The Power of Bonds

Steve McDonald
by Steve McDonald, Bond Strategist

There’s a lot of money being made in the corporate bond market, and it’s all due to the threat of rates rising - not falling.

Most investors know bonds go up in price as interest rates go down. But no one - and I’m not exaggerating here - no one understands the opportunity in certain corporate bonds being driven by the current threat of rising rates.

We’ve been stuck in the 1.7% to 2% range on the 10-year Treasury for some time. Most now know this has to change. Rates must move up eventually. You can’t pick up The Wall Street Journal or any other money-related publication without seeing something about rising rates and the collapse of bond prices.

But this threat of rising rates has been the catalyst for a lot of activity in the usually boring, stodgy bond side of the money world. And it’s producing huge annual returns... huge for bonds.

Here’s what is going on…

Refinancing Debt At Low Rates

Every business, private and public, with outstanding bonds is looking at what they now believe is the top of the 30-year bond run. Rates appear to have bottomed and prices have topped out, or at least seem to have topped out.

In what appear to be rock-solid business decisions, every company that can refinance their debt at the current, artificially low rates is doing so. That means if a bond can be called, it’s being called. But, these companies have to pay hefty premiums to get their bonds off the market.

If there isn’t a call feature, bonds are being tendered. A tender is when there isn’t an outstanding call feature and a company offers to buy its bonds before maturity. These are optional, you do not have to accept the offer, but the companies still have to pay the bond owner nice premiums over market rates.

Both calls and tenders mean big savings for the companies (cutting rates saves interest expense) and big returns to the bond owners.

In a bond portfolio I manage, recent calls, tenders and sales before maturity have produced annual returns in the 25% to 40% range - 25% to 40% returns from bonds we expected to return 5% to 10% a year.

Remember, we’re talking about bonds. Popular wisdom would have you believe you can’t get more than 3%. So much for popular wisdom!

A Tender on Chesapeake Energy

Chesapeake Energy recently had a tender offer on its BB- rated, 6.5% bond that matures in August 2017. We paid about 104 (or $1040) for the bond. We expected to earn 5.41% annually.

5.4% from a BB- rated bond is excellent in this market, but we earned an annual return of over 40% by selling the bond when a tender offer was made.

The amazing part of this trade was that the tender offer might not have been legitimate. The offer was made by a third party, and there is some question whether they have the money to buy the bonds. But the fact that they made the offer at all drove the price of the Chesapeake bond to 111. (That’s $1110.)

We sold the bond when the price spiked on the offer, and were also paid interest for the entire time we owned it.

Here’s how the numbers worked out.

We bought the bond on November 21, 2012 and sold it around January 24. We held it for about two months, so we were paid accrued interest (AI) of 6.5% for the full two months. That was about $10.83 per bond.

By the way, AI applies to almost all called and tendered bonds, and all bonds sold before maturity, as well.

We earned about $60 per bond in capital gains, 110 to 104.

That’s a total gain of $70.83 per bond in two months at a cost of $1040.

So, $60 in capital gains, plus $10.83 AI, divided by our cost of $1040, divided by our holding time of two months, times 12 months for an annual return of 40.86%.

10.83 / 1040 / 2 x 12 + 60 = 40.86%

We had expected to earn 5.41% per year if we held it to maturity. We would have received 10 interest payments of $32.50 ($325), minus the AI we owed to the previous owner of $17.69, minus our premium of $40, divided by our cost of $1040, divided again by our holding time of 57 months, times 12 months for an annual return of 5.41%.

10 x 32.50 - 40 - 17.69 / 1040 / 57 x 12 = 5.41%

Take the Money and Run!

Some advisors would tell their clients to hold a BB- bond in the gas business to get all the interest payments. It would pay a greater total amount over a longer period.

My 30 years in the markets tell me, if someone is willing to give me more money than they have to, four and a half years before they have to give it to me, take the money and run.

Beyond the 40% return, the unrecognized benefit of this Chesapeake bond trade is that we got our money out of the market in as short a time as possible.

This is an absolute essential in this bond market. As rates run up, which they will, a constant flow of money out of bonds allows you to buy bonds at the new higher rates.

Bonds are less volatile, pay their interest and principal on set schedules, allow you to know exactly how much you will earn before you invest one cent, let you sleep at night and make a lot of money even when rates are at historic lows.

That’s the power of bonds!

Good investing,

Steve

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