PREVIOUSLY, our articles have aimed at informing the wider public about different investment products that exist in the marketplace. The wide array of investment structures and characteristics means that you can find something tailored specifically to your needs. However, today we go a step further to discuss investment strategy — in other words, how we can use these products to make money.

Investment strategies

The traditional and conservative way to make money on bonds (and just about every other financial instrument) is to buy and hold. Bonds, with very attractive interest rates or yields, are purchased and held until they mature. This gives a fixed income stream at specific intervals.

Another way of investing in bonds is by employing an investment strategy called “laddering”. A series of bonds is bought with different interest rates and maturity dates. A rung on the “ladder” represents an individual bond in the series and the distance of one rung from the next is represented by the duration or tenure of each bond. The objective is to structure the bond maturity dates (or “rungs”) to coincide with your need for cash or other investments. This strategy is popular among large institutions as well as high net worth individuals who need to maximise the use of their medium-term funds.

Investors can also make money from bonds through active portfolio management. Here the investor’s primary objective is that, of capital appreciation, that is buy at a discount and sell at a premium. The investor also enjoys income during the period within which the bonds are held. Timing is literally everything as the investor does not want to sell the bonds too quickly when further upside is likely to occur. Neither does the investor want to hold the bonds for so long as to wipe out any appreciation that could have been previously realised. An analytical eye must be kept on the interest rate and macro-economic environment at all times.

Regardless of the strategy, a sound understanding of the credit quality, liquidity and financial soundness of the issuer of the bonds must be garnered by the investor.

Practical examples of successful investment strategies

Most recently, we believe municipal “Build America Bonds” issued by the US State Governments have presented quite an opportunity to take advantage of capital accumulation. The prices of these bonds fell significantly in the last quarter of 2010 due to a sharp increase in supply. As mentioned in a previous article, “Build America Bonds (BAB’s) are a type of municipal bond that were designed by the Obama administration to make funding more accessible and cheaper for Government entities during the credit crisis. This was achieved through an effective subsidy from the Federal Government. This subsidy could take one of two forms: A direct cash payment to the issuer, equivalent to 35 per cent of the interest cost or a tax credit of equal proportion to the bond holders. The issuer has the choice of how it would like the subsidy to be applied.” This programme ended on January 1, 2011. As such, there were a number of large issuances at the end of 2010, as US Government entities scrambled to take advantage of the cheaper funding. Prices are depressed now and given the fixed supply of these bonds as well as the anticipated recovery in the US market; we anticipate that the price may rise in the future.

Past examples of successful portfolio management include the purchase of AIG 2013 bonds that were bought at 43 cents on the dollar in 2009 (after the US Government took a 95 per cent stake in the company). These bonds were recently sold at a premium of 103.125. A combination of all three strategies is sometimes employed. For example, the June 2010 purchase of short-term British Petroleum 11/10/2010 bonds at 97 cents on the dollar with the intention to buy and hold, yielded investors a conservative gain at maturity when the bond was redeemed at 100 cents on the dollar. Underlying all these purchases was a sound understanding of the issuing entity’s financial soundness and systemic importance.

Pamela Lewis is the Manager of Investment and Client Services at Sterling Asset Management. 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.net