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Coupon collecting: A silent march

31 July 2018

In the post-2008 era, finding attractive sources of yield has proved a perennial challenge. Jeremy Smouha explains that it remains possible to construct a high-quality portfolio with a significant yield premium. However, the ride is not always a smooth one.

When you constantly read in the news about falling bond prices, it is easy to forget that the return of a bond portfolio is made up of both price movement and accrued coupon payments over time. Especially in a year like this one, when year-to-date performance across most credits has been negative, in aggregate.

The buy and hold approach to bond investing, which relies principally on collecting coupons therefore faces a perennial challenge. Coupons accrue slowly on a day-to-day basis and price movements can disguise the attractiveness of an individual bond’s return. A 6% coupon collects only 0.01645% per day, but that is 18% over three years – a very attractive return when compared with Libor – so, even if central banks are threatening to raise rates a little from current levels, there remains the scope to generate a substantial premium return through diligent portfolio construction.

In our efforts to achieve such a challenging yield objective in a low rate environment, we are willing to venture down a company’s capital structure to find the best combination of yield, value and capital preservation, but we still predominantly hold investment grade issuers. In aggregate, our portfolios offer a yield-to-maturity that is well in excess of typical benchmark indices.

We specialise in the financial sector and in specialist segments of the credit issuance market, such as undated, floating rate and fixed-to-floating debt instruments. The objective is to unearth overlooked and undervalued issues which offer the higher level of yields more commonly associated with junior or subordinated issues. Most importantly, by participating in the junior issues of quality companies, we are typically able to harness the higher returns these securities often offer without having to bear an increased risk of default.

Returns can be beguiling

While coupons accrue steadily over time, this march forwards can be silenced by a combination of noise, volatility and short-term price movements. However, it is well worth noting that the full coupon effect has yet to kick in. This is particular pertinent for us, given the higher yielding nature of the securities we typically invest in. I personally yearn for that moment when news headlines rejoice in the 0.01645% “surge” in the value of such issuers in one day and appreciate its significance from the perspective of our aim to deliver 18% in collected coupons over three years.

The buy and hold approach effectively has another string to its bow in the form of the ‘pull to par’ (bond prices inevitably converge towards their par value as maturity approaches). And, of course, the more a bond price falls below its 100 (nominal) redemption price the more it needs to recover to get back there by redemption date.

In my 30 years of experience in bond investing, time and again we have seen that, once a period of drawdown is finished, the following months witness a bounce as the pull to par is added to the inexorable stream of accrued income. The prevailing environment feels very similar to that of the first quarter of 2016, when we witnessed a very rapid recovery following a period of uncertainty.

Important legal information

The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.

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