Cash Flow versus Yield
Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
Interest rates are low and central banks around the globe are bringing them lower. The demand for any kind of yield is escalating. It just so happens that the U.S., even with a flat low Treasury curve, boasts comparatively attractive yields in a notably safe marketplace. Of course, “high yields” and “safe” are relative words but their importance should not be underestimated or ignored when evaluating investment choice in a market that many investors find challenging. Global rates have fallen such that nearly $15 trillion in debt has negative yields. Volatility has increased and thus risk has increased. The formula for disaster can develop when an investor is dependent upon a fixed income and is faced with generally low interest rates, alternatives that pose higher or unknown risks and a required cash flow to sustain a desired lifestyle.
As we have discussed in numerous commentaries, a portfolio’s fixed income allocation should not be altered by reaching for substitutes that pose unacceptable risks to long term objectives. Individual bonds are true fixed income instruments because they feature a stated maturity. Therefore, when held to maturity, individual bonds maintain a predictable income, defined cash flow and return of face value, regardless of interest rate movement over the holding period.
Within the fixed income world, two bonds that have many identical features but a distinguishable difference in coupon and price, can produce nearly the same result when held to maturity but also can serve two very discernable purposes. First let’s compare these bonds in the box to the right.
- Like credit ratings
- Identical cash invested
- Same maturity date
- Same yield to maturity
- Different coupon
- Face value different
- Price different
When these two bonds mature in nine years, the first bond will return $75,000 of principal and the second will return $100,000. Mistakenly, it can be concluded that the first bond is penalized because the upfront premium isn’t returned. It is returned but in a different way. Each year, the higher coupon bond produces $5,250 ($75,000 x 7.00%) in cash flow versus $3,000 ($100,000 x 3.00%) on the 2nd bond. The variance in amount is not because of income differences. Remember the income (yield) is the same (3.00%) on both. The difference is that a portion of the premium is being returned each coupon payment period on the premium bond. If interest rates stayed the same over the life of the bonds, the amount invested ($100,000) and the accumulated amount received (face value + coupon + reinvested cash flow) over the life of the bond would be nearly the same no matter which bond was held. The difference is in how it comes back to an investor. If one knew interest rates would rise over the holding period, it would actually be advantageous to hold the premium bond because the higher cash flows allow reinvestment into a higher interest rate market sooner. Contrarily, if one knew interest rates would fall, keeping more money invested longer is beneficial.
The current market creates a particular challenge for investors reliant on specific cash flows. Utilizing the right coupons may afford an answer. If an investor held the 7.00% coupon bond and utilized the whole coupon payment to meet their cash flow needs, at the end of nine years when the bond matured, the investor would now have $75,000 to reinvest instead of the initial $100,000 invested. This investor did not lose $25,000, they used a portion of their principal paid back as part of their coupon cash flow, to meet their needs. This works better with individual bonds because the risk is spelled out and known from the start. It is far different than a stock dropping in value $25,000. That is principal not used but lost and requires a market reversal to get it back.
Coupons can be matched to meet investor needs and when an investor’s needs are greater than current interest rates, a potential solution may incorporate higher coupon (premium) bonds. Of course investors must understand that this involves a calculated use of some of their principal which in many cases, can be a viable plan to take that investor through their retirement years.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.