Today we’ll take a look at an advanced bond portfolio management subject: When to use premium coupon bonds and when to use discount coupon bonds.
Premium coupon bonds are bonds whose coupon is higher than the given interest rate For example, if you buy a high quality bond with a 6% coupon due in 5 years at a 4% yield to maturity, that bond would trade at a premium, or trade at over 100 cents on the dollar.
Discount coupon bonds are bonds whose coupon is lower than the given interest rate. For example, if you are buying a high quality bond with a 2% coupon due in 5 years at a 4% yield to maturity, that bond would trade at a discount, or trade at less than 100 cents on the dollar.
Some people might say, “What difference does it make? 4% yield to maturity on my money is 4% yield to maturity. Why should I care what the coupon of the bond is?” Smart portfolio managers know there is a big difference in how bond prices behave when interest rates change.
Let’s set the stage: It is June 2019 and we are looking at 2 bonds.
Bond A: 4% coupon due June 1 2035 and it is not callable. The bond is available at 5% yield to maturity and the price is $89.075. This is an example of a discount bond
Bond B: 7% coupon due June 1 2035 and it is not callable. The bond is available at 5% yield to maturity and the price is $121.849. This is an example of a premium bond.
Interest rates are low but are expected to move up due to the good economy in the US.
Perhaps one portfolio manager on a $1mm bond portfolio doesn’t have experience with bonds…perhaps he thinks “5% is 5%…..and since all bonds come due at 100 cents on the dollar, it doesn’t really matter which bond I buy for my client.”
So, the first portfolio manager bought the discount bond, bond A in our example and paid $89.075
A second portfolio manager, one with more experience, purposefully bought the premium bond, bond B in our example. She knows what happens when interest rates rise and she has a lot of experience with bonds. She paid $121.849.
Let’s move ahead in time one year to June 2020.
Remember, bonds come due at 100 cents on the dollar. So, a discount bond will slowly move higher (accretion) towards 100 cents on the dollar and a premium bond will slowly move lower (amortization) towards 100 cents on the dollar. If rates haven’t changed, bond A is now worth $89.534 (it accreted). Bond B is now worth $120.930 (it amortized).
But lo and behold, rates have changed! Both portfolio managers were correct in thinking that rates would rise. In fact, interest rates for bonds due June 1 2035 have gone from 5% to 7%! Quite a move in 12 months.
Bond A is now worth $72.411. Its price fell from its amortized value of $89.534 to $72.411. That’s a loss of $17.123.
Bond B is now worth $100. Its price fell from its accreted value of $120.930 to $100. That’s a loss of $20.930.
Let’s see how that interest rate change has affected our bond portfolio performance.
The first portfolio manager, the one that bought bond A, has a 19.12% portfolio loss (($89.534 – $72.411)/$89.534). That equates to a more than $191,000 loss on a $1mm bond portfolio.
The second portfolio manager, the one that bought bond B, has a 17.3% loss (($120.930 – $100)/$120.930). That equates to $173,000 loss on a $1mm bond portfolio.
Simply by buying a premium coupon bond (bond B), the second portfolio manager has outperformed the first by almost 2% (1.82%). She saved her client more than $18,000 versus the portfolio manager who bought the discount bonds. Her client is happy that the bond portfolio is less volatile and her client is very happy that her portfolio outperformed portfolios of discount bonds. That portfolio manager is praised by her boss and thanked by her clients.
By buying a discount bond (bond A), the first portfolio manager underperformed the second by 1.82%. His client lost $18,000 more than necessary with this interest rate change and his boss is upset and fires him. He decides he needs to learn more about bonds.
Most portfolios are diversified between stocks and bonds. Some portfolios may be heavily weighted towards bonds, especially for older or more conservative clients. Does your portfolio manager know bonds?
Questions? Comments? Reach out to us. We have extensive knowledge and experience with bonds and would welcome your thoughts.