3 Bond Investing Strategies that Can Help Make the Most of Your Principal
Alternatives to the “set it and forget it” approach to investing in bonds.
By Don Burrows
Senior Vice President
Investors who are recalibrating their asset allocations right now might be considering adding municipal bonds to their portfolio. And it’s easy to see why. Bonds have long been viewed as an investment vehicle built for downside protection.
While the new coronavirus pandemic initially took its toll on the municipal bond market in March and April, the market rebounded in May with positive weekly net flows, modest supply, and attractive yields.
However, the opportunity exists for the markets to become volatile again, and while interest rates are at record lows, it’s hard to determine where they will be in a month from now, much less in one year.
Municipal bond investors seeking to preserve capital, generate income, and take advantage of tax efficiencies are already staying the course and focusing on long-term gains. Yet, while most investors simply hold a bond until maturity, there are bond investment strategies that, if patient, may be a better use of their investment capital.
The following are three common strategies that can help you reduce interest rate risk and increase income:
The ladder strategy consists of tactically allocating your money into individual bonds with varying maturity dates. These bonds are typically short-, mid-, and long-term bonds.
This strategy is a helpful alternative to wrapping up a large sum of money in a single investment. Instead, the staggered maturity dates free you up to reinvest in bonds with higher interest rates—should they rise—or invest in another security with a higher yield.
Bond laddering also provides you with consistent interest income throughout the life of the bonds, as well as expected principal repayments at defined intervals.
The barbell strategy is similar to laddering, with the exception that you’re investing in only very short-term and very long-term bonds. By deploying this strategy, you’re able to reap the benefits of both.
Short-term bonds typically have low yields. However, they provide you with more liquidity and give you the flexibility to adjust your investments more often. If interest rates rise, you can reinvest the bonds that are maturing earlier into higher-yield bonds.
Long-term bonds typically have higher yields that provide you with a steady flow of higher-yield income over a longer duration. Their longer duration leaves you more susceptible to interest rate fluctuations. However, if rates rise, you’ll benefit from not having all your money wrapped up in long-term bonds. Conversely, if rates fall, you’ll have long-term bonds with interest rates locked in for the life of the bond.
The bond swap strategy consists of selling the bonds in your portfolio and using the proceeds of that sale to replace them with new bonds. There are many reasons you would deploy this strategy:
Tax swap — You can offset capital gains taxes by swapping bonds toward the end of the year and write off the losses.
Interest rate swap — You can take advantage of changing interest rates with bond swapping. In a falling interest rate environment, you can swap the bonds they hold at a premium with new bonds that have a similar yield and purchase them at par. In a rising rate environment, you can swap bonds with a lower coupon for bonds with a coupon rate that matches the markets’ higher interest rates.
Maturity swap — You can also swap bonds to shorten or lengthen the maturities of the bonds they hold. If interest rates fall, you can swap bonds with shorter maturities for longer ones in order to take advantage of rising prices. Swapping for a bond with a longer maturity may also increase yield. Conversely, if interest rates rise, swapping bonds with longer maturities for shorter ones can help stabilize the price of a bond.
Credit swap — You can swap bonds with lower credit ratings for bonds with higher credit ratings to create downturn protection. While the overall yield may be lower, the decreased chance of issuer default offsets the reduced payments.
Making the Most of Your Principal
Each bond investment strategy has its advantages and disadvantages. However, the important thing to remember is that these strategies can only be helpful if you’re in it for the long term. They’re designed to help you with interest rate risk and provide you with an expected stream of income, rather than realize large returns.
As always, you should speak with a financial professional to determine whether any of the strategies above align with your risk/return needs. To schedule a complimentary consultation, find a HilltopSecurities financial professional near you or call 214.953.4000.
Want to Learn More About Municipal Bonds?
Our latest guide, “Investing in Municipal Bonds,” breaks down the key concepts of municipal bonds and provides answers to frequently asked questions. To learn more about municipal bonds, download our free guide today.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications, and other factors.
The value of bonds fluctuates with changes in market conditions. When sold, bonds and bond shares may be worth more or less than their original cost. As interest rates rise, bond prices typically fall, which can adversely affect a bond’s performance. Specific bonds differ in their sensitivity to changes in interest rates depending on their individual characteristics, including duration. Call risks: Declining interest rates may accelerate the redemption of a callable bond, causing an investor’s principal to be returned sooner than expected.
Investment income from municipal bonds may be subject to the alternative minimum tax (AMT), and capital appreciation from discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
Hilltop Securities Inc. (HTS) is a registered broker-dealer, registered investment adviser and municipal advisor firm that does not provide tax or legal advice. This information is intended for educational and informational purposes only and does not constitute legal or investment advice. HTS is a wholly owned subsidiary of Hilltop Holdings, Inc. (NYSE: HTH) located at 1201 Elm Street, Suite 3500, Dallas, Texas 75270, (214) 859-1800. Member: NYSE/FINRA/SIPC.