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Will the Fed carry out its threat to reduce bond purchases and putting upward pressure on rates, or will it continue on and allow them to settle down? Who knows what the Fed will do? If you listen to some pundits bonds are the universally accepted worst investment. In fact, there are so many bond bears one has to worry if the consensus is wrong. Regardless of where one stands, it is wise to prepare for multiple outcomes.

There is no simple way around it, rising interest rates are bearish for bonds. When the trend is against the investor, there is no easy money To profit, bond investors must learn to make money the hard way, by doing their homework and buying smart. Bonds are an important diversifier in a broad investment portfolio and removing them may introduce additional risks. Many income investors can't live without them and need a strategy.

Bond Investment Strategy

Most investors have a general idea that rising rates are bad for bonds lowering their value. But in spite of the hysterical cries of the opinion merchants, not all bond prices will fall like a rock. Different bonds fluctuate differently. Some will decline rapidly and others will glide down like a hang-glider off a fiscal cliff.

These slower-moving bonds can give investors forward motion from yields and without taking it all away falling book values. Done right, bond investors can manage a soft, profitable landing in a rising rate environment. To do this, bond buyers must find a way of earning more income from interest, than they lose in falling values.

Many investors have a equity investment strategy and understand the difference between a growth stock and a value stock or a small cap equity and a large cap. But, many lack the same clear understanding of the bond market. They don't know the difference between a zero-coupon bond and a perpetual bond or a high-coupon bond and a low coupon bond, a short-term bond and a long-term bond, a discount bond and premium bond, a convertible bond and straight bond.

Investors often resort to grab bag approach, by buying a broad bond ETF (BND) (AGG) and living with it good or bad. Many leave it to a large bond manager (BOND) who may be broadly competent but has no idea of your individual needs. These managers may be willing to take bets that are unsuitable for you. They are often constrained by the large purchases they must buy.

Just as a buy and hold strategy works better in a bull market than a bear, these broad approaches to bond selection work better in an up market than in a down market.

Stock market investors can sit out a bad market, but income investors need income and don't have the luxury of sitting in cash until the bond market improves. The popular advice to buy short-duration bonds leaves the income investor with little or no current income.

For investors relying on income, a targeted strategy is essential. There isn't an easy income solution in today's market. Mr. Buffet's advice to own stocks and sell them off for income doesn't work if you can't afford a 50% draw-down like he can. But, if income is necessary, understanding that different bonds behave differently is the key to building a lower-volatility bond portfolio that you can live with if rates rise.

Developing a Bear Market Bond Strategy

A bond buyer pays out money and then gets it back periodically first in coupon interest and then later in a final payment. But it is how he or she gets it back that matters in designing a winning bond portfolio.

The value of a risk-less bond is simply the present value of the periodic coupon or income stream plus the present value of the final payment. The further into the future these payments are, the less valuable the payment.

In an inflationary environment, a promise to pay $1000 next year is more valuable than a promise to pay $1000, 100 years from now. At a 3% inflation rate, the final $1000 payment on a 100 year bond will only be worth $52 in today's money. It has a present value of $52.

Profitable Bond Selection

Designing a winning bond portfolio requires understanding two opposite types of bonds-perpetual bonds and zero-coupon bonds. These bonds differ in how the buyer pays out their money and how they get it back. Perpetual bonds never give investors their money back and zero-coupon bonds never give buyers their interest. Both of these bonds are rare, but their mechanics are instructive when designing bond portfolios.

Perpetual Bonds

Perpetual bonds pay a periodic coupon, or interest payment, but never mature. In many ways, they are like an annuity. The investor buys one and is paid interest forever. An example of these bonds are British Consols. These bonds were issued first in 1751 and are still available.

A more modern exchange-traded example is ING Perpetual Debt Securities (ISP) $20.00 par now yielding about 5%. Nonredeemable non-callable preferred stocks also function like perpetual bonds.

Dividend stocks (VIG)(PFM) also share some of the same characteristics - they function like a variable-coupon perpetual bond. The investor buys the stock and receives a dividend that can vary and no final payment from the issuer.

The market value of a perpetual is the interest rate divided by the price. A $100 bond with a $1 coupon yields 1%. A $66 bond with a 1% coupon yields 1.5%. - 1 divided by 66. Since they never mature, perpetual bonds are volatile with the change in yield on a percentage basis. The $100 - 1% perpetual depreciates 33% to $66 when the rate increases 50% from 1 to 1.5%. In this case, a 50 basis point yield increase results in a 33% decrease in value.

A $100 perpetual bond with a $5 coupon yields 5% and a $91 bond with a $5 coupon yields 5% five divided by 91 or a 5.5% return. At this interest rate, a 50 basis point increase lowers the bond value by 9% instead of 33%.

The increased volatility at low coupons is because perpetual values decrease with the percentage change of the rate increase--not basis point increase. A change from 1.5 is 50 basis points or a 50% increase but a 50 basis point increase from 5 to 5.5 is only a 10% increase.

Perpetuals are sensitive to the later; the percentage change of the interest rate. Because of this behavior, everything else equal, a portfolio of high-coupon perpetual bonds is less volatile to rising rates than a basket of low-coupon perpetuals.

This relationship is important in today's low-interest environment because yield changes from low rates are larger percentage changes.

When designing a portfolio, calculate the amount of a bond's present value income from interest versus the amount from return of principal. With long-term bonds, the coupon payment will be the bulk of the value to investors.

For instance, at 3% inflation, a $10000, 5%, 50-year bond will return $500 annually for 50 years with a present value of $12870 and a final payment with a present value of $2280 for a total of $15150. The final maturity payment is only 15 percent of the total return. At the other extreme, the final payment on a one-year 5% bond is 95% of the return. The longer the bond, the less valuable the final payment.

Zero-Coupon Bonds

Zero-Coupon Bonds are the opposite of perpetual bonds. Zeros pay no interest, only a final payment. US Savings Bonds and Treasury Notes, and STRIPS are examples of zero-coupon bonds. There are also zero-coupon municipals and agencies and ETFs that invest in zeros(EDV)(ZROZ).

Investors typically buy these bonds at a discount to their par value, the compounded interest is embedded in the appreciation of the bond. Short-term zeros go at a small discount and long-term zeros go at steep discounts. Oddly, for a while, treasury notes sold at a premium, generating a negative interest rate, but that a story for another day.

The value of a zero-coupon bond is simply the present value of the final payment. A 20-year zero at a 1% compounded return would price at $81.95. A $100 zero-coupon bond with a 1.5% compounded return would cost $74.25. In these examples, a 50 basis point increase in rates results in a 10 percent price change. Of course, a zero-coupon perpetual would be worthless.

At a higher coupon, a $100, 20-year bond with a 5% return would be priced at $37.69.

A $100 bond with a 5.5% return would be priced at $34.27 - an equal 10% decrease from 50 basis point increase in rates.

As shown, zero-coupon bonds are equally volatile at low interest rates and higher interest rates. In comparison to the perpetual, the zero doesn't lose volatility as the interest rate increases. Remember, perpetuals are more volatile at low-rates and less volatile at high rates.

Today's short-duration low-interest treasuries(BIL) (SHY) with their extreme rates are almost zero-coupon bonds. Non-divided growth stocks also exhibit many of the same behaviors. Unfortunately, if when you buy a non-dividend stock to hold for 10 years, you have no idea what your final payment will be. Growth stocks are like a zero coupon bond with a variable final payment.

Coupon Bonds

These extreme bonds are rare, most bond portfolios will hold coupon bonds-investments having both a coupon and a maturity. Coupon bonds are a hybrid of zeros and perpetual bonds. There is a final payment like a zero and a periodic coupon like a perpetual. Longer-term coupon bonds act more like perpetual and lower-coupon bonds act more like zeros. The type of coupon bond investors want to own depends on their beliefs about long-term rates and economic activity.

Choosing Bonds For Rising Rate Environment

As shown in the below chart, zero-coupon discount bond values remain equally volatile when yields increase. If not held to maturity, they can be dangerous in a rapidly rising rate market. Perpetual bonds, on the other hand, become exponentially less volatile as coupon rates increase and moderate losses when, and if, yields rise.

Change in Yield

Change in 30 year Zero-coupon

Change in Perpetual

2 to 3

25%

33.3%

3 to 4

25

25.0

4 to 5

25

20.0

5 to 6

25

16.7

6 to 7

25

14.3

7 to 8

25

12.5

Investment Selection

The longer a bond's term is the more it behaves like a perpetual, and the less volatile it becomes as rates increase. The lower a bond's coupon the more it behaves like a volatile zero as yield rise. When designing a portfolio for rising rates, avoid buying a bond simply for the maturity date or the interest rate. Instead, buy it because of the behavior it will exhibit under the economic and rate environment you are trying to protect against.

We are in a historically low yield environment. Today, most new issue bonds are low yielding and act more like zero coupon bonds. Because they are low-yield, near zero-coupon bonds they will stay equally volatile as interest rates increase.

Credit quality aside, the least volatile bonds to own in a rising interest rate environment are high-coupon near-perpetual bonds. These long-term high-yielding bonds also protect the investor if rates decrease by generating more current income than low-yield bonds. If rates stay low these bonds pay a large coupon, if yields rise they lose less value than a long-term low-coupon bond.

When selecting high-coupon bonds investors should be aware of credit quality. Many high-coupon bonds are low-grade junk bonds which carry additional credit risks. They should also be aware of call schedules which can hurt effective yields and generate losses.

No bonds do well in a rising environment, but these bonds act less bad. The investor is hoping to make a positive gain by getting more in coupon then they lose in book value. This will provide a softer landing.

Contrarian investors that believe the Fed is bluffing and interest rates will fall should favor zero-coupon bonds and other low-coupon bonds. These investments increase rapidly in value when rates decline. Today, STRIPS are an asymmetric investment, if rates go down, they can be sold at a profit. If rates go up, investors get their money back at maturity. However, the ride can be rough.

Beware of mutual funds and ETFs

Portfolios getting their fixed-income exposure from ETFs are at a disadvantage, because fixed-income ETFs don't mature, they act like perpetual variable-coupon bonds. There is no final payment and the investor cannot customize the coupons and maturities to their liking. ETFs and bond mutual funds can help diversify small portfolios , but are riskier than owning individual bonds.

An investor that owns a treasury will not lose money, they will get their money back with interest. In a rising environment, they may grow to dislike the interest rate, but they will get their money back. An ETF or mutual fund investor may not. The ETF industry is starting to address the final payment problem with ETFs that mature(IBDA)(BSCD), but the selection is sparse.

Source: Income Strategies For Raising Rate Markets