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Deciding When To Sell Corporate Bonds

BondSavvy seeks to maximize the total investment return of each corporate bond investment opportunity it presents BondSavvy subscribers.  While we know what coupon a bond will pay us, the biggest variable in how successful a corporate bond investment will be is what capital gain or capital loss we will realize while owning the bonds.  In doing so, we follow a well-known investment principle many only associate with stock market investing: buy low and sell high.   

This fixed income blog post examines the factors impacting how we decide when to sell bonds. 

When we recommend corporate bond investments, we want to achieve an investment return that is greater than the bond's yield to maturity and outperforms the leading corporate bond funds and ETFs.  We do this by recommending corporate bonds trading at a compelling value relative to the issuing company's financial performance and strength.  We actively monitor the financial performance of each bond issuer, as well as the performance of each bond and ultimately decide when to sell bonds we previously recommended.  Simply put, our goal is to sell bonds at a higher price than which we recommended them.  This will typically include selling bonds before maturity.  We call this 'active corporate bond investing,' which we believe is a superior investment strategy to creating a traditional hold-to-maturity bond ladder

When to sell bonds: A real-life corporate bond investing case study

The below example shows two bonds BondSavvy founder and fixed income expert Steve Shaw previously owned: Apple 3.850% 5/4/43 (CUSIP 037833AL4) and Cablevision 5.875% 9/15/22 (CUSIP 12686CBB4).  Since this blog post was written early in the history of BondSavvy, this "When to sell bonds" case study was for a pre-BondSavvy investment.  Please view our corporate bond returns page to see the investment performance of all of BondSavvy's exited and current corporate bond recommendations.  

Steve bought both corporate bonds at significant discounts to par value.  He purchased the Apple 3.850% '43 bonds at a price of 85.07 on October 28, 2013 and sold them fewer than five years later on May 9, 2018 at 95.32, achieving an annualized rate of return of 6.4%.  This investment return was significantly higher than the 4.8% yield to maturity quoted when he purchased the bonds.  He bought the Cablevision 5.875% '22 bonds on December 8, 2015 at an offer price of 79.25 and sold the bonds two years later on January 9, 2018 at a price of 99.12.  This investment achieved a 17.6% annualized return on investment compared to the 10.1% quoted yield to maturity.

Figure 1: Examples of Selling Bonds Before Maturity
Selling corporate bond

These examples not only show the importance of investing in bonds with compelling values but also deciding when to sell bonds once we believe we have maximized our capital gain.  When BondSavvy presents new corporate bond investment opportunities during The Bondcast, it is only the first step of maximizing a corporate bond's investment return.  Once we make a new investment recommendation, we closely monitor bond price changes and the financial performance of the issuing companies.  We also evaluate changes in Treasury yields and how these are impacting the bond prices of the investments we recommend.

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Other examples of selling bonds before maturity

The above examples referencing Apple bonds and Cablevision bonds are just two case studies for when to sell bonds.  Our Tiffany bonds blog post shows how we achieved a 26% investment return after holding the bonds slightly over four months, as the value of the bonds was bolstered by LVMH's announced acquisition of Tiffany.  In addition, please view returns of our exited recommendations to see how deciding when to sell bonds has enabled BondSavvy subscribers to achieve returns that have beaten the popular iShares LQD and HYG corporate bond ETFs.     


Factors impacting when to sell corporate bonds

Our goal is to extract as much investment return from each corporate bond recommendation as possible over as long of a time period as possible.  In rare cases, we may hold corporate bonds to maturity, but, generally speaking, we recommend selling bonds before maturity to lock in capital appreciation and maximize investment returns.  Our typical bond investment holding period is between one to four years, but holding periods can vary, as was the case with our investment in Tiffany bonds, which we held slightly over four months. Below are factors that help determine when to sell bonds:    


1) How much has the bond price appreciated since we have owned it?


As shown in Figure 2, corporate bond prices have ceilings. The chart shows a distribution of corporate bond prices available on E*TRADE on October 11, 2018. It shows that very few corporate bonds were trading at or above 125 -- only 4% on this date.  Corporate bond prices trade as a percentage of face value, so a price of 125 means that the bond is valued at a 25% premium to its $1,000 face value. No bond traded at or above 150, showing that bonds can only rise so much in price -- a key difference to how stock market investments trade.   


Corporate bond investors must be mindful of this ceiling on bond prices.


Therefore, if we recommend a corporate bond at par (100) and it increases to 125, we may recommend selling this bond so we can lock in our capital gain. We ultimately need to gauge a bond's upside, and, as bonds increase materially in price, the likelihood of further price increases diminishes. Since all bond prices return to par at maturity, we seek to sell bonds at a high point when possible.

 

Figure 2: Range of Corporate Bond Prices

Prices distribution

* Investment-grade corporate bond search conducted 10/11/18 on E*TRADE for bond maturities between 5-15 years. Bonds are quoted as a percentage of their face value.

Locking in capital appreciation is especially important when holding a low-yielding, investment-grade corporate bond. For example, if you own a corporate bond that increased from par to 120 and the bond pays a 4% coupon, a significant fall in the bond's price could wipe out an investor's interest income for several years. With high-yield corporate bonds, we can be somewhat less 'trigger-happy' in deciding when to sell bonds, as these bonds can often 'out-yield' a reduction in the bond's price.

This active investing approach differs significantly from traditional bond ladders, where investors buy several bonds of various bond maturities and hold all bonds until maturity.  These bond ladders cap investor returns at a bond's yield to maturity and create complacency among investors, which can lead to higher default rates.   

2) Has a bond's risk/return profile significantly changed?


During each edition of The Super Bondcast webcast presentation, for each of our currently recommended corporate bonds, we provide updates to each bond issuer's financial performance as well each bond's price performance. We also discuss the drivers of bond price changes and whether they were driven primarily by changes in comparable Treasury yields and / or changes in credit spreads.  Credit spreads are the difference between a specific CUSIP's yield to maturity and the yield to maturity of a Treasury bond with a comparable maturity date.  They reflect the extra yield corporate bondholders receive to compensate them for the supposed higher default risk a company has vs. the US Treasury.

Our goal with the Super Bondcast is to determine whether previously recommended bonds continue to present a compelling risk/return profile relative to other bonds available in the US corporate bond market.  

A key input in this analysis is comparing the credit spreads, leverage ratios, and other financial metrics of our recommended bonds to other US corporate bonds.  As we discuss in our Tiffany blog post, the credit spread of the Tiffany bonds we previously recommended had fallen close to the credit spread of Apple bonds with similar maturities.  Since Apple, at the time, was a superior credit than Tiffany, we didn't believe Tiffany's credit spread could tighten further, which limited the upside of the Tiffany bonds.  We, therefore, decided to sell the Tiffany bonds and achieved a 26% corporate bond return over a 4 1/2 month period.

In cases when a bond issuer's credit quality has improved but the bond price has fallen, we will typically recommend subscribers buy more of such bonds, as they are better values than when we originally recommended them. While bond prices can rise and fall quickly, changes in a company's credit profile often take several quarters and, at times, a number of years, to fully manifest themselves. BondSavvy therefore monitors both performance of the issuing company and the recommended bonds to assess whether a bond's risk/return profile has changed.

3) How likely is a near-term upgrade or downgrade in the bond's credit rating?


When BondSavvy makes an initial investment recommendation, we evaluate a bond issuer's momentum so we can assess how likely a credit ratings upgrade or downgrade is. Most bond investors, especially institutional investors and index funds, are reactionary to bond ratings -- selling on downgrades and buying on upgrades. This behavior can cause material changes to bond prices.           

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As we update our fixed income investment recommendations, we revisit how close a bond issuer is to ratings upgrade and downgrade thresholds and the likelihood of the company to reach either. We also assess the likelihood of a company being acquired by a company with a higher credit quality. For example, if we recommended a bond issued by a company with a B1 / B+ bond rating and it was acquired by a company with an investment-grade credit rating, the bond we recommended should appreciate significantly in price since the higher-credit-quality acquiror would assume the company debt of the target company. If the pro forma credit metrics continue to be strong, there is a high likelihood that our recommended bond would be upgraded to match the credit rating of the acquiring company. Predicting who will buy whom is mostly a fool's errand, but we look to understand which industries are consolidating and which companies are likely buyers.


4) Does the issuing company have default risk?

When we make initial bond purchase recommendations during The Bondcast subscriber webcast, we seek to recommend bonds that have low prices and high yields relative to the risk of the issuing company.  While we generally recommend bonds issued by companies with low leverage ratios and low default risk, a company's default risk can change over time.  When we make an initial recommendation, our work is just beginning, as, every quarter following a new recommendation, we update our buy/sell/hold recommendation based on our issuing companies' most recent quarterly financial results.

In assessing default risk, we evaluate business profitability and cash flow trends and assess upcoming key events.  These key events could include an upcoming bond maturity date or interest payment.  There could also be financial covenants to which the issuing company must comply.  

In deciding when to sell bonds, we carefully monitor an issuing company's default risk and may elect to sell a bond recommendation if we believe an issuer will have difficulty turning the corner.  That said, the market can often be merciless on bonds issued by companies having financial difficulty. These bonds are often downgraded by the major bond rating agencies, which can cause a free-fall in bond prices.  Selling bonds in such panics is often unfavorable given the poor prices a seller is likely to receive. 

In addition, a bond being in 'default' does not always mean bond investors get wiped out.  For example, a bond issued by Tupperware had fallen to 20% of par value in 2020 given the company's weak financial performance and concern on whether the bond could be refinanced by its 2021 maturity date.  Tupperware began tender offers, where it offered investors payment for the bonds at well below par value.  This was technically a "default" since some bondholders were receiving less than par value for their bonds.  We recommended subscribers hold onto their Tupperware bonds, as we believed the company was going to weather 2020 and be able to refinance the bonds.  Fortunately, the company's business did turn around and it was able to execute a new financing.  Our bonds were later called at a price above par value.


5) Are we expecting rising interest rates?

High-yield corporate bonds (also referred to as "junk bonds" or "below-investment-grade bonds") can have limited sensitivity to changes in Treasury yields, as their performance is typically driven, in larger part, by the underlying financial performance of the issuing company.  Investment-grade corporate bonds, on the other hand, can be highly sensitive to changes in US Treasury yields. Therefore, when evaluating when to sell bonds, we assess US Treasury yield trends and whether we see material changes in US Treasury yields over the near term. 

Underlying Treasury yields will move up and down throughout our ownership of a bond. Since we present investment recommendations over the course of a year, underlying Treasury yield trends may be more or less favorable for certain recommendations. That said, we will incorporate our general views on the interest rate environment when we consider selling bonds before maturity and seek to mitigate the adverse impact of rising rates on our bond recommendations.

During 2022, US Treasury yields rose sharply, which caused many long-dated investment grade corporate bonds to fall to between 55% to 65% of par value.  We have generally found buying high-quality investment-grade bonds trading at these levels to be compelling investment opportunities.  

6) Is our recommended bond callable and at what price?

Most bond investors are familiar with a corporate bond's maturity date, which is the contractual date a bond issuer must pay back bondholders the $1,000 face value for each bond they own.  While the maturity date can impact the price volatility of corporate bonds, it's important for bond investors to understand how bond call schedules can impact a bond's opportunity for capital appreciation and its price ceiling.

If a bond is callable, it means that it can be bought back by the company prior to maturity.  Callable bonds fall into two categories: 1) those deemed to be 'make whole' calls and 2) those with a set call schedule.  We will discuss each type of callable bond and its impact on when to sell bonds:

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Corporate bonds with make-whole call provisions

Generally speaking, most investment-grade corporate bonds are subject to what is known as a 'make-whole' provision.  This provision is in the favor of the bondholder and is seldom exercised given the often onerous cost to the company.  Suppose a company bond is issued with a 40-year maturity and the company wants to call the bond after ten years.  To execute the make-whole call, the issuer would have to pay the bondholder the present value of all future interest and principal payments due the bondholder from years 10 until the maturity date.  As you can imagine, even with discounting the future interest and principal payments due on the bond, executing a make-whole provision could be very expensive for the issuing company.

While bonds with make-whole provisions can be deemed "continuously callable," that term gives investors the wrong impression given that bonds with make-whole provisions are seldom called well in advance of maturity.

An alternative to executing the make-whole call provision is for a bond issuer to 'tender' for its bonds.  In bond tenders, an issuing company offers to buy corporate bonds back at a specific price on a specific date.  Participating in the tender offer is at the option of the bondholder.  Tender offers present a way for bond issuers to redeem bonds early and not incur the substantial cost of effecting a make-whole-call provision.

Corporate bonds with a specific call schedule ("call schedule bonds")

Bonds not subject to a make-whole call will typically be subject to a specific call schedule that sets out the call dates and call prices for the particular corporate bond.  Most high-yield corporate bonds have call schedule provisions in their bond indentures, and it's a key part of corporate bond investing.  From the bond issuer's perspective, if the company's credit quality improves over the life of the bond, it wants to be able to redeem the bonds and issue new bonds at a lower coupon rate.  Since bondholders will be giving up coupon payments for a period of time that could last from one to several years, certain call dates will be subject to a call premium to compensate bondholders for lost income.  Here's how this works.

Figure 3 shows the call schedule for the Tennant 5.625% 5/1/25 bonds (CUSIP 880345AB9), a company that manufactures and sells industrial cleaning machines.  Tennant issued these bonds on January 22, 2018, and they mature approximately seven years later on May 1, 2025.  The Tennant call schedule works as follows:

  • If Tennant calls the bonds from May 1, 2020 through April 30, 2021, it will redeem the bonds at a price of 104.219% of face value, or $1,042.19 per bond;
  • If Tennant calls the bonds from May 1, 2021 through April 30, 2022, it will redeem the bonds at a price of 102.813% of face value, or $1,028.13 per bond;
  • If Tennant calls the bonds from May 1, 2022 through April 30, 2023, it will redeem the bonds at a price of 101.406% of face value, or $1,014.06 per bond;
  • Anytime thereafter, the bonds may be redeemed at par

Figure 3: Tennant 5.625% 5/1/25 Call Schedule

Tennant call

As you can see, the further we are out from the maturity date, the higher the call premium, as bondholders must be compensated for lost coupon payments for a longer time period.

We initially recommended the Tennant bonds at an offer price of 97.32 on December 12, 2018.  As shown in Figure 3, starting May 1, 2020, the bonds were callable at a price of 104.219% of par value.  During September and October 2020, the Tennant bonds have hovered right around 104.00 in price.  It's doubtful the Tennant bonds will increase in price materially above the 104.219 call price, as investors buying the bonds on, say, October 30 at an illustrative price of 106.00 would achieve a negative return if the bonds were called at 104.219 on November 13.  This situation can happen, which is why the Tennant bonds have been a 'hold' as the bond price has approached the May 1, 2020 call price.  The call provision of the Tennant bonds has put a ceiling on the bonds, and it's something we have to pay close attention to as we consider modifying our recommendation of the Tennant bonds.

When to sell bonds conclusion

Buying good bonds at good prices is extremely important; however, it is only part of the bond investing puzzle.  Investors need to maximize capital gains from fixed income investments just like they would with stock market investments.  BondSavvy monitors all previously recommended corporate bonds to evaluate the points covered in this post and to update BondSavvy subscribers on when to sell bonds we previously recommended.


 

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les commented on 24-Jan-2020
Thanks 4 info on selling bond positions. Good luck on NYC presentation
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