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.
When we recommend corporate bond investments, we want to achieve an investment return that is greater than the bond's yield to maturity. 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 and to do so prior to a bond's maturity. We call this 'active corporate bond investing,' which we believe is a superior alternative investment strategy compared to creating a traditional hold-to-maturity bond ladder.
A real-life corporate bond investing case study
The below example shows two bonds BondSavvy founder Steve Shaw previously owned: Apple 3.850% 5/4/43 (CUSIP 037833AL4) and Cablevision 5.875% 9/15/22 (CUSIP 12686CBB4). 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.
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.
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 benchmark bond ETFs and, many times, the S&P 500.
Factors impacting when to sell corporate bonds
In our How To Invest in Corporate Bonds and Corporate Bond Investing 101 videos, we discuss BondSavvy's investment process for evaluating new corporate bond investment opportunities. These videos are focused on investment selection, one half of our fixed income investment equation. The other key part is: when to sell bonds we previously recommended?
Our goal is to extract as much investment return from each corporate bond as possible over as long of a time period as possible. In certain cases, we may hold corporate bonds to maturity, but, generally speaking, we recommend selling bonds prior to maturity to lock in capital appreciation and maximize return on investment. Our typical bond investment holding period is between one to four years. 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 the below chart, 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 currently trade 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 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 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.
* 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, for each of our previously recommended corporate bonds, we provide updates to each bond issuer's 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, the difference between a specific CUSIP's yield to maturity and the yield to maturity of a Treasury bond with a comparable maturity date. 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 and financial ratios 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 far 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 achieve a 26% 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 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 credit ratings -- selling on downgrades and buying on upgrades. This behavior can cause material changes to bond prices. Learn more by reading our credit ratings blog post.
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) For investment-grade bond recommendations, what is our feel on the interest rate environment?
High-yield corporate bonds (also referred to as "junk bonds" or "below-investment-grade bonds") are not sensitive to changes in Treasury yields whereas investment-grade corporate bonds are since they are priced off the benchmark Treasury that has a comparable bond maturity date. Therefore, when evaluating when to sell bonds rated investment grade, we assess Treasury-yield trends and whether we see material changes in interest rates 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 corporate bonds and seek to mitigate the adverse impact of rising rates on investment-grade corporate bonds.
With many Treasury yields rising for the first three quarters of 2018, investment-grade corporate bond prices fell, with many high-quality bonds trading between 80% to 90% of face value. We have generally found buying high-quality investment-grade bonds trading at these levels to be compelling investment opportunities.
Corporate bond investing wrap-up
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 so that it can answer the four above questions and recommend to subscribers when to sell bonds we previously recommended.