Protect Your Portfolio With Cushion Bonds

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 |  Includes: NRU
by: David Cretcher

The problem now facing income investors is how to protect themselves against the possibility of increasing interest rates. Rising interest rates present risk for bond investors. When interest rates go up, the market value of bonds declines, as more desirable higher-interest bonds come to market. This market behavior leaves the investor with a conundrum. Go short maturity and risk losing income from lower interest payments or go long maturity for higher coupons and lose market value when interest rates climb.

A Slow Agonizing Loss

In this situation, there are different strategies available to the investor. The first choice is buying short-duration bonds. The quick payoff provides fresh money for investing into higher interest bonds as rates rise. The problem with this tactic is the short duration bonds pay very low interest rates.

The Japan Problem

There is currently a popular belief that interest rates are near all time lows and can't possibly stay here for long. What goes down must surely go back up. However, this hypothesis does not always work in practice. Just because interest rates are currently very low doesn't mean they won't stay low.

Take the case of Japan where the interest rates decreased 20 years ago and still haven't moved back up. For all we know, interest rates may increase this year or, like Japan, interest rates may stay down for years. The problem for the investor is it is very costly to stay in low-interest bonds for 20 years. Every year of low interest rates is one more year of weak compounding inside the portfolio. This will cause the investor to lose time.

A Fast Painful Loss

On the opposite hand, if investors invest in long maturities for more yearly income and there is an interest rate rise - they lose market value as bond buyers seek new higher-coupon bonds.

A Lose-Lose World

This problem sets up a no win outcome, short-term bond buyers lose current income and long-term buyers risk losing market value. The former is a certainty, the latter is a risk. The income investor is in a tough situation.

What is The Solution?

For investors needing significant steady income, premium bonds are one strategy to provide higher coupons with a cushion against rising interest rates. These cushion bonds sell over par value because they pay above market interest rates. Typically, premium bonds are long-term bonds with high coupons issued when market interest rates were higher. These premium-priced bonds offer buyers several advantages in rising rate environments.

How Bond Premiums are Calculated

When an investor sells a bond paying an above market yield, the seller will want more for the higher interest bond than one paying the current market rate. This premium amount is mathematically the sum of extra interest the bond pays over the life of the investment. Everything else equal, the bond buyer will pay a seller the total of extra interest the higher-coupon bond pays out during its lifespan.

For instance, if you own a 6 percent high-quality non-callable bond maturing in 20 years and the current market rate for a similar new twenty-year bond is three percent, the higher coupon bond will payout three extra percent per year for the next twenty years. On a $1000 bond this amounts to an extra 30 per year or $600 over the lift of the bond.

In this simplified example, the new bond would be worth $1600 instead of $1000. The new buyer will receive the current interest rate of 3 percent per year or $30 and an additional $30 in premium interest plus $1,000 par value at maturity. The buyer pays an extra $600 upfront and gets it back as the bond is paid back.

This is basically how the math works, but in reality there is reverse compounding involved, because some of the money comes back sooner than 20 years. To calculate the true premium, a buyer must use a complicated present-value calculation. The actual premium will be somewhat less.

Advantages of Premium Bonds

It turns out complicated premium bonds can be more profitable to investors in rising interest markets and can provide them with a cushion against rising interest rates. Here's how.

Less Price Sensitivity to Interest Rate Changes

First, high-coupon premium bonds are less responsive to interest changes. They decline less in value when interest rates increase and appreciate less when the rates decrease.

This lower-sensitivity to rates is because on a high-coupon bond the rate change is relatively smaller. If interest levels are low, say at two percent and the market rate increases from one percent to three percent the change is a relative increase of 33 percent of the coupon (one percent divide by three percent). With a higher coupon six percent bond, an increase of one percent is only 16 percent of the coupon (one percent divided by six percent).

This relative difference means a one-percent interest rate increase will affect the market value of a low-coupon bond much more than the value of a high-coupon bond. This mathematical trait also offers protection against increasing interest rates.

Increased Cash Flow

Second, The added interest payments give the investor another investment hedge. A larger coupon has more cash flow available to reinvest at higher interest as rates rise. If the coupon is six percent vs. three percent, as in our earlier example, this provides an additional three percent per year to reinvest at the new higher rate.

A Faster Breakeven

The higher coupon allows the investor to get their original investment back quicker. Imagine a one-percent perpetual bond and a ten-percent perpetual bond. The one-percent bond will pay back the investor in interest in 100 years, one percent per year. The ten-percent bond will pay the investor their initial investment in interest in just ten years.

It turns out that even with the additional premium paid for a high-coupon cushion bond the breakeven is faster than a par bond. This faster breakeven creates an additional hedge by lowering the time the investor's money is at risk.

Relatively Cheaper

The third advantage is premium bonds tend to sell for less than their theoretical premium. Investors tend to be resistant to paying over par for bonds and often under-price the bonds. So the coupon is relatively bigger than a par bond.

Putting the Cushion Bonds to Work

Investors can find premium bonds on the bond market. For investors using only the exchanges, there are a few exchange-traded bonds currently trading at a premium.

Here are examples. These are not recommendations. I have not analyzed them. They are simply securities selling for more than par value that match the criteria of an investment grade high coupon, premium exchange-traded bond. Unlike over-the-counter bonds these bonds trade flat and are subject or going ex-dividend. They are also callable and have call risk.

(NYSE:NRU) - National Rural Utilities Coop Finance Corp., $25 par 5.95% Subordinated Notes due 2/15/2045, callable on or after 2/15/2010 at par. Moody's A3.

(ELB) - Entergy Louisiana LLC, $25 par 6.00% Series First Mortgage Bonds due 3/15/2040, callable on or after 3/15/2015.

(GLB) - Georgia Power Co., $25 par, Series 2008C 8.20% Senior Notes due 11/1/2048, Moody's A3 callable on or after 11/1/2013.

Important Risk Considerations

High-coupon bonds are less sensitive to interest rate risk, and will give limited protection, but these bonds are not exempt from interest changes. The investor may still see a loss on their investment in a rising rate environment.

The bonds may also be subject to the risk of early call. With good luck the losses, if they occur, will be offset by larger coupon payments. Investors will benefit most from these investments when interest rates decline, stay flat or rise slowly over many years.

These securities can also trade at low volumes and the trade size can affect the market price. Investors having a limited understanding of interest rate and bond mechanics, call provisions, trade volume movements and exchange-traded bonds should seek professional guidance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational and educational purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. Please consult your financial and tax advisors before investing.