By Matthew Jones, CFA
Investment Manager for Harvest Investment Consultants
In the first quarter of 2009, Harvest Investment Consultants, LLC provided information about the structure of corporate bonds and detailed the compelling investment opportunity that we had identified in that sector. The corporate bankruptcies and onset of global recessionary conditions in late 2008 and early 2009 lead to a credit market freeze and high-quality companies were unable to issue new debt. Over the last six months, the capital markets have been gradually improving and we believe the corporate bond market has moved closer to “fair value” levels. High quality corporate bonds that are relatively short in maturity can still provide attractive income opportunities and lower levels of volatility compared to riskier asset classes due to their priority level on a company’s balance sheet.
Harvest continues to scrutinize different areas of the fixed income universe to uncover solid investment opportunities for clients as not all areas of the fixed income universe have recovered at the same pace as corporate bonds. The purpose of this letter is to provide a brief outline of the structure of other fixed income opportunities that can be combined with corporate, government and municipal bonds to create a broadly diversified fixed income portfolio. These instruments include:
- Agency Step Bonds
- Zero Coupon Bonds
- Structured Notes
- Variable Certificates of Deposit
Agency Step Bonds:
These bonds are issued by Agencies that have either direct Federal Government backing or implicit Federal Government support and include Federal Farm Credit Bank, Federal Home Loan Banks, Fannie Mae, Freddie Mac and Ginnie Mae. Often, these bonds may contain a “call” feature, which allows the issuer to repurchase the bond at a specified date prior to the stated maturity. In a “step” agency bond, the annual coupon that is paid to the investor can change at specified intervals over the life of the bond. An example is the following six-year Federal Farm Credit Bank bond (FFCB):
Year 1 Coupon: 3.00%
Year 2 Coupon: 3.00%
Year 3 Coupon: 5.00%
Year 4 Coupon: 5.00%
Year 5 Coupon: 7.00%
Year 6 Coupon: 7.00%
In this structure, the increasing coupon rates will help compensate the investor if general market interest rates rise during the life of the bond.
Zero Coupon Bonds:
Zero Coupon Bonds do not pay interest to the investor at periodic intervals during the term of the bond. Instead, the bond is issued at a “discounted” price and will mature at a higher price. Thus, in lieu of receiving periodic cash flow, the investor will gradually see the value of the bond move from the original price to the redemption price at maturity. Due to specific tax treatment, these bonds are ideal for tax-deferred accounts. It is important to note that there can be day-to-day volatility as the price appreciates to the final value. A recent investment for Harvest clients includes the following zero coupon bond issued by Fannie Mae:
Purchase Price: 54.925
Maturity Price: 100.00
Term: 121 months
The effective return of receiving $100.00 at maturity for every $54.925 of purchase price is approximately 6.00% annually for ten years.
Structured notes are instruments whose payoff or final value is determined by the performance of some underlying index, benchmark or specific asset. These notes are typically subject to the credit worthiness of the issuing company and can generally be illiquid and difficult to sell before maturity. An example of a structured note would be:
S&P 500 Structured Note with 20% “Cap” and Two Year Term
This investment is meant to replicate a portion of the performance of the S&P 500, but it is important to note that the actual investment instrument is a note, not the actual S&P 500. At the end of the two-year term, the investor in this structured note would receive the original investment back plus the identical percentage return on the S&P 500 up to a total return of 20%. If the S&P 500 happened to decline over the two year period, the investor would get their original investment back but no additional appreciation. Put another way, the investor would be giving up any returns on the S&P 500 above 20% in exchange for a maximum loss of 0% if the index happened to fall over the two year period. As mentioned, these products are often difficult to sell in between the issue date and the maturity date and are intended to be held to maturity. While Harvest has not yet found structured notes that would be a great fit for clients, we will continue to monitor this market for its ability to provide diversification and risk reduction.
Variable Certificates of Deposit:
A variable certificate of deposit is an investment instrument where the coupon or income paid to the investor may vary based on some other index. One primary benefit of the certificate of deposit structure is that FDIC insurance is available to protect investors from losses of principal. Unlike a “Step” Agency bond, the variable payment amounts in a variable certificate of deposit are not known at the time of purchase. One use of variable certificates of deposit is to provide a “hedge” or diversification benefit or to allow investors to benefit from a change in the interest rate environment. An example of a variable certificate of deposit would be a five year CD in which the coupon is reset every year based on an interest rate benchmark and a “spread” or amount of additional return above that benchmark.
Variable Certificate of Deposit based on Two Year U.S. Treasury Rates + 2.50%
Year: Benchmark: Additional Yield: Total Return:
1 1.50% 2.50% 4.00%
2 2.00% 2.50% 4.50%
3 1.00% 2.50% 3.50%
4 1.75% 2.50% 4.25%
In variable certificates of deposit, investors can benefit from rising interest rates, but may also receive lower total returns if the benchmark moves in a disadvantageous way.
It is important to note that Harvest Investment Consultants charges no commissions, mark-ups or additional fees on fixed income products. Harvest maintains a network of relationships at banks, investment companies and fixed-income trading desks so that it can purchase the fixed income alternatives mentioned in this article directly from the issuer or originator in order to provide the best possible price execution to the client.