How to Get Higher Interest Rates on Safer Bonds
Interest-Rates / Corporate Bonds Dec 04, 2013 - 12:48 PM GMTBy: Investment_U
Steve McDonald writes: The bond market is a difficult place to earn a livable income during times of very low interest rates. The only way to earn a decent yield is to take risks on lower-quality bonds or to accept much longer maturity curves than good sense dictates.
But if you know where to look, there’s a virtually unknown feature in some bonds that can significantly increase your current income and beat the biggest threat to your money in the current bond market, while offering the increased level of safety that bonds are known for.
This almost-too-good-to-be-true trait is called a “death put.” It works in every portfolio, but it’s especially effective for those in or near retirement who need higher income and higher quality.
A death put enables the estate of a deceased bondholder to sell the bond back to the issuer at par. No matter how low the price has dropped, a bond with a death put matures at par upon its owner’s death.
And this unique quality normally doesn’t cost any more than a bond with traditional maturity features.
The Danger of the Long Curve
Maturity risk is where most bond buyers will lose a lot of money in the next few years.
The longer the maturity of a bond, the higher its coupon, which is why in this zero-interest rate environment most investors are buying them.
But bonds with longer maturities also drop more in value when rates go up. That’s where the unsuspecting bond buyer is going to lose a lot of money.
The only options are to hold more price-stable, short maturities and suffer through low yields, or accept longer maturity curves and watch your principal vaporize when rates move up.
But with a death put, you know before you buy a bond that – in the most likely scenario of falling bond prices and increasing rates – your bond prices will reset to par when you die.
This strategy may appear self-defeating because the owner doesn’t benefit from the price increase. But in addition to protecting your estate from what will most certainly be lower bond prices, the death put allows you to go way out on the maturity curve for higher current income from higher quality bonds.
Death Puts in Action
Here’s a very long maturity bond that, without a death put, would be crazy to own in this market. It’s a Prospect Capital (Nasdaq: PSEC) bond that matures on May 15, 2043!
That’s 23 years too long for this market unless you have a death put.
A bond without a death put with a maturity this long would drop at least 50% when rates finally move up. But because it will reset to par when the owner dies, the potential price fluctuation is negated.
In fact, it is priced at $960 so it will actually have a small capital gain of $40 per bond when it resets.
But what really makes this a great deal for a retired person looking for livable income is that it is rated BBB and pays a coupon of 6.25%. That’s at least two to three times what you can get from a BBB-rated bond with a shorter maturity.
You can also use a death put with shorter maturities. The benefits are not as great as on the longer end of the maturity curve. But it will add one more layer of safety in what promises to be a very tough market for the unprepared.
For example, there’s a Cenveo (NYSE: CVO) bond with a death put and a maturity of just 3 1/2 years that, in a worst-case scenario, will pay about 10% a year. But it is rated CCC.
CCC is a whole world away from the safety of an investment-grade BBB.
In this environment, where we know bond prices will drop – and this one’s CCC rating means it will drop more than higher-rated bonds – the death put will give its owner the additional assurance that at some point, either at his death or at maturity, he will recoup any market fluctuation.
Extra Assurance
This extra assurance will make all the difference between panic selling at a loss when rates finally spike and staying put. Riding out market fluctuation is how you really make money in bonds.
Obviously, a BBB bond paying 6.5% will be more appealing to a retired person who needs the additional security. But a bond that pays 10% as a worst-case scenario, with a super-short maturity for price stability and the extra safety that a death put adds, is also a viable option for most investors.
Death puts are not common but they are out there. And they may be the only viable option for retired persons who need high income from high-quality bonds.
Good investing,
Steve
Source: http://www.investmentu.com/2013/December/how-to-get-higher-rates-on-safer-bonds.html
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