2003 Lane Reports

"Stretching" For Yield

Saturday, March 1, 2003
by J. Brad Strom, CFA

With interest rates at or near historic lows, it is very tempting for the investor to go “in search of” greater yields on their fixed income investments. That typically translates into moving out along the yield curve, longer maturities - - and/or down the rating ladder, lower credit quality. Either tactic could spell trouble for the fixed-income investor.

The most immediate concern is for investors attempting to “stretch” for higher yields by targeting lower credit-quality bonds as a means of enhancing returns. Should the domestic economy slip back into recession (the much talked about “double-dip”) before the inevitable expansion gets underway, some of the more marginal credits could find themselves dangerously close to bankruptcy, not a good scenario for their bonds' prices. Longer duration bonds of stable companies would, however, fair well in this environment, at least until the economy begins to recover and moves into its subsequent growth cycle.

Whether or not we must first endure a brief period of continued economic weakness before the economy begins its recovery phase, in the not too distant future we will begin to see signs of sustained economic growth - - improvements in wage growth, consistent increases in non-farm payrolls, a drop in the unemployment rate, and increased capital spending by businesses. As this process unfolds, inflationary concerns associated with an expanding economy and a renewed sense that the equity markets may have finally bottomed (facilitating a shift out of the relative safety of the fixed income markets back into stock investments) will combine to foster what could be a prolonged period of rising interest rates. In this rising interest rate environment, the worst possible place to be is at the “long” end of the yield curve. All things equal, the longer the term (or maturity) of a bond, the greater its price sensitivity to any given change in interest rates. (Bond prices are inversely related to interest rate changes.) In other words, as interest rates rise, bond prices fall. The longer the term of the bond, the more it will fall as interest rates rise.

The above scenarios are what form the basis for Marc J. Lane Investment Management, Inc.'s preference, when managing fixed income portfolios, to utilize a two-pronged approach - - one part passively managed, the other actively managed. The passively managed section comprises roughly 70% to 80% of our clients' fixed income allocations and utilizes a laddered maturity structure of individual tax-appropriate bonds, primarily corporate or municipal issues. The remaining portion is then managed “actively,” purposefully adjusting the portfolio's weighted average “duration” (or its overall level of sensitivity to a given change in interest rates) through the purchase and sale of U.S. Treasury notes and zero-coupon Treasury strips at the long and/or short end of the yield curve, to take advantage of trends we see developing in the credit markets. Using this “active” style of management allows us to make timely adjustments to bond portfolios when market conditions change.

When using a laddered maturity approach within bond portfolios, individual Treasury and either corporate or municipal bonds are purchased with maturity dates staggered across the yield curve. Maturities are extended out as far as the yield curve is steep or as far as our duration targets permit.

Our current duration target equates to a weighted average maturity of roughly four to five years. All bonds within the laddered portion of the portfolio are purchased with the intention of holding them to term and collecting their full face value upon maturity. Proceeds are then rolled over into new bond purchases at the end of the ladder, taking full advantage of what is normally an upward sloping yield curve.

Even during a period of rising interest rates, when bond prices are falling, this can be a winning strategy. Though bond holdings may lose some of their value as rates rise, they will inevitably return to face value at maturity. The proceeds can then be rolled over at the now higher prevailing interest rates as can the accumulated interest payments. Provided that all bonds are originally purchased at or near their par value, and no bonds need to be sold in this environment (maturities are simply allowed to “roll off”), the portfolio never actually realizes any losses and its yield gradually rises as maturing bonds are reinvested at ever increasing rates.

A strategy of this nature successfully limits interest rate risk in this portion of the portfolio and allows it to act as an anchor to the rest of the investment portfolio. The remaining 20 to 30% of the bond allocation, not committed to the ladder of tax- appropriate bonds, can then be used to “actively” manage bond portfolio duration by either buying or selling U.S. Treasury notes and strips at the either end of the yield curve.

When the Firm's Investment Policy Committee feels that the economy is either in the midst of, or about to enter, one of these prolonged periods of rising interest rates, we typically shorten our target portfolio duration by swapping out of the very liquid, longer- term Treasury issues and into short-term issues, thereby reducing the bond portfolio's degree of sensitivity to rising interest rates. If, however, our Committee feels that rates are beginning a long-term downward trend, we extend our duration targets, selling short-term holdings and moving into the 10 to 15-year maturity range with Treasury issues. This strategy affords us the opportunity to generate competitive returns while minimizing turnover and trading costs.

Given the high level of uncertainty in today's marketplace and the likelihood that we may be on the verge of entering a period of rising interest rates, “stretching” for additional yield above and beyond that available in quality, near-term instruments may not be the best solution for investors in search of higher yields. A more patient, well-thought-out strategy concentrating on total return, as opposed to current yield, may prove to be the right answer.

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The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.

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