate risk, inflation risk, liquidity risk, default risk and reinvestment risk.

Interest Rate Risk

When interest rates rise, bond prices fall – all else being equal. An existing bond generally pays a fixed coupon, so if rates rise and new issuers offer a higher coupon, the price of the existing bond should fall until its yield (coupon / price) matches the new market rate. Generally speaking, the shorter your maturity structure, the less interest rate risk you incur. We tend to keep a relatively short average maturity to help control interest rate risk.

Inflation Risk

Most bond coupons are fixed. Inflation will therefore eat into the buying power of your fixed coupon payments. One way to mitigate inflation risk is to diversify into Treasury Inflation Protected Securities (TIPS), which we utilize at times.

Liquidity Risk

In March of 2020, when COVID first appeared on the scene, bond liquidity dried up for a couple of days. It was difficult to sell even Treasury securities, which are the most liquid bonds in the world. This risk that no buyers will be available to purchase your bond if you need to sell is called liquidity risk. Broadly speaking, the larger the market for a certain type of bond and the lower the default risk, the more liquid it is.

Default Risk

Default can occur when an issuer ceases interest payments, or worse, does not have the capital to redeem the bond for face value at maturity. We seek to address default risk by purchasing government guaranteed instruments and high-quality corporate (investment grade) issuers.

On the “guaranteed” side of the equation, we frequently utilize brokered certificates of deposit (CDs) that banks issue and the Federal Deposit Insurance Corporation (FDIC) insures. These instruments trade like bonds. We can buy them and sell them on the open market using bids and offers. The FDIC insures the face value of CDs plus interest earned up to $250,000 per issuer / per account registration. What the FDIC does not insure are market value fluctuations and premiums we might pay to acquire the CD. However, the bulk of the investment is government guaranteed.

We also use instruments that U.S., state and local governments issue directly. These issuers also guarantee the face value of these bonds but like CDs they do not offer any guarantee as to the any change in market value or premiums we pay to acquire the bonds. U.S. Treasury securities have the backing of the full faith and credit of the United States, while state and local bonds typically have the backing of a taxing authority or the revenue from a particular project or entity.

Finding high-quality corporate bonds is a little trickier. Today a company can seem quite secure, and tomorrow things could be very different. Take for example an oil company that has a spill, an airplane manufacturer that suffers a crash, a telecom company with questionable accounting, etc. Because we look to bonds for safety first, we keep our corporate exposure selective and relatively short from a maturity perspective.

Reinvestment Risk

Bond investors also face the risk that future cash flows from coupon payments and maturities will come when interest rates are lower. Callable bonds are especially vulnerable to reinvestment risk because issuers redeem these bonds when interest rates decline. We address this risk by trying to avoid callable bonds and by laddering the bonds we purchase.

Laddering is a key component of our investment philosophy and an absolutely vital tool in difficult markets. In laddering, we buy bonds that mature each year, with each year representing a “rung” on the ladder. Creating a ladder accomplishes several important functions when it comes to our investment process.

Since bonds mature at their par value, all the market fluctuations between issuance (or purchase) and maturity are irrelevant. Regardless of the current market turmoil, a maturing bond pays us par and allows us one of three opportunities:

– Provide you your needed / desired cash flow regardless of the current market.
– Provide an opportunity to rebalance and dollar-cost-average into your equity allocation if the market is down and your stock allocation has fallen below target.
– If all is well, the market is high and your income is satisfied, then we can buy a new bond, extend the ladder holding the money, in a disciplined and repeatable process for the rainy day that will always arrive.

You work with us because our investment process is sound. We strive to buy good companies and conservative bonds. Our process is unglamorous, even boring, and we sleep well at night even in a turbulent market like this because if we stay the course and, if history is any guide, we will thrive.

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