Successful Bond Investing in a Low-Interest Rate Environment

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Cabot Money Management's fixed-income portfolio manager, William Larkin, discusses navigating the complexities of the low-yielding bond market.

Disclosure: These seminars are for discussion purposes only. It is not an offer to buy or sell individual securities or investments. Investors should consider their own individual investment objectives, risks, charges and expenses of their portfolio carefully before investing. Investments are not FDIC insured and may lose or fluctuate in value. Please request our Form ADV Part II for complete disclosures.

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Successful Bond Investing in a Low-Interest Rate Environment

  1. 1. SUCCESSFUL BOND INVESTING IN A LOW-INTEREST RATE ENVIRONMENT<br />Presented by:<br />William Larkin, Jr., Portfolio Manager<br />
  2. 2. THE YIELD CONUNDRUM<br />BONDS are lending arrangements made between a lender (saver) and borrower (spender)<br />A<br />B<br />SAVER<br />SPENDER<br />Cheap Capital<br />Date Certain<br />Available Financing<br />Income Producing<br />Flexibility – Bond Options<br />Stable Investment<br />Fair & Reasonable Return<br />Fair & Reasonable Terms<br />DEMAND FACTORS<br />SUPPLY FACTORS<br />Safety<br />Refinancing<br />Uncertainty<br />Expansion<br />Fear<br />Acquisition<br />
  3. 3. THE ECONOMIC CYCLE<br />Peak<br />Financial System Imbalance<br />Early Recession<br />Late Expansion<br />Strong Buying Demand<br />Late Recession<br />Early Expansion<br />Trough<br />Strong Selling Pressure<br />
  4. 4. WHERE ARE WE TODAY?Macro Perspective<br />
  5. 5. WHERE ARE WE TODAY?Micro Perspective<br />
  6. 6. TYPES OF BOND RISKS<br />The Greatest Hazard Is To Take NO Risk<br />
  7. 7. THREE PRINCIPLES THAT DETERMINE A BOND’S RETURN<br />#1 LIQUIDITY<br />#2 CREDIT<br />
  8. 8. #3 DURATION RISK<br />Time<br />Low Variability<br />High Variability<br />
  9. 9. #4 REINVESTMENT RISKS<br />Time<br />Causes <br />Market Timing<br />Being To Defensive<br />Bonds are Called Away<br />Principle Payments Accelerate<br />
  10. 10. WHAT EVERYONE WANTS IS IN CONFLICTWITH WHAT THE MARKET IS OFFERING<br />Return<br />Certificates of Deposits<br /> US Treasury Bonds<br />Liquidity<br />Safety<br />High Yield Bonds <br />
  11. 11. RISK-ADVERSE INVESTORS ARE LINING UP FOR NEGATIVE REAL RETURNS<br />Solutions<br />
  12. 12. WHY HAS DEMAND FOR ZERO SKYROCKETED?<br />Part I<br />In Behavioral Finance there’s a term called Risk Intolerance, which is defined as market conditions when investors refuse to take risk to earn a return. An abrupt shift in risk tolerance is similar to passengers on a ship all moving to one side of the ship at the same time. Things obviously become unstable.<br />3-Month T-Bill<br />Yield = 0.15% <br />1-Yr Treasury Bond<br />Yield = 0.23%<br />6-Month T-Bill<br />Yield = 0.19%<br />
  13. 13. LOW INTEREST RATES STIMULATES ECONOMIC GROWTH<br />PART II<br />LOW INTEREST RATES DRIVE DOWN BORROWING COSTS AND CREATE CHEAP CAPITAL<br />SAVERS ARE FORCED TO SEEK HIGHER-RISK OPPORTUNITIES<br />HIGHLY LEVERAGED ENTERPRISES AND HOUSEHOLDS CAN ENJOY ATTRACTIVE<br />RE-FINANCING OPPORTUNITES<br />GOVERNMENT INTERVENTION<br />
  14. 14. RETURN SCENARIOS<br />Investment Objective: Seek a Fair and Reasonable Return<br />High Yield (H0A0) 7.95% (Yield) +631 (Spread)<br />Emerging Markets Debt (HaD0) 7.07% (Yield) +519 (Spread)<br />Fixed-Rate Preferred Sec. (P0P1) 5.13% (Yield) +178 (Spread)<br />US Corp Bonds (C0A0) 3.84% (Yield) +185 (Spread)<br />Municipal Bonds (U0T0) 1.97% (Yield) +58 (Spread)<br />Asset-Backed Securities (RoFo) 1.57% (Yield) +153 (Spread)<br />Mortgage Backed Securities (MoAo) 2.63% (Yield) +47 (Spread)<br />US Agency Bonds (UAGY) 1.39% (Yield) +28 (Spread)<br />US Treasury Bonds (G0Q0) 1.55% (Yield) (Zero Spread)<br />US T- bills 0-3 months (G0B1) 0.13% (Yield) (Zero Spread)<br />Spreads a/o 9/15/10<br />
  15. 15. THE EXTREME COST OF SAFETY HAS REDUCED THE EARNING POWER OF BONDS<br />High Yield Bond = $7,950<br />Corporate Bond = $3,840<br />Mortgage Back Security = $2,630<br />US Government Agency = $1,390<br />US Treas. Security = $1,550<br />US T-Bill = $130<br />Based on a $100k Investment<br />
  16. 16. ECONOMIC RECOVERY COULD BE A SERIOUS PROBLEM FOR RISK- AVERSE INVESTORS<br />
  17. 17. The Alarm Bell is Sounding<br />#1 Mutual fund inflows (Heavy Buy Activity  End of Cycle)<br />#2 A recovery will limit fear and uncertainty (Reduce Demand)<br />#3 Inflation Expectations will Rise (Negative Real Returns)<br />#4 Bond Yields will have to Rise to attract investors<br />#5 Bond returns need to be fair and reasonable (Important Logic)<br />
  18. 18. Defense Against Credit Events<br />Diversification (Utilizing Multiple Asset Classes)<br />Seek Strategies W/O Specific Limitations (Avoid the Box)<br />Utilize High Yield Strategies (3 Types)<br />Individual Corporate bonds (Insulation)<br />EEM Debt (multiple options w/diff. Risk Characteristics)<br />Exploit the Grey Areas (Between Income and Equity)<br />
  19. 19. QUESTIONS?<br />
  20. 20. US GDP (1970 – 2010)<br />Recessionary Periods<br />1975<br />1980<br />1982<br />1991<br />2008<br />
  21. 21. Threshold Returns<br />5% (BBB Corp.)<br />3% (Muni & A Corp)<br />17-Yrs<br />12-Yrs<br />7 - Yrs<br />

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