(Stock Index Performances as of 01/31/2011)

Blue Haven Capital has been asked several times lately about how to best structure a bond portfolio in anticipation of higher interest rates over the next 24 to 36 months. Not only have current clients asked about this, but so have business reporters and even a few stock brokers who are a bit less familiar with bonds.

The yield on the 2 year US Treasury note is hovering very close to 1/2%, which puts it near record-low territory. How does one balance the need for income with the need to protect the bond portfolio from rising interest rates? One way is to use higher coupon callable bonds.

High Coupon Bonds
Higher coupon bonds react less in price to a given interest rate change than lower coupon bonds. Let's take a hypothetical 2% rise in interest rates on two different 10 year bonds. One of the bonds has a 2% coupon and one has a 5% coupon, but the yield to maturity is the same on both. If interest rates rise 2%, the high coupon bond might lose 14% of its value while the low coupon bond could lose over 16% of its value. By using the higher coupon bond rather than the lower coupon bond in the portfolio, the careful bond portfolio manager might be able to save a client upwards of 2% on his or her bond portfolio in a rising interest rate environment...that's $20,000 on a $1mm portfolio.

If a portfolio manager is considering two equally safe bonds, and both are offering the same yield to maturity in 10 years, then perhaps now is the time to purchase the higher of the two coupons.

Callable Bonds
When a corporation or municipality issues bonds, often they retain the right to call the bonds back from the owner at a predetermined price. For example, XYZ Corporation might issue a bond due in 2020 but callable in 2015. When 2015 comes around, the XYZ Corporation might call the bonds, or they might not. If interest rates have fallen, the XYZ Corporation might want to do what many individuals have done with their mortgages and refinance that debt. If interest rates have risen, XYZ Corporation might decide not to call in the bonds.

Given two equally safe bonds, one callable and one NON callable, the callable bond should trade at a higher yield than the non callable bond. If a portfolio manager is considering two equally safe bonds, then perhaps now is the time to purchase the callable bond and get the extra yield that it offers.

High Coupon, Callable Bonds
With a bit of diligence, bond portfolio managers may be able to find attractively priced high coupon callable bonds. When interest rates are near their lows and expected to rise in the next 3 to 5 years, the proactive bond portfolio manager who buys higher coupon callable bonds will be doing his or her clients a favor and potentially saving them upwards of 4 or 5% of their portfolio value. By using high coupon bonds, the portfolio manager in the above example could improve portfolio performance by 2% or more. By using callable bonds, the portfolio manager improve portfolio performance by another 2% or more depending upon the maturity of the bonds. The combination of high coupons and callability may be just what a bond portfolio needs when faced with the possibility of higher interest rates.

As always, we welcome your questions or comments.