There’s more to bonds than just receiving the coupon payments
Stock investors are usually under the impression that investing in bonds is nothing more than income investing – it’s perceived as being dull and boring. While it is true that the primary purpose of bonds is to provide an income rather than a capital gain, there are actually a wide variety of bond strategies that profit from capital gains.
These strategies often combine stocks and bonds together to form a single strategy. Indeed there are also speculative bond strategies for the more experienced investors who are able to manage the higher level of risk.
Capital Gains Investing
This strategy is essentially the bond equivalent to long-term stock trading with stocks that pay dividends.
While the value of all marketable bonds fluctuate around their face value, corporate bonds tend to be more volatile and it is this volatility that produces the large price swings which this strategy benefits from.
After a bond is issued the resale price is subject to supply and demand in a secondary market such as NYSE Bonds. While it is the yield that drives the price of the bond, the yield itself is based on the markets perception for the economic outlook and the company’s financial position.
A popular trading strategy is to buy a corporate bond or even a municipal bond when the bond value is less than their face value with the expectation that new bonds will be issued at lower interest rates. Should the investors view prove correct then the price of older bonds will rise so that their current yield is attractive compared to newly issued bonds.
When bonds are bought below their face value, the investor has the option of selling the bond when the price is sufficiently above the face value or they can hold the bond until maturity. In either case the investor is assured of a capital gain and they also receive the coupon payments.
Table 1. below shows a selection of corporate bonds that are currently priced below face value (Data May 20, 2017).
Table 1. Corporate Bonds below Face Value
Investors can hold bonds that are not callable until maturity if they want to do so, however a lot of corporate bonds are callable which means the issuer can recall these bonds at their discretion (usually when interest rates drop).
Convertible Bonds Strategy
A popular strategy is to buy corporate bonds which are convertible into stock. These convertible bonds can be thought of as an option that pays interest.
Example: Avid Technology NASDAQ:AVID convertible bond with 2% yield, 2020 maturity and a strike price of $21.94 for conversation into common stock. The current common stock price is $5.25 (May 19, 2017).
When an investor buys a convertible bond they have the option of exchanging the bond for stock in the company at a predetermined stock price. The strategy is quite simple and merely involves buying a convertible bond and exercising it if the stock price is favorable. Should the stock price not reach the required price for conversion then the investor can simply hold the bond and collect the coupon payments.
If the bond is converted to stock, the investor can simply sell the stock for a capital gain or they can hold the stock.
If the investor holds the stock, a common strategy is to implement a stop-loss. If the stock price trades below the stop-loss level then the stock is sold. The advantage of using a stop-loss, rather than immediately selling the stock, is that stock price can continue to increase – especially when market conditions are bullish.
Investors generally select convertible bonds based on the likelihood of the stock price increasing above the bonds conversion price.
Fixed Allocation Rebalance
A popular diversification strategy is to allocate a fixed percentage of a portfolio to stocks and allocate the remaining to bonds. For example, a portfolio might be setup with 60% stocks and 40% bond funds.
After the portfolio is setup, market conditions will drive both the price of stocks and the price of bonds which can lead to the percentage proportions to change. The portfolio in one year’s time might end up as 70% stocks and 30% bond funds, due to the increase in the price of stocks and the decline in the value of bonds.
While this is a desirable outcome with stock prices increasing, the original allocation for diversification was set at 60% stocks and 40% bonds. The idea with a fixed allocation portfolio is to maintain the original setup by selling stocks and buying additional bonds or bond fund shares when stocks represent an increased portion of the portfolio.
So for the example where stocks now represent 70%, the investor would sell 10% worth of stocks and buy additional bonds or bond funds.
As the proportion of stocks increases, the stock market is becoming more overpriced which is the typical result of a bull market. The strategy simply involves reducing the amount of stocks owned as the stock market advances higher. In effect the strategy locks in some open profit before the inevitable bear market comes along and at the same time buys more bonds which typically perform better during bear markets.
The rational behind the fixed allocation rebalance strategy is:
Allocation rebalance:
- When stocks are expensive and bonds are cheap – sell some stocks to buy more bonds.
- When stocks are cheap and bonds are expensive – sell some bonds to buy more stocks.
When selling a portion of stocks (say 10%), this means to sell 10% of the shares owned for each stock held in the portfolio. For example, if an investor owns 100 shares in company XYZ then sell 10 shares.
When buying say 10% more bonds, with a bond fund this as easy as buying 10% more shares in that bond fund. If there are more than one bond fund, then an additional 10% is purchased for each bond fund held.
Should the investor hold stock funds, then the same applies – for this example, sell 10% of the fund shares owned.
Re-evaluating the percentage proportions of stocks and bonds by their current value should be performed at least once a year.
A variation of the fixed allocation strategy is a variable allocation over time. The common reason for varying the allocation proportions is when using the investors’ age to determine the allocation to bonds.
Example: A 40 year old investor starts a portfolio by allocating 40% to bonds and 60% to stocks.
In one year’s time, the investor is now 41 years old and would now allocate 41% to bonds and 59% to stocks.
Thus if stocks increased to 70%, the investor would sell 11% of stocks to bring the allocation down to 59% and not to the original 60%.
Also bonds would be bought so that the portfolio now has 41% in bonds and not the original 40%.
Thus with a variable allocation over time, the portfolio is constantly rebalanced to a new allocation proportion. So for the investor’s age example, the percentage in bonds is rebalanced every year to an increasing balanced level (which increases at the rate of 1% per year).
Value Stocks Strategy
This strategy is essentially a value stock investing strategy and was used extensively by the famous investor John Templeton.
As bull markets progress, it becomes increasing difficult to find good value stocks trading at a discount. Basically most of the good stocks are by now overvalued and the only stocks left trading at low valuations are the stocks that are fundamentally undesirable and have little to no future prospects.
The basis for the strategy is to reduce the number of shares owned in overvalued stocks as the bull market continues to climb higher. This locks in the open profits as these overvalued stocks are at a high risk of correction, especially when the inevitable bear market comes along.
The profits received are used to buy more good stocks which are undervalued. This process continues until there are no more good stocks available to buy which are undervalued. The investor then allocates their capital to bonds. Treasury bonds or Treasury bond funds are a good choice as these have a poor correlation with the performance of stocks.
A small selection of Treasury Bond mutual funds is provided below in Table 2.
Table 2. U.S. Treasury Bond Mutual Funds
As the bull market climbs higher, more shares are sold and the profits are used to buy more treasury bonds or bond funds (since there are no good undervalued stocks left).
Eventually the bear market arrives and stock prices begin correcting. As the bear market progresses, good quality stocks at undervalued prices begin to appear. This is where some bonds are sold and the capital used to buy these bargain priced quality stocks. The further the bear market declines, then the greater the number of bargain priced quality stocks that can be found.
At some point in the bear market decline, the investor will have sold all of their bonds to finance the purchase of their value stocks. The bear market may well continue, but the investor is now probably out of spare capital. Sooner or later the eventual bottom is reached and the next bull market cycle begins and the whole process is repeated again.
To summarize, the strategy starts to buy bonds as bull markets reach high levels, it then holds bonds through the early phase of bear markets and starts to sell bonds to buy stocks as the bear market heads towards its bottom.