Step-up bonds: Achieving higher risk adjusted returns

A step-up bond is simply a bond that has a coupon which increases by specified amounts over time. The coupon on a step-up bond increases at regular intervals until the maturity date. The coupon rates, their rate of increase, and the terms and conditions governing the instrument are established at the point of issuance.

Let’s say an investor purchases a five-year step-up bond from Company A. This step-up bond has a rate of three per cent for the first three years and five per cent for the last two years.BenefitsA step-up bond provides a fixed stream of income to an investor. This reduces some of the uncertainty inherent in standard variable rate notes and allows the investor to plan his finances for the future with greater accuracy. Essentially, these bonds minimise interest rate risk to the investor over time.These bonds were very popular at the beginning of the global recession as investors sought to hedge against the decline in economic activity. Step-up bonds are issued by Government agencies as well as private corporations. Weak or just below investment grade corporations issue step-up bonds as a way to encourage investors to purchase their debt in spite of a less than perfect financial position. For example, Anheuser-Busch InBev NV (rated A by S&P), the world’s largest brewer, issued step-up bonds in 2010 with a condition that interest increases by 25 basis points for every one rating notch the company is cut below investment grade, up to a maximum of 200 basis points.However, US Government Sponsored Enterprises and Federal Government Agencies also issue these instruments to provide investors with more attractive rates of return. This debt is rated AAA by Moody’s and Fitch, and is implicitly backed by the US Government and can provide investors with higher risk adjusted rates of return.Downside risksMost step-up bonds have embedded call options. A callable bond gives the bond issuer the right to purchase the bond back from the bond holder before the maturity date. Issuers are more likely to call bonds during periods of low interest rates. This creates an element of reinvestment risk as investors may have to reinvest the proceeds from their redeemed bond at a lower rate.When to invest in themStep-up Bonds are particularly attractive in low interest rate environments. The idea is that as interest rates increase so too will the coupon on the bond, but at predetermined intervals. If short-term interest rates do not increase in the near term then the bond continues to offer attractive rates of return and when the step-up occurs.OpportunityStep-up bonds issued by US Government agencies are an effective tool which can be used to obtain higher rates of return. The slightly more intricate structure increases the coupon, but on an instrument of investment grade credit quality.Leverage can be a beneficial tool that can be used to further enhance returns. Let’s say an investor purchases US$100,000 of a five-year step-up bond from Company A. The initial coupon on this bond is three per cent per annum. The investor could borrow up to 80 per cent of the value of the bonds or $80,000 and use $20,000 of his/her equity to purchase $100,000 of the bonds. This allows the investor to earn a return on equity of 11 per cent per annum.These strategies and instruments can be employed to maximise the return on your investment portfolio. However there are numerous risks that one must consider before pursuing these types of activities. Contact an investment advisor to help you assess the risks and benefits of these instruments.Dave Cameron is Vice President — Securities Trading at Sterling Asset Management Limited. Sterling provides medium to long-term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.netStep up bonds carry coupon rate which increases by specified amounts over time, or based on certain conditions. For example, Budweiser maker Anheuser-Busch InBev NV issued step up bonds in 2010 with a condition that interest increases by 25 basis points for every one rating notch the company is cut below investment grade. (PHOTO: DAQUELLA MANERA)

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Step-up bonds: Achieving higher risk adjusted returns

Should you invest in bonds rather than repos?

AS most investors may know, bonds are loan instruments issued by corporate entities and governments to raise funds for a variety reasons, including: expansion, working capital requirements, and to pay down debt which may carry higher interest rates.

A “Repo” is an abbreviated term for a repurchase agreement. It is essentially a loan instrument, and operates such that a dealer sells government securities to an investor (who is the lender), and at the same time agrees to repurchase the securities from the investor at a specified price on a future date. That future date is usually short, and in the Jamaican context that could be up to 365 days. Because of the short-term nature of repos as well as the fact that these instruments sometimes have the backing of a sovereign body, the liquidity risk of repos is usually considered very low. And as a corollary, so is the return.Savvy investors, who are seeking better returns, will prefer to invest in bonds instead of repos. This is because bonds generally provide the investor with regular interest income, mainly semi-annually or quarterly, as well as provide prospects of capital appreciation.Here is an example which will help. An investor earning five per cent per annum on a US$100,000 repo will earn US$5,000 in interest at the end of one year (before withholding tax) for a total of US$105,000. Another investor with the same US$100,000 earning five per cent per annum on a bond will also earn US$5,000 in coupon (coupon is the term given to the interest paid on bonds). However, the investor in the bond has the prospect of benefiting from capital appreciation. Let us use the example the Royal Bank of Scotland 9.5 per cent 2022 bond. On May 24, 2012 an investor bought 100,000 face value of the bond at a price of 103.50, amounting to US$103,500. On May 22, 2013 he could sell them at a price of 120.375, receiving US$120,375 for them. This amounts to a capital appreciation of US$16,875. His total return of US$21,875, representing his capital appreciation plus his coupon represents a 21 per cent return as opposed to just five per cent with the repo. One can now very easily see how an investor in bonds is considerably better off than an investor in a repo.The beauty about that bond too, is that the issuer is investment grade rated hence carrying lower levels of credit risk. Speaking of risk, one such risk is that the price of the bond could fall below that which the investor paid for it, and this would result in a capital loss if the investor sells at the lower price. This brings into focus the question of timing, as well as objective, both of which are important considerations in trading securities. A savvy investor seeking high returns will try as much as possible to purchase bonds which have prospects for price appreciation. The bonds mentioned above may not offer the investor the same magnitude of returns if he were to purchase those same securities now at the current prices. However, if the objective were to get a particular level of interest on a regular basis, the investor may be perfectly justified in buying at current prices.Finally, choosing suitable bonds may be too much for investors to do on their own, especially if they are not themselves in the market on a daily basis, and may require the help and advice of a trusted financial advisor, especially someone who is in tune with the daily rigours of the market. A good financial advisor can also show an investor that risk is not something to be feared but rather something to be faced, armed with all the necessary information and strategies. Then the investor will be equipped to invest comfortably in bonds instead of making do with the low returns of repos.Pamela Lewis is VP, Investments and Client Services at Sterling Asset Management Ltd. Sterling provides financial and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm or visit our website at www.sterling.com.jm If an investor bought US$103,000 Royal Bank of Scotland 9.5 per cent 2022 bond on May 24, 2012 he could have sold them on May 22, 2013 at a price of US$120,375. His total return of 21 per cent would far exceed the five per cent he would have earned if he invested in a repo. (PHOTO: AP)

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Should you invest in bonds rather than repos?

Bonds for equity investors

The fixed income asset class has a fairly widespread reputation for being conservative and less rewarding than other asset classes. Fixed income instruments usually rank above equity in the capital structure of a corporation, and as such, have a higher claim on a company’s assets in the event of bankruptcy.

As such, fixed income assets usually have lower yields since there is slightly less risk. However, many different types of fixed income instruments have been created and issued which can appeal to traditional equity investors who crave higher returns but slightly less risk.This week, we take a closer look at hybrids — fixed income instruments with features of both debt and equity. These instruments are most commonly issued by large financial institutions across the globe, and they form part of their tier 1 or tier 2 capital base. The capital base of a financial institution, from an accounting standpoint, is classified as equity. However, this “equity” ranks above common or even preferred equity.Let’s take a look at the features that hybrids share with debt and equity. For example, they pay a fixed or floating coupon at pre-established intervals. However, the issuer usually maintains the right to suspend this payment. Similarly, hybrids can have a maturity date, but this date is usually very far into the future, for example, 30 or 40 years. Maturity dates far out into the future and the ability to suspend interest or principal payments are some of the common “equity like” features of hybrids. Hybrids also have another very important feature; they usually contain an embedded conversion option, which allows the issuer to convert the principal of your investment into common equity in very specific circumstances. These circumstances usually describe severe financial difficulty which threatens their ability to meet their minimum capital requirements. To compensate investors for these risks, the issuing institutions usually pay a relatively attractive coupon rate.These types of instruments also display more price volatility than other plain vanilla bonds, and can provide more opportunity for capital gain. Capital gain is an important source of return for the active equity investor. Bonds can also provide generous returns through price appreciation. The price of a bond can rise and fall, just like a stock. However, the issuer has effectively guaranteed you repayment at 100 cents on the dollar. However, during the life of the fixed income instrument, many factors can cause the price to rise or fall. Much like equities, these notes are affected by the company’s financial or strategic market position, general news, and changes in the macro or micro economic landscape. It is also important to note that bonds are not only for low interest rate environments. Fixed income instruments can be structured to take advantage of rising interest rate volatility and higher interest rates. In sum, the fixed income asset class is versatile and can still provide very attractive returns for relatively lower levels of risk than equities.Another important premise here is that investors do not have to compromise the creditworthiness of their investments in order to attain higher returns. There are many different types of structures that can be tailored to the different risk appetites investors. These types of instruments allow an investor to preserve the high credit quality of their investments, by taking on other risks that do not threaten the principal of their investment.Marian Ross is Assistant Vice President – Business Development with Sterling Asset Management Ltd. Sterling provides medium to long term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor.Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.com.jm

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Bonds for equity investors