BondsOnline Advisor

Don't Underestimate the Power of the Coupon

by Stephen Taub

All things considered, 2004 wasn't too shabby for bond investors, especially considering the Fed was in a tightening mode for half the year and the yield curve was flattening.

Treasuries, municipals and mortgages were each up around 4% or so, US corporate bonds and international bonds more than 5% and high yield bonds more than 8%. "This year was surprisingly good," concedes Mary Miller, director of T. Rowe Price's fixed income division. "The performance was better from the credit sensitive issues."

In fact, long-term rates are finishing the year lower than where they started the year despite the rate increases at the short end, which is counter intuitive. "This signals a sanguine view of inflation and long-term growth," Miller explains.

So, what will the bond market do for an encore in 2005? Afterall, most fixed income pros are confident the Federal Funds rate will surge from 2% to between 3% and 4%.

The resounding recommendation: Stay the course.

"Bonds play the role of insurance in a portfolio," reminds Margo Cook, head of institutional fixed income for BNY Asset Management, who oversees $5 billion in fixed-income assets.

Miller agrees. She points out that even if investors are inclined to have an equity heavy portfolio when they perceive a healthy stock market, bonds could help provide most of that anticipated return but reduce the volatility.

For example, if you go back 10 years-which includes the Roaring 90s for stocks-a portfolio that was divided evenly between stocks and bonds would have provided 86% of the returns than a portfolio made up of just stocks, with just 52% of the risk. Even if you had 75% of your assets in stocks and just 25% in bonds, you would have enjoyed nearly 94% of the all-stock return with 76% of the risk.

Can investors still expect this relationship to persist in 2005? Miller says yes. "If you do this over a (longer) period of time, the numbers don't change much," she adds.

The big reason: the coupon. Cook reminds investors that even if rates rise in 2005 as much as the pundits are predicting, investors should never underestimate the power of the income component of fixed income investments. So, it's important to keep reinvesting as rates move up. "The coupon drives the rate of return," she stresses.

In fact, Cook points out that over the past 54 years, intermediate bonds-defined as one to 10-year paper-only suffered negative total returns three different years-in 1955, 1958 and 1994. The reason is because the coupon kept being reinvested. "You need a big jump in rates to have a negative return," she adds.

Long-term bonds have suffered 17 losing years, including three since 1994. But, the last three down years-1994, 1996 and 1999-were followed by a double-digit return. And in six of those losing years since 1950, the decline was less than 1%.

On average, from 1950 to 2004 bonds have enjoyed a 6.3% annual return. In 50 of those 55 years, the income return exceeded the price return. More significantly, all but 0.2% of the 6.3% return came from the income component.

So, with all of this in mind, does it mean it doesn't matter which asset classes to invest in during 2005?

No. Cook figures investors can reap a 4% to 8% return next year, depending upon the risk they take.

She recommends 60% in investment grade corporate bonds, 20% in high yield bonds and 20% in international bonds, which will continue to do well if the dollar continues to fall.

Price's Miller agrees with Cook for the most part.

For example, a positive credit environment should allow investors in corporate bonds to earn the spread with little further price appreciation expected. And, although she believes the rally in high yield has mostly run its course and the asset class is basically over-valued, she still thinks it offers incremental return. But, she concedes, "I'm concerned since they have done so well.

She also thinks international bonds are attractive. "A wide range of economic positions and rates offer opportunity against the backdrop of a weaker dollar," Miller notes.

She believes munis are attractive for taxable investors versus other high quality alternatives and mortgage securities should not be harmed by prepayments. "Mortgage-backed bonds' extra yield should cushion rate increases," she adds.

On the other hand, she says Treasuries will experience a bumpier ride as cyclical inflation, higher borrowing needs and deficits weigh on the market.

Even so, bonds should do well enough so if stocks experience a strong year, BNY's Cook says, "All you lose is the opportunity cost in bonds."

All things considered, 2004 wasn't too shabby for bond investors, especially considering the Fed was in a tightening mode for half the year and the yield curve was flattening.

Treasuries, municipals and mortgages were each up around 4% or so, US corporate bonds and international bonds more than 5% and high yield bonds more than 8%. "This year was surprisingly good," concedes Mary Miller, director of T. Rowe Price's fixed income division. "The performance was better from the credit sensitive issues."

In fact, long-term rates are finishing the year lower than where they started the year despite the rate increases at the short end, which is counter intuitive. "This signals a sanguine view of inflation and long-term growth," Miller explains.

So, what will the bond market do for an encore in 2005? Afterall, most fixed income pros are confident the Federal Funds rate will surge from 2% to between 3% and 4%.

The resounding recommendation: Stay the course.

"Bonds play the role of insurance in a portfolio," reminds Margo Cook, head of institutional fixed income for BNY Asset Management, who oversees $5 billion in fixed-income assets.

Miller agrees. She points out that even if investors are inclined to have an equity heavy portfolio when they perceive a healthy stock market, bonds could help provide most of that anticipated return but reduce the volatility.

For example, if you go back 10 years-which includes the Roaring 90s for stocks-a portfolio that was divided evenly between stocks and bonds would have provided 86% of the returns than a portfolio made up of just stocks, with just 52% of the risk. Even if you had 75% of your assets in stocks and just 25% in bonds, you would have enjoyed nearly 94% of the all-stock return with 76% of the risk.

Can investors still expect this relationship to persist in 2005? Miller says yes. "If you do this over a (longer) period of time, the numbers don't change much," she adds.

The big reason: the coupon. Cook reminds investors that even if rates rise in 2005 as much as the pundits are predicting, investors should never underestimate the power of the income component of fixed income investments. So, it's important to keep reinvesting as rates move up. "The coupon drives the rate of return," she stresses.

In fact, Cook points out that over the past 54 years, intermediate bonds-defined as one to 10-year paper-only suffered negative total returns three different years-in 1955, 1958 and 1994. The reason is because the coupon kept being reinvested. "You need a big jump in rates to have a negative return," she adds.

Long-term bonds have suffered 17 losing years, including three since 1994. But, the last three down years-1994, 1996 and 1999-were followed by a double-digit return. And in six of those losing years since 1950, the decline was less than 1%.

On average, from 1950 to 2004 bonds have enjoyed a 6.3% annual return. In 50 of those 55 years, the income return exceeded the price return. More significantly, all but 0.2% of the 6.3% return came from the income component.

So, with all of this in mind, does it mean it doesn't matter which asset classes to invest in during 2005?

No. Cook figures investors can reap a 4% to 8% return next year, depending upon the risk they take.

She recommends 60% in investment grade corporate bonds, 20% in high yield bonds and 20% in international bonds, which will continue to do well if the dollar continues to fall.

Price's Miller agrees with Cook for the most part.

For example, a positive credit environment should allow investors in corporate bonds to earn the spread with little further price appreciation expected. And, although she believes the rally in high yield has mostly run its course and the asset class is basically over-valued, she still thinks it offers incremental return. But, she concedes, "I'm concerned since they have done so well.

She also thinks international bonds are attractive. "A wide range of economic positions and rates offer opportunity against the backdrop of a weaker dollar," Miller notes.

She believes munis are attractive for taxable investors versus other high quality alternatives and mortgage securities should not be harmed by prepayments. "Mortgage-backed bonds' extra yield should cushion rate increases," she adds.

On the other hand, she says Treasuries will experience a bumpier ride as cyclical inflation, higher borrowing needs and deficits weigh on the market.

Even so, bonds should do well enough so if stocks experience a strong year, BNY's Cook says, "All you lose is the opportunity cost in bonds."

All things considered, 2004 wasn't too shabby for bond investors, especially considering the Fed was in a tightening mode for half the year and the yield curve was flattening.

Treasuries, municipals and mortgages were each up around 4% or so, US corporate bonds and international bonds more than 5% and high yield bonds more than 8%. "This year was surprisingly good," concedes Mary Miller, director of T. Rowe Price's fixed income division. "The performance was better from the credit sensitive issues."

In fact, long-term rates are finishing the year lower than where they started the year despite the rate increases at the short end, which is counter intuitive. "This signals a sanguine view of inflation and long-term growth," Miller explains.

So, what will the bond market do for an encore in 2005? Afterall, most fixed income pros are confident the Federal Funds rate will surge from 2% to between 3% and 4%.

The resounding recommendation: Stay the course.

"Bonds play the role of insurance in a portfolio," reminds Margo Cook, head of institutional fixed income for BNY Asset Management, who oversees $5 billion in fixed-income assets.

Miller agrees. She points out that even if investors are inclined to have an equity heavy portfolio when they perceive a healthy stock market, bonds could help provide most of that anticipated return but reduce the volatility.

For example, if you go back 10 years-which includes the Roaring 90s for stocks-a portfolio that was divided evenly between stocks and bonds would have provided 86% of the returns than a portfolio made up of just stocks, with just 52% of the risk. Even if you had 75% of your assets in stocks and just 25% in bonds, you would have enjoyed nearly 94% of the all-stock return with 76% of the risk.

Can investors still expect this relationship to persist in 2005? Miller says yes. "If you do this over a (longer) period of time, the numbers don't change much," she adds.

The big reason: the coupon. Cook reminds investors that even if rates rise in 2005 as much as the pundits are predicting, investors should never underestimate the power of the income component of fixed income investments. So, it's important to keep reinvesting as rates move up. "The coupon drives the rate of return," she stresses.

In fact, Cook points out that over the past 54 years, intermediate bonds-defined as one to 10-year paper-only suffered negative total returns three different years-in 1955, 1958 and 1994. The reason is because the coupon kept being reinvested. "You need a big jump in rates to have a negative return," she adds.

Long-term bonds have suffered 17 losing years, including three since 1994. But, the last three down years-1994, 1996 and 1999-were followed by a double-digit return. And in six of those losing years since 1950, the decline was less than 1%.

On average, from 1950 to 2004 bonds have enjoyed a 6.3% annual return. In 50 of those 55 years, the income return exceeded the price return. More significantly, all but 0.2% of the 6.3% return came from the income component.

So, with all of this in mind, does it mean it doesn't matter which asset classes to invest in during 2005?

No. Cook figures investors can reap a 4% to 8% return next year, depending upon the risk they take.

She recommends 60% in investment grade corporate bonds, 20% in high yield bonds and 20% in international bonds, which will continue to do well if the dollar continues to fall.

Price's Miller agrees with Cook for the most part.

For example, a positive credit environment should allow investors in corporate bonds to earn the spread with little further price appreciation expected. And, although she believes the rally in high yield has mostly run its course and the asset class is basically over-valued, she still thinks it offers incremental return. But, she concedes, "I'm concerned since they have done so well.

She also thinks international bonds are attractive. "A wide range of economic positions and rates offer opportunity against the backdrop of a weaker dollar," Miller notes.

She believes munis are attractive for taxable investors versus other high quality alternatives and mortgage securities should not be harmed by prepayments. "Mortgage-backed bonds' extra yield should cushion rate increases," she adds.

On the other hand, she says Treasuries will experience a bumpier ride as cyclical inflation, higher borrowing needs and deficits weigh on the market.

Even so, bonds should do well enough so if stocks experience a strong year, BNY's Cook says, "All you lose is the opportunity cost in bonds." 

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others