I have talked about preferred shares and other types of income assets in the past couple of weeks. The columns have prompted a number of emails, one in particular from a broker who correctly, corrected me on a position that not all income assets mature. In fact a number of new perpetual preferred shares have come to the market recently, and as the name suggests, there is no maturity date. 

I think maturity dates are important if only to provide a frame of reference as to how one might utilize income assets within a portfolio. A maturity date provides an exit point at a specific price, which in my opinion, renders the psychological impact of day to day price fluctuations moot. Or at the very least categorizes day to day price movements as a nuisance issue.

Coming full circle, it is useful to again define a fixed income asset, and again, define its role within a portfolio. 

Our define of a fixed income asset is a security producing a fixed stream of income with a maturity date. This narrower definition excludes perpetuals, but does allow for securities such as bonds, strips, mortgage-backed securities, and preferred shares that have a maturity date. 

We can also say that the price of a fixed-income security is interest rate sensitive. Specifically rising when interest rates fall and vice versa. The maturity characteristic matters only to the extent that it determines price volatility. And day to day price volatility matters only to the extent that it provides a diversification effect within the portfolio. 

To understand, we need to examine the properties of a bond which is the classic fixed income asset. Note that the pricing properties of our hypothetical bond would also apply to good quality preferred shares with a maturity date. 

At the outset, we know that a bond’s price is inversely related to the direction of the change in interest rates. When rates rise, bond prices fall, when interest rates fall, bond prices rise. 

Bond prices change because the bonds’ coupon and term to maturity are fixed. Because bond returns must maintain some kind of relationship to what current interest rates are, and because the coupon rate and term to maturity don’t change, something has to give. That something is its price. 

To make the point, let’s suppose that one year interest rates are at 3%. Given that, investors would be willing to pay $100 for a 3% coupon bond, maturing in one year. An investor in that bond would be getting a 3% return from the fixed coupon payments over the next year, which is fair enough, considering interest rates are 3%.

Now suppose interest rates rise to 4%. That 3% bond must now offer investors a 4% return, or no investor would buy it. More to the point, investors who already own it would not be able to sell it. At least not for $100. 

However, if the seller dropped his price to $99, other investors would now be willing to buy it. Why? Because if the bond were purchased at $99, and held to maturity, the investor will receive $100 a year later, for a $1 gain plus the 3% in interest income. The $1 capital gain plus the interest income boosts the bond’s total return to 4%. That total return (any capital appreciation plus interest income) is referred to as the bonds yield to maturity. 

The same is true if interest rates fell to 2%. A bond paying 3% is relatively attractive in this environment. The seller could raise his price to $101, and buyers would still be interested. By upping the price for a bond that pays a 3% coupon, the buyer would net 2% over the next year.

Moving to property two; the lower the coupon rate on the bond, the more that bond’s price rises and falls. The coupon rate on a bond is the contractual interest obligation of the issuer to pay the bondholder a set dollar amount on various predetermined dates, usually twice a year (note preferred shares p[ay quarterly dividends). 

The amount of the payment depends on the coupon rate of the bond, expressed as a percentage of the face value of the bond. For example, a 6% bond would pay the holder of the bond $6 per year for every $100 face value of the bond held. Because most bonds pay twice per year, this investor would actually get two payments of $3 each, spaced six months apart.

Coupon rates come in all sizes, from less than 2% to more than 14%, and every increment in between. The level of the coupon rate determines, in part, how much a bond goes up or down in price when interest rates change. If a bond has a high coupon rate, say 12%, interest rate changes won’t affect the price of this bond very much. The same rate change would affect the price of a 4% bond a lot more.

That is important information to a bond manager. If the manager felt that interest rates were heading for a long, sustained series of decreases, as we saw in 2001, that manager might switch his bond holdings into lower coupon bonds to increase his capital gains. In the current market where rates have been rising, the better performing bond managers have been holding higher coupon bonds and probably shorter maturities, which leads to our next property. 

Property three; the longer the term of the bond, the more that bond’s price rises and falls. For the same change in interest rates, longer-term bonds change more in price than shorter-term bonds. And the longer the term, the more the price moves. Much like the swings on a teeter-totter. The longer the teeter-totter the more violent the swing from top to bottom. 

The longer the time to maturity the longer the investor has to wait for principal to be repaid. And that means greater risk. Over long periods, the economy could be subjected to recession, inflation, war, political uncertainty, etc.. The longer the term, the less the predictability and the greater the price volatility. That’s why longer term bonds typically offer higher yields.

The fourth property affecting price is credit quality. Bonds come in a wide variety of credit qualities and changes in the markets view about the bond’s quality can have a significant effect on its price. Remember how a ratings review impacted General Motors Acceptance Corporation (GMAC) and Ford Motor Credit.

Government of Canada bond issues are rated at the top of the food chain, because the federal government always has an unquestioned ability to pay. In theory, the government could place a 100% tax on the bond, and bingo, it’s paid off! As you move down the ratings, you encounter provincial government issues, high-grade or investment grade corporate bonds, non-investment grade corporate bonds, and then higher risk bonds called high-yield or “junk” bonds. 

Basically then, fixed-income securities prices are affected by four major influences, current interest rates, coupon rate, term to maturity and credit quality. Understanding these properties can go a long way to helping you understand the role these assets play in a diversified portfolio. 

The impact of fixed income price volatility is minimized within a portfolio context, if you buy the fixed income asset for cash flow and diversification.