Actively managing bond maturities to enhance yields – Jessica Rusit

Bond yields can be further increased when bonds approaching their maturity or redemption date are reinvested in advance. We examine the benefits of active maturity management and prepayments to get the most out of fixed income portfolios.

Background

There are many benefits for bond investors looking at the upcoming maturities of their bond portfolio, which is another way to earn a higher yield. By awaiting the maturity date of a bond when principal is repaid, investors may limit their reinvestment opportunities to bond investments available at maturity. This is called reinvestment risk and it may result in returned funds earning lower returns when held in cash, as investors wait for a suitable investment option.

When the demand for a bond exceeds the available supply, yields generally fall in the face of strong demand (and prices rise). This situation is exacerbated when a bond matures or is called and, depending on the size of the issue, can result in up to AUD 200 million or more of maturing funds seeking reinvestment at the same time, often driving up the price.

Another key reason to reinvest positions ahead of upcoming maturity dates is to ensure that the yield does not erode as the price of the bond approaches maturity. Draw to par refers to the price of the bond returning to a final value of $100, which is redeemed at maturity. This plays into one of the basic tenets of bond investing – the term risk premium – which we’ll discuss in more detail below.

Term risk premium

The concept of time value of money plays an important role in bond investing, which refers to shorter maturities generally having less time premium and therefore lower yields, compared to longer dated securities. As the time to maturity decreases, the return also decreases, as there is less perceived risk and therefore less reward.

When a bond is originally issued, the credit spread paid over the risk-free rate is generally higher the longer the bond has to maturity. This is because there is more credit risk (risk of default) associated with lending over longer periods, compared to shorter periods, and the possibility of redeploying lost funds.

Similarly, a normal-shaped risk-free yield curve will also offer higher risk-free rates (returns) the further away from maturity. This is evident by looking at the Australian government’s yield curve. Remember that the credit spread and the risk-free rate together constitute the yield of a corporate bond.

Over the life of the bond, as the term to maturity gradually shortens, the credit spread and the risk-free rate both decrease (all other things being equal) as duration and credit risk are gradually assessed. With this, the initial yield of the bond drops, causing the price of the bond to rise. The investor was rewarded for taking on both duration and credit risk, as we demonstrate using the Stockland 4.5% November 2022 bond as a concrete example.

Increase in yields

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

The second scenario, where the Stockland 2022 bond was held to maturity, has a lower IRR than the first scenario where the bond may be exited at a price above the final redemption amount of $100, locking in a gain in capital of about $0.70. By holding the bond for an additional 6 months, investors are not rewarded with additional returns; rather, investors will be exposed to the risk that there will be no attractive investment options at maturity.

Internal Rate of Return (IRR) of Stockland Nov 2022 Fixed Coupon Bond

As shown in the chart below, the price of the Stockland 2022 bond peaked at over $108.00 in 2019 and has been steadily declining since then as the bond nears maturity.

Stockland Bond Price History 2022
Stockland Bond Price History 2022

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

Conclusion

By actively managing future maturities, bond investors are able to enhance their yields and mitigate reinvestment risk. This feature is not available for all asset classes and is more unique for fixed income portfolios. By developing the best strategy to actively manage the reinvestment of those positions that need to be repaid shortly, an investor is able to maximize their portfolio returns.

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