Actively manage bond maturities to improve returns

Jessica Rusit

FIIG Securities

Returns on bonds can be further increased when bonds approaching their maturity or call dates are reinvested ahead of time. We look at the benefits of actively managing maturities and early redemptions to get the most out of fixed income portfolios.

Background

There are many benefits to fixed income investors reviewing upcoming maturities on their bond portfolio, which is another way a higher return can be achieved. By awaiting the maturity date of a bond when the principal is repaid, investors could be limiting their reinvestment opportunities to those bond investments available at maturity. This is known as reinvestment risk and can result in returned funds yielding lower returns while held in cash, as investors await a suitable investment option.

When the demand for a bond outweighs the available supply, yields typically move lower on strong demand (and prices higher). This is exacerbated when a bond matures or is called and depending on the size of the issue can result in up to AUD200m or more of matured funds looking to reinvest at the same time often pushing prices higher.

Another key reason to reinvest positions ahead of upcoming maturity dates is to ensure the return isn’t eroded as the bond price pulls to par the closer it nears maturity. Pulling to par refers to the price of the bond gravitating back to a final value of $100, which is repaid at maturity. This plays into one of the basic principles of bond investing - term risk premium - which we further discuss below.

Term risk premium

The concept of time value of money plays an important role in fixed income investing, which refers to shorter maturities typically having less time premium and hence lower yields, compared to securities with longer dated maturities. As the time until the maturity date decreases, so too does the return as there is less perceived risk and hence less compensation.

When a bond is originally issued, the credit spread paid over the risk-free rate is usually higher the longer the bond has until maturity. This is due to there being more credit risk (risk of default) associated with lending for longer periods, compared to shorter periods of time, and for the optionality of redeploying funds being lost.

Likewise, a normal shaped risk-free yield curve will also offer higher risk-free rates (yields) the further out to maturity. This is evident looking at the Australian Government yield curve. Remember the credit spread and the risk-free rate together make up the yield of a corporate bond.

Over the life of the bond, as the length of time to maturity gradually shortens, the credit spread and risk-free rate both decrease (all things being equal) as duration and credit risk are gradually priced out. With this, the bond’s original yield moves lower, causing the bond price to rally. The investor has been rewarded for taking both duration and credit risk, as we demonstrate using the Stockland 4.5% Nov 2022 bond as a real-life example.

Increasing returns

In the below chart we show the internal rate of return (IRR) for the Stockland Nov 2022 fixed coupon bond, which currently has less than a year until maturity, but was issued with a seven-year tenor. In both scenarios we have assumed that the bond was purchased at primary issuance for $100. The first scenario calculates IRR of this investment assuming the bond is sold now, following its May coupon payment while the second scenario assumes the bond is held until maturity in November 2022.

The second scenario, where the Stockland 2022 bond was held until maturity has a lower IRR than the first scenario where the bond can be exited at a price above the final redemption amount of $100, locking in a capital price gain of ~$0.70. By holding on to the bond for an extra 6-months, investors are not getting rewarded with additional returns; rather investors will be exposed to the risk that there may not be attractive investment options at the time of maturity.

Internal rate of return (IRR) for the Stockland Nov 2022 fixed coupon bond

As shown in the below chart, the price of the Stockland 2022 bond peaked at over $108.00 in 2019 and has been gradually moving lower since then as the bond moves closer to maturity.

Stockland 2022 Bond Price History

As illustrated with the Stockland 2022 example above, the return is far more attractive when upcoming maturities are actively managed and reinvested ahead of maturity dates, than to allow the deterioration in the capital price.

Conclusion

In actively managing upcoming maturities, fixed income investors are able to improve their returns, and mitigate reinvestment risk. This isn’t a feature that is available to all asset classes and is more unique to fixed income portfolios. In working out the best strategy for actively managing reinvestment of those positions due to redeem shortly, an investor is able to maximise their portfolio returns. 

........
FIIG Securities Limited (‘FIIG’) provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without considering one or more of your objectives, financial situation and needs. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, make any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. FIIG, its employees and related parties earn fees and revenue from dealing in the securities as principal or otherwise and may have an interest in any securities mentioned in this document. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation and legal advice, tailored to your specific objectives, financial situation and needs, prior to making any investment decision. FIIG does not provide tax advice and is not a registered tax agent or tax or financial advisor, nor are any of FIIG’s employees or authorised representatives. FIIG does not make a market in the securities or products that may be referred to in this document. A copy of FIIG’s current Financial Services Guide is available at www.fiig.com.au/fsg. An investment in notes, bonds or securities should not be compared to a bank deposit. Notes, bonds and securities have a greater risk of loss of some or all of an investor’s capital when compared to bank deposits. Past performance of any product described in any communication from FIIG is not a reliable indication of future performance. Forecasts contained in this document are predictive in character and based on assumptions, such as a 2.5% p.a. assumed rate of inflation (unless otherwise specified), foreign exchange rates, or forward interest rate curves generally available at the time, and no reliance should be placed on the accuracy of any forecast information. The actual results may differ substantially from the forecasts and are subject to change without further notice. FIIG may quote to you an estimated yield when you purchase a bond. This yield may be calculated by FIIG on either A) a yield to maturity date basis; or B) a yield to early redemption date basis. Some bond issuances include multiple early redemption dates and prices, therefore the realised yield earned by you on the bond may differ from the yield estimated or quoted by FIIG at the time of your purchase. The information in this document is strictly confidential. If you are not the intended recipient of the information contained in this document, you may not disclose or use the information in any way. No liability is accepted for any unauthorised use of the information contained in this document. FIIG is the owner of the copyright material in this document unless otherwise specified.

Jessica Rusit
Associate Director – Investment Strategy Group
FIIG Securities

Jessica Rusit has over 15 years of experience in financial markets, and over 9 years working in fixed income markets. Prior to joining FIIG, Jessica worked in funds management and private wealth management, at Challenger and JBWere, respectively....

Expertise

No areas of expertise

I would like to

Only to be used for sending genuine email enquiries to the Contributor. Livewire Markets Pty Ltd reserves its right to take any legal or other appropriate action in relation to misuse of this service.

Personal Information Collection Statement
Your personal information will be passed to the Contributor and/or its authorised service provider to assist the Contributor to contact you about your investment enquiry. They are required not to use your information for any other purpose. Our privacy policy explains how we store personal information and how you may access, correct or complain about the handling of personal information.