Incapital News

How to use bond ladders to address both inflation & deflation

Mon, 09 Aug 2010 05:00:00 GMT

A recent survey of financial professionals on fixed income allocations indicated a continuing strong preference for municipal and corporate bonds.

Among the seven asset classes listed, municipal bonds ranked first in terms of ‘most likely to increase’ allocations during the next six months. Over 65% of advisers responded that they expected to increase allocations to municipal bonds in the near term. Investment-grade corporate bonds ranked second, with 62% of advisers expecting to increase the percentage allocated to high grade corporates.

Why are so many advisers and investors choosing municipal and corporate bonds in the current interest rate environment? The conventional answers might include yield enhancement relative to US Treasuries, reliable income and a high degree of principal security.

A less often cited reason for fixed income securities is that laddered bond portfolios can address both inflation and deflation concerns.

Deflationary pressures are on the minds of many fixed income professionals, including PIMCO’s Bill Gross who observes that the U.S. may be ‘tipping toward deflation’. Mr. Gross said recently that ‘deflation isn’t just a topic of intellectual curiosity, it’s happening’, citing an annualized 0.1% decline over the past two years in the U.S. consumer-price index.2

While an extended period of deflation may not be the most likely economic scenario, notable economists such as St. Louis Fed President James Bullard have warned of a Japan-like period of deflation and slow growth.

In a slow growth and mild deflation environment, intermediate- and longer-dated municipal and corporate bonds typically perform well. If inflation pressures return, short-dated bonds will roll off to enable reinvestment at higher rates.

When faced with the question of ‘how best to own bonds?’, investment professionals often decide to build custom bond portfolios instead of paying fund or ETF management fees. The recent survey indicated that about 40% of advisers typically favor individual bonds for fixed income allocations, while 44% favor bond funds and 16% favor bond ETFs.3

Municipal and corporate bond funds and ETFs have several potential advantages: instant diversification, tradability, and professional management. Bond funds and ETFs are proven instruments that can add value, particularly for smaller portfolios.

However, if a fixed income portfolio is over $250,000, a custom portfolio of bonds could be a good choice. And if the portfolio has at least 10-15 issues of highly-rated bonds, it may be sufficiently diversified.

An interesting option for laddering bonds is a ‘hybrid barbell’ approach, which is essentially two ladders. A ‘liquidity generator’ in the short end could be comprised of a 1-5 year ladder with sequential 6 month final maturities. This short ladder is designed to create fresh principal in a perceived ‘rich’ short term market, with an expectation for reinvestment at higher rates in an inflationary environment. The second ladder could be an income or ‘yield generator’ which focuses on 10-20 year maturities where higher yields are available. Taken together, this hybrid ladder addresses liquidity needs while still benefiting from the relative value further out the yield curve.

Naturally, there is credit risk to be considered, and sufficient time must be allotted to determine the creditworthiness of each holding. The probability of default among the vast majority of municipal bonds is very low. However, the default risk may rise in localities with high jobless rates, foreclosures, lower home values and slowing retail sales – all of which constrict state and local tax revenues.

Likewise, while the default risk of investment grade corporate bonds is historically low, it is not insignificant. Bond funds and ETFs are diversified to address this risk, and well-managed portfolios of individual bonds can achieve the same objective.

Custom-built laddered portfolios of new issue and secondary municipal and corporate bonds have numerous advantages. These include defined maturity and interest payment schedules, control over exactly which bonds are held, and tax efficiency.

New issue bonds can further simplify the process of owning individual securities, with clear pricing and tax consequences. Online resources for building custom bond portfolios include FINRA’s investinginbonds.com and Incapital's incapital.com.

John Radtke is the president of Incapital LLC, a securities and investment banking firm based in Chicago, Boca Raton, and London. Incapital underwrites and distributes fixed income securities and structured notes through over 900 broker-dealers, advisory firms and banks in the US, Europe and Asia. Any opinions expressed in this article are not necessarily the views of Incapital LLC.

1 Survey Source: Incapital July 2010 online survey of 722 Investment Professionals

2 Full context of the Bill Gross quote from wsj.com on August 1, 2010: http://online.wsj.com/article/SB10001424052748703787904575403204077239996.html?KEYWORDS=bill+gross

3 Incapital survey results from July 2010 are available on request from info@incapital.com.

Basic FDIC Insurance Coverage Permanently Increased to $250,000 Per Depositor

Wed, 21 Jul 2010 20:43:00 GMT

On July 21, 2010, President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which, in part, permanently raises the current standard maximum deposit insurance amount to $250,000. The standard maximum insurance amount of $100,000 had been temporarily raised to $250,000 until December 31, 2013. The FDIC insurance coverage limit applies per depositor, per insured depository institution for each account ownership category.

The temporary increase from $100,000 to $250,000 was effective from October 3, 2008, through December 31, 2010. On May 20, 2009, the temporary increase was extended through December 31, 2013.

"With this permanent increase of deposit insurance coverage to $250,000, depositors with CDs above $100,000 but below $250,000 will no longer have to worry about losing coverage on those CDs maturing beyond 2013. We strongly encourage all bank depositors who have questions about their insurance coverage to go to our Web site at www.fdic.gov and use our Electronic Deposit Insurance Estimator (EDIE) or call our toll-free number at 1-877-ASK-FDIC. Insured deposits provide the comfort and peace of mind to depositors that their money is 100 percent safe – provided they keep their deposit balances within the insurance limits," said FDIC Chairman Sheila C. Bair.

To help consumers, bankers and others understand how the new law affects deposit insurance coverage and to help consumers verify whether their deposit accounts are fully protected, the FDIC provides the following resources:

Information on deposit insurance on the FDIC Web site: Updated brochures on deposit insurance coverage (including the basic guide, Deposit Insurance Summary, and the more comprehensive guide, Your Insured Deposits) and a new version of the "Electronic Deposit Insurance Estimator" (EDIE), an interactive service that allows consumers to quickly and easily check whether their accounts are fully protected, are now available on the FDIC's Web site (www.fdic.gov).
A toll-free consumer assistance line: Help and information about deposit insurance and other matters of interest to bank customers are available at 1-877-ASK-FDIC (1-877-275-3342) Monday through Friday from 8:00 a.m. to 8:00 p.m., Eastern Time. For the hearing-impaired, the number is 1-800-925-4618.

# # #

Congress created the Federal Deposit Insurance Corporation in 1933 to restore public confidence in the nation's banking system. The FDIC insured deposits at the nation's 7,932 banks and savings associations and it promotes the safety and soundness of these institutions by identifying, monitoring the addressing risks to which they are exposed.

The FDIC receives no federal tax dollars – insured financial institutions fund its operations. FDIC press releases and other information are available on the Internet at www.fdic.gov, by subscription electronically (go to www.fdic.gov/about/subscriptions/index.html) and may also be obtained through the FDIC's Public Information Center (877-275-3342 or 703-562-2200). PR-161-2010

Incapital Acquires Blue Sky Asset Management

Tue, 06 Jul 2010 05:00:00 GMT

Trans-Atlantic deal creates a leading global independent provider of structured investments and fixed income securities

Chicago & London July 5^th 2010 – Incapital, a securities and investment banking firm based in the US and UK, announced today that it has acquired the business of London–based structured investment specialist Blue Sky Asset Management. The trans-Atlantic deal combines two leading independent providers of structured investments and fixed income securities for institutional and professionally advised investors.

In the US, Incapital LLC is a market leading provider of structured investments and fixed income securities. Incapital underwrites and distributes through broker-dealers, banks and institutional investors.

Blue Sky Asset Management (Blue Sky) is a leading independent provider in the UK and Europe, with a reputation amongst high end wealth managers and professional advisers for its research based, client-centric, ‘intelligent’ structured investment approach. Established in 2007 by a team of senior industry figures, the firm’s approach has been regularly recognised through industry awards including ‘Best in the UK’, ‘Best Research Process’ and ‘Most Useful Industry Website for Investors in the UK’.

Blue Sky’s business will merge into Incapital’s UK-based affiliate, Incapital Europe Limited, with a management team that is widely respected in the UK intermediary channel. This team will be led by Chris Taylor, James Chu and Mark Dickson – all of whom will assume Managing Director roles within Incapital Europe.

‘‘The combination of Incapital and Blue Sky creates a leading global independent platform for fixed income and structured investments. Incapital Europe’s clients will immediately benefit from the significant scale and capabilities of the combined business units,” said Incapital LLC president John Radtke. “Incapital Europe will announce initiatives in the UK, Channel Islands and Continental Europe, bringing an expanded list of major banking counterparties, educational resources for professional advisers and building on the exceptional reputation that both firms have for client-centric innovation."

Chris Taylor, taking on the role of Managing Director at Incapital Europe, said: “UK wealth managers and professional advisers understand the benefits of dealing with independent structured investment providers – not least the advantages and value of open architecture counterparty platforms. However, it’s a simple fact that the independent firms active in the UK have lacked the capability and capital to operate at the highest level – or to satisfy the increasingly deep due diligence processes and requirements of advisers and investors. This trans-Atlantic deal creates an independent provider capable of competing at the highest level. Incapital Europe will immediately occupy a market leadership position, leveraging significant counterparty and trading advantage, with genuine scale, depth of resource and capability.”

Incapital Europe will rebrand Blue Sky’s award winning website – cited as the ‘Most Useful Industry Website for Investors in the UK’, by the Financial Times. The unique Blue Sky ‘Guide to Understanding Counterparties’, which highlights ‘due diligence’ considerations for advisers and investors, and the Blue Sky ‘Counterparty Platform’, which provides credit rating and CDS information for the major structured product counterparties, will continue to be offered – and will be expanded.

Incapital Europe will also retain and build upon Blue Sky’s exclusive strategic alliance with economic and investment research specialist Redtower Asset Management – with the highly regarded research papers ‘Global Temperature’ and ‘Observers’ continuing to be produced for professional advisers, and made available via the company’s website IncapitalEurope.com or provided to advisers who register to receive them.

For more information please contact:

Incapital Europe
Chris Taylor, Managing Director
christopher.taylor@incapital.com

Dr James Chu, Managing Director
james.chu@incapital.com

Mark Dickson, Managing Director
mark.dickson@incapital.com

Incapital LLC
Jim Schaberg, Managing Director
jim.schaberg@incapital.com

How Tom Ricketts uses confidence to drive Incapital LLC

Fri, 02 Jul 2010 18:40:00 GMT

http://www.sbnonline.com/Local/Article/20007/68/0/Going_all_the_way.aspx?Category=124

Cover Story - Going all the way

Smart Business Chicago | July 2010
Winner Financial Services

If Tom Ricketts has as much success with the Chicago Cubs as he has had with Incapital Holdings LLC, he’ll go down in history as a truly legendary figure in the Windy City.

Ricketts’ family acquired the historic baseball club in 2009 and Ricketts became the Cubs’ chairman. But since 2000, he’s been helping to provide the liquidity necessary to make things happen around the world through his successful investment bank. Incapital has underwritten corporate bonds for well-known issuers such as Bank of America, GE Capital Corp., HSBC Finance, Freddie Mac, Boeing Capital, Caterpillar Financial, Dow Chemical and American Express.

Ricketts, the firm’s co-founder, chairman and CEO, developed the idea for Incapital out of two pilot investment banking operations in which he assumed much of the financial risk.

He was willing to take the risk because he was confident he could formulate an executable business plan and his ability to do so became evident in the early months of Incapital’s formation. The plan was comprehensive and involved a technology focus that potential competitors lacked.

With the opportunity to build systems from scratch, Incapital was able to customize its technology for the direct benefit of both bond issuers and bond distributors.

Ricketts encourages his employees to constantly seek continuing education and opportunities to improve their skills. Often that’s through the attainment of new degrees, but Ricketts also provides in-house training and education through all-company meetings. And it’s all to provide an environment of growth and to keep people consistently moving forward.

But it’s not just the growth of the company Ricketts pursues. He encourages his employees to join him in supporting worthy charitable causes from breast cancer research and wounded veterans to disaster relief and needy families. Whether it’s business or philanthropy, Ricketts wants to win.

How to reach: Incapital Holdings LLC, (312) 379-3700

Bond market bubble fears may overlook secular trends

Mon, 28 Jun 2010 05:00:00 GMT

http://www.investmentnews.com/article/20100629/FREE/100629896

Much recent press has been devoted to warnings of bonds as the next potential market bubble. The rationale typically revolves around ‘excess allocation’ to bonds and bond funds by investors during the past 18 months. With fixed income securities attracting allocations previously weighted to equities and higher risk assets, bond buyers are being cautioned not to reach for yield near cyclical lows.

A recent article in Financial Times makes an anti-bubble case for bonds. David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates, cites several key variables which may account for continued inflows into bonds.

First, there are 78 million baby boomers in the U.S. with an average age of 54. These boomers will increasingly be likely to invest for capital preservation and income in the coming years. With memories of two bear markets in equities within the past decade, capital appreciation is less likely to be a major goal for this cohort.

The second key factor is the overall percentage of allocation for U.S. household assets. Until recently, about 60% of the overall U.S. asset mix has been about evenly split between equities and real estate, with less than 10% in bonds. The percentage allocation to bonds is highly likely to expand in the coming decade. The anti-bubble view is that secular increase in demand for fixed income securities will counter the expected increase in supply from private and government sectors.

With potential inflation on the minds of many bond bubble enthusiasts, will new bond buyers regret locking in current yields? Rosenberg deflates the inflation argument by making the case that deleveraging cycles typically last as long as seven years, and the current cycle is only at year two.

The deleveraging trends worldwide come at a time when most measures of underlying inflation are 1-2%. The deflationary forces of debt consolidation provide medium and long-term bond buyers with at least a modest yield pick-up over core inflation rates.

For holders of individual bonds, an additional anti-bubble point is simply that bonds have a stated interest maturity date and pre-set interest payment dates. A bond that matures at a known date with a known value cannot be judged in the same context as assets with no defined maturity value.

Certainly there are several risks when considering bonds in any environment, including credit risk and interest rate risk. However, investing in a laddered portfolio of high quality fixed income securities is a strategy for all seasons, offering shelter from market cycles and bubble talk.

Source for U.S. Household Asset Mix: Financial Times, June 22, 2010 ‘Predictions of a bond market bubble are all wrong’ by David Rosenberg

Fixed-income allocations: How to evaluate your next move

Mon, 24 May 2010 05:00:00 GMT

What are the key distinctions in choosing individual bonds or bond funds for fixed income allocations?

Bond funds and bond ETFs have attracted significant asset flows in the past year. Since January 2010, bond fund inflows are tracking close to a record pace. (1)

Ownership of individual bonds by U.S. investors is also at an all-time high. Retail investment into corporate, municipal, US Treasury and GSE bonds remains robust, even with historic low interest rates. (2)

How are advisers currently allocating fixed income assets?

Our firm recently surveyed 2,050 financial advisers regarding fixed income product preferences. We reached out to broad group of advisers representing national and regional broker-dealers, independents and RIAs.(3)

The survey asked advisers if they generally recommend bonds, bond funds or bond ETFs. We found that 42% of advisers recommend primarily individual bonds, while 40% typically recommend bond funds or bond ETFs. The other 18% currently utilize a roughly even mix of bonds, funds and SMAs.

A large percentage of advisers clearly believe that a portfolio of individual bonds can match up to professionally managed bond funds and ETFs. What criteria should advisers and investors consider in making their fixed income allocations and in selecting bonds vs. bond funds?

Diversification: Adequate diversification in an investment grade bond portfolio can typically be achieved with 10-20 different securities. If the overall portfolio is large enough, individual bonds can be diversified by both credit and maturity. With high yield bonds, 30-40 different securities may be needed for adequate diversification. In the high yield and emerging market sectors, bond funds are often most suitable for individual investors.

Credit Risk: Credit ratings from S&P, Moody's and Fitch continue to be the standard measurements of credit risk. However, these ratings should not be the sole criteria when diversifying a bond portfolio, whether as individual bonds or bonds funds. As we are seeing in the Eurozone, event risk and potential restructuring of debt are additional factors for consideration.

Income/Defined Maturity: Is a known cash flow with a stated final maturity a major goal? Both bond funds and individual bonds can deliver regular income, but for predictable income and defined maturities, individual bonds are often the preferred option. With a custom portfolio of bonds, the adviser and investor have control over exactly which bonds are owned at any given time, typically with more predictable tax consequences.

Liquidity/Pricing: How important is daily or intra-day liquidity? Bond funds have end-of-day liquidity while bond ETFs are even more tradable. Secondary markets for individual bonds vary widely, but price transparency is improving. With TRACE reporting for corporate bonds and MSRB trade data for municipals, advisers have better access to secondary pricing.

Laddering/Interest Rate Risk: Laddering is a diversification strategy which involves purchasing an assortment of bonds with various maturities. Buying a range of maturities typically reduces a portfolio's exposure to interest rate risk.(4)

While short-term bonds usually offer a higher degree of stability, an investor may sacrifice returns which are often available from longer-term bonds. Conversely, longer term bonds may expose the investor to more volatility, and the possibility of losses if sold prior to maturity.

For example, a ladder may consist of equal amounts of bonds maturing in two, four, six, eight and ten years. In two years, when the first bonds mature, the investor may reinvest the money in a bond with a ten year maturity, thereby maintaining the bond ladder portfolio.

The return on a laddered portfolio is typically higher than a portfolio of only short-term issues. The overall portfolio risk would also be less than a portfolio of only longer-term issues. When compared to buying bonds of a single maturity, the laddered approach offers potential protection against interest rate changes while providing a predictable stream of income.

If interest rates fall, the bonds that mature in two years would have to be reinvested at a lower rate. However, the other bonds in the portfolio would have an above-market return. Alternatively, if interest rates rise, the total portfolio might pay a below-market return, but the maturing bonds can be reinvested in bonds with the higher rate environment

Expenses: Over an expected portfolio life, a one-time transaction fee for individual bonds can be less expensive than a bond fund's ongoing fees. In the event professional management is not needed (e.g. for higher grade bonds), individual bonds with a single commission may be preferable to a bond fund with potential up-front commissions, annual expenses and management fees.

Investor goals & additional considerations: What is the investor's expected holding period? What are the investor's age and circumstances? Bond funds can be ideal for retirement accounts, especially when fractional shares and monthly accumulation are appropriate. Individual bonds, however, are often selected in the years prior to and during retirement, or for both taxable and tax-exempt securities. Taxable municipal bonds (Build America Bonds) are also a growing asset class.

With bond funds and ETFs, tax implications vary according to the composition and turnover of the portfolio manager's holdings. There may be unexpected tax liabilities when assets are liquidated in a bond fund.

If individual bonds are chosen, will secondary bonds or new issue bonds be preferable? Tax consequences for bonds purchased at premiums or discounts should be considered, although secondary market bonds often offer relative value. With new issue bond programs designed for individual investors, advisers have many options for creating customized portfolios.

While bond funds and ETFs have many attractive features, individual bonds deserve consideration where suitable.

John Radtke is the president of Incapital LLC , a securities and investment banking firm based in Chicago, Boca Raton, and London. Incapital underwrites and distributes fixed income securities and structured notes through over 900 broker-dealers, advisory firms and banks in the US, Europe and Asia

Year-to-date through April, bond funds in the U.S. had net inflows of $118.7 billion, a 45% increase from $81.9 billion in the first four months of 2009, according to the Investment Company Institute.
Source: Federal Reserve of New York ‘Ownership of Individual Securities’
Source: Incapital Survey of 2,050 financial advisors on April 25, 2010
‘Interest Rate Risk’ is further explained below:

As a general rule, bonds tend to rise in value when interest rates fall, and fall in value when interest rates rise. Usually, the longer the maturity, the greater the degree of price volatility. In the case of callable bonds, both the maturity and call date will factor into price movements in the secondary market.

If bonds are held to maturity (or the call date, if called), investors are typically less affected by price fluctuations in the secondary market. The price volatility is known as interest rate risk, or market risk, and generally is reflected on the brokerage firm's statement pricing. This interest rate risk will impact the price an investor would receive if a bond is sold prior to maturity, but not if a bond matures or is called at par value (typically $1,000 per bond).

Many investors have questions about the inverse relationship between bonds and interest rates. Why are previously issued bonds worth less when interest rates rise, and worth more when interest rates fall?
When interest rates rise, new issues come to market with higher yields than older bonds, typically making those older ones with comparable maturities worth less. Hence, their prices go down.

When interest rates decline, new bond issues come to market with lower yields than older bonds, typcially making these previously-issued, higher-yielding bonds worth more. Hence, their prices go up.

As a result, investors selling bonds prior to maturity or call date may receive more or less than their original investment.

Rising interest rates will typically reduce the near-term market value of bond investments. Generally, the secondary market price of longer maturities will be more sensitive to changes in interest rates. The table below is an indication of the sensitivity of outstanding issues during a one-year time given different interest rate scenarios. Short-term total returns (income plus price change) will decline if rates rise. However, holding bonds to maturity will result in receiving income at the stated coupon rate plus full return of principal (assuming no default by the issuer).

Incapital Appoints Lou Williott As Vice President, Institutional Sales

Thu, 20 May 2010 05:00:00 GMT

CHICAGO -- Incapital LLC, a leading underwriter and wholesale distributor of fixed income securities and structured notes, announced today that Lou Williott has joined the firm's growing Institutional Sales group.

We are committed to hiring proven leaders to serve our institutional clients," said Gerry Jablonski, Managing Director, Institutional Sales. "Lou's solid experience, coupled with his strong relationships, will increase the value we provide to our institutional clients."

Mr. Williott brings more than 30 years of experience to the firm. He joins Incapital from Fundamental Capital Markets where he served as Senior Vice President – Institutional Sales. Previously, he was a Senior Vice President at Sterne Agee Capital Markets and BB&T Capital Markets. Mr. Williott started his career at Prudential Securities where he worked for 19 years. Mr. Williott will continue to be located in Columbus, Ohio as a remote employee of Incapital's Boca Raton, Fla. office and will focus on taxable and nontaxable fixed income products.

Lou Williott received his Bachelor of Science degree from The Ohio State University in 1976 where he played fullback as a member of the four-time Big Ten Championship football team under Coach Woody Hayes.

"Incapital continues to invest in our Institutional platform, creating positive opportunities and unparalleled service," said Incapital President John Radtke. "Lou's addition positions us very strongly as we continue to grow our business and expand our product offerings."

About Incapital

Incapital is a securities and investment banking firm with offices in Chicago, Boca Raton and London*. Incapital underwrites and distributes fixed income securities and structured notes through more than 900 broker-dealers, banks and institutional accounts in the U.S., Europe and Asia.

* Incapital Europe Limited is an FSA registered entity and an affiliate of Incapital LLC, located in London.

Incapital Appoints Louise M. Herrle as Managing Director, Capital Markets

Tue, 11 May 2010 05:00:00 GMT

CHICAGO, IL (May 11, 2010) -- Incapital LLC, a leading underwriter and wholesale distributor of fixed income securities and structured notes, announced today that Louise M. Herrle has joined the firm’s expanding Capital Markets group.

“Louise brings over 30 years of proven experience in financial services and debt capital markets,” said Incapital President John Radtke. “She will strengthen our growing capital markets team and enhance our ability to provide our clients with sound and objective capital markets advice and solutions.”

Ms. Herrle has extensive background in managing global debt programs, Treasury and Corporate Finance. Her positions have included Chief Investment Officer at Chrysler Financial, Senior Managing Director, Treasurer and Head of Corporate Finance for Residential Capital (ResCap) and Treasurer of Freddie Mac, Prior to her work at Freddie Mac, Ms. Herrle was Senior Vice President and Treasurer of the Federal Home Loan Bank of Pittsburgh.

Debt programs managed by Ms. Herrle at both Freddie Mac and ResCap were the recipient of numerous industry awards including Best Borrower, Bond Deal of the Year and Best Corporate Issuer.

Ms. Herrle has been a featured speaker at numerous industry conferences in the U.S., Europe and Asia Ms. Herrle studied economics and mathematics at Robert Morris College where she graduated Magna Cum Laude with a Bachelor of Science in Business Administration degree

About Incapital

* Incapital Europe Limited is a London-based FSA registered entity and an affiliate of Incapital LLC.

Silver Lining: Laddering Individual Bonds

Mon, 10 May 2010 05:00:00 GMT

Investors can limit fixed income losses due to rising interest rates by laddering individual bonds and holding them to maturity

Anxiety prevails among fixed income managers over the prospects of rising interest rates and what it will do to their product’s reputation as a "safe" investment. Although the Fed recently signaled that it will not be raising rates immediately, the specter remains for investors who thought they were buying safety only to see their bond funds systematically erode as rates start to rise.

Many investors do not understand the counterintuitive nature of the inverse relationship between interest rates and bond values. Those who looked to bonds to protect their portfolios from the volatility of 2008 probably do not realize that the value of their bond portfolios will get hammered as interest rates rise. They assume that the lower volatility of bond funds means that their portfolio cannot lose value, which of course is not true. In fact, some bond fund vendors are beginning to issue warnings to customers that they should consider diversifying out of bond funds so the hit will not be quite so bad when the rates actually begin to climb from their current historic lows.

How bad can the hit be? A Schwab analyst suggests that, for bond portfolios with an average duration of five years, every percentage point rise in interest rates will cause the portfolio to drop in value by about 5%. There are a lot of technical assumptions behind that estimate, but it gets the point across.

Investors holding bond funds because they think they will be shielded from market fluctuations will be sorely disappointed, but not all bond investors will be hurt by rising rates. For example, retirees (or anyone else) buying fixed income to create predictable cash flows by laddering individual bonds and holding them to maturity will not be harmed by the intervening paper losses on their bond holdings. In fact, these bond investors may welcome cheaper bonds because they will make the cost of continuing the cash flows cheaper. By holding individual bonds instead of bond funds, investors who need to generate income from their portfolio can actually take advantage of rising interest rates and immunize their cash flows. College textbooks, both old and new, refer to the idea of holding bonds to produce cash flows as a "dedicated" portfolio strategy.

The Tale of Two Bond Investments
Investors generally gain exposure to fixed income either through funds or through individual securities. Bond funds and individual bonds serve fundamentally different roles, particularly for retired investors looking to generate income from their portfolios. Bond funds are designed as total return vehicles that seek to deliver lower volatility than stocks. The goal is to grow faster than withdrawals. However, the underlying characteristics of bonds are lost when they are aggregated in a single portfolio that serves thousands of clients. Although bond funds have low volatility, this doesn’t mean that they can’t lose money, which is exactly what will happen in the short run as rates rise. An investor would still have to sell shares in order to generate income, magnifying the negative effect of reverse dollar cost averaging.

The unique characteristics of individual bonds, on the other hand, can be engineered to deliver predictability along with low volatility. The amount of coupon interest and the timing of maturities for individual bonds are known when the investor buys the bond. So with a little timing, you can match the cash flows using the coupon and redemptions so that the portfolio will be completely immunized from changes in interest rates (since you hold the bonds to maturity) and perfectly match the duration of the income stream regardless of the type of shift in the yield curve.

Liability Driven Investing for Individuals
It used to be that individuals could rely on a pension from their employer to deliver predictable retirement income. Now, most individuals are left to their own devices to generate income from their portfolio. But the pension fund and the individual face the same challenge, building a portfolio to match the projected future income stream. In the institutional investing world, this approach is referred to as "liability driven investing" (LDI), also called goals-based investing

LDI can be implemented with individuals through dedicated (cash-matched) bond portfolios. The idea of a dedicated bond portfolio is to synchronize bond maturities and coupon payments to precisely match future cash flow needs and then hold the bonds until they mature. The cash flows, of course, are the withdrawals retirees must make each year to pay their living expenses. Individual bonds can supply perfectly timed cash flows year after year, without missing a beat. That is why they are called "fixed income" instruments.

Immunization and Predictability
Like its cousin the bond ladder, a dedicated bond portfolio is immunized against rising interest rates because the individual bonds are held to maturity. The value of the portfolio itself is not protected from rising interest rates, but the cash flow stream produced by the bonds is protected. By taking this cash-generating portion of the portfolio off the table risk is nullified where it counts.

Providing predictable cash flow is precisely what a dedicated portfolio is dedicated to do. In fact, holding U.S. Treasuries, agencies, CDs, and TIPS to maturity is probably the closest thing to perfect predictability that exists when it comes to future cash flows. Unlike a bond fund, retirees do not have to worry about what will happen if interest rates are up (and their portfolio value is down) just when they have to sell to get cash for living expenses.

Utilizing dedicated bond portfolios also avoids nearly all the classic risks associated with bonds. As already pointed out, market risk due to rising interest rates is eliminated because the bonds are held to maturity. Reinvestment risk is eliminated because the cash is not reinvested—it is withdrawn and used for living expenses. Default risk can be nearly eliminated by using CDs, Treasuries, and agencies (using AAA rated corporates or munis would carry a low default risk but not eliminate it because defaults do occasionally happen). Inflation risk can be reduced by building inflation adjustments into the target income stream or eliminated entirely by using TIPS.

Consider a couple who retired on January 1, 2010, with a $1 million nest egg. Assume their advisor recommended a 60% stock/40% bond allocation with an initial withdrawal rate of 5% increasing each year with inflation. The couple withdrew $50,000 for living expenses for 2010. If inflation during 2010 turns out to be 3%, they will expect to withdraw $51,500 in 2011, and so on.

To generate and protect the future cash flows regardless of market performance, the couple could buy $400,000 in individual bonds and hold them to maturity. Each bond would supply income in two ways: the coupon interest it produces each year plus its redemption value when it matures. These cash flows are known in advance and would arrive as scheduled, regardless of what happens to interest rates.

The trick is to buy the bonds in just the right amounts and maturities so that the total cash flows match the withdrawals needed for each year. An income stream starting at $51,500 and growing at 3% per year would add up to $457,955 over the next eight years. These are the liabilities that drive the investment, hence the moniker "LDI."

The table above illustrates an example of a set of bonds that would supply this income stream. At current low yields on CD’s and TIPS (about 2.9%), this bond portfolio would cost $401,068. But its cash flows sum to $458,474, matching the annual targets nearly perfectly (bonds must be bought in $1000 increments, so the match cannot be exact).

Once the dedicated bond portfolio is in place, it will provide cash flows for the withdrawals in just the right amounts at just the right times. As each year passes, the same 8-year time horizon of protection can be maintained for as long as needed by adding a new bond with an 8-year maturity if desired. In practice, the entire portfolio would need to be re-configured to adjust for the cash flows from the new bond but this is the idea. Doing it every year over a lifetime would be the equivalent of self-annuitizing.

There is nothing sacred about eight years. Other horizons can be used (5 to 10 year are common for retirees). At today’s yields, each year of cash flow takes about a 5% allocation to fixed income, assuming the initial withdrawal rate itself is at or below 5%. For instance, if the couple had wanted a 30% allocation to fixed income, they could have secured about six years of income; a 50% allocation would buy about 10 years of income. Most retirement portfolios’ fixed income allocations fall into a 30% to 50% range, with 40% being the most popular.

The Impact of Rising Rates
At higher interest rates, the cost of funding the cash flow stream in our example would drop. This is why personal investors following this strategy might welcome a rise in rates.

To project the impact of higher rates, assumptions must be made. Starting with the base case of current rates, the same analysis was done assuming a parallel shift in the yield curve and using yields higher by 0.5%, 1%, 1.5% and 2%. The table above tabulates the results.

In the Base Case of current rates, the cost of the portfolio ($401,068) was about 87% of the 8-year cash flow it produced ($458,474). But if rates rose by 2%, the cost would be $370,426 or about 81% of the same cash flow. That represents a drop of about 8% for the cost of the overall bond portfolio.

Imagine that interest rates dropped by 2% immediately after the investor purchased the portfolio. Although the paper losses would be significant at more than $30,000, notice the income delivered by the portfolio remains unchanged. This same rate change would impact a bond fund values in a similar way. But there is a difference: the investor using a total return approach would have to sell shares in order to generate enough cash thereby selling a depressed asset. This sequence risk magnifies the impact of the withdrawal on the portfolio.

In fact, rising interest rates will be seen as a blessing for investors who use a dedicated bond portfolio. As shown in Table 2 (above), rising interest rates make it cheaper to buy future income. As income is consumed out of the portfolio each year, investors will likely look to extend the portfolio time horizon back out to the original (8-years in the case above).

Conclusion
Rising interest rates do indeed cause bond values to fall. For investors who utilize bond funds in a total return approach to generating income, rising rates may well continue the whipsaw effect that started in their equity portfolio in 2008. Portfolios of individual bonds dedicated to generating cash flows with redemptions and coupon interest will fare much better. The simple idea of precision laddering bond maturities to match income needs solves many of the problems that rising rates and fluctuating markets can cause. Rising rates mean lower costs to provide the same cash flows, and will be viewed as a silver lining for smart bond investors.

Stephen J. Huxley , PhD, is chief investment strategist and Brent Burns, MBA, president of Asset Dedication, LLC, in Mill Valley, California. They are both founding partners of the firm and can be reached via www.assetdedication.com or 866-535-0897.

Are BABs in your future?

Fri, 16 Apr 2010 17:51:00 GMT

http://www.investmentnews.com/article/20100419/FREE/100419891

Build America Bonds were introduced in April 2009 to create jobs and to help municipalities offset borrowing costs with a 35 percent direct subsidy from the U.S. Treasury. BABs have had a strong reception from both issuers and investors, with 1,066 separate BABs issues financing more than $90 billion in new municipal building projects.

President Obama has proposed making the BABs program permanent with a 28 percent subsidy rate at least through 2014. The administration has stated that an expanded BABs program would provide greater certainty in municipal financing and enhance retail ownership of these securities.

From an investment point of view, BABs can fit well inside both taxable and tax-deferred accounts. With a wide range of maturities from a diversified base of issuers in 48 states, BABs are typically competitive in yield with similar quality corporate bonds. The table below is example of recent BAB issuance with yield comparisons to corporate bonds and tax free bonds in similar maturities.

Metropolitan Nashville Convention Center BAB Yield Comparison:

Maturity

Nashville BAB

Financial Index

Industrial Index

Nashville Tax-Free

TEY

UST Yields

2016

4.86

5.23

5.03

3.39

5.21

3.05

2020

5.69

5.39

5.33

4.24

6.52

3.84

2025

6.21

5.40

5.41

4.65

7.15

4.40

Metropolitan Nashville Convention Center Authority BABs are rated AA3/A; Nashville’s Tax-Free Bonds are rated A2/A (Moody’s/S&P)

Financial & Industrial Corporate Indices track bonds rated AA/AA

Source: Bloomberg. All Yields and Ratings effective April 15, 2010

It should be noted that the market for BABs can vary depending on many factors, including available supply and credit quality. For example, recently issued BABs from Mooresville North Carolina (rated A3/AA-) currently trade at yields approximately 50 basis points lower than the Nashville Convention Center BABs. Washington County Oregon Water & Sewer BABs (rated AA3/AA) trade at yields approximately 100 basis points less than the comparable Nashville issues.

Taxable munis and investment grade corporate bonds are generally correlated to US Treasuries, but have additional risk considerations. Sites such as incapital.com and investinginbonds.com offer further risk disclosure for all three types of securities.

The success of the BABs program has created a viable alternative for fixed income portfolios. For most financial advisers, BABs are likely to become an asset class worth considering for taxable bond allocations.

Please consult your financial advisor prior to investing any money in these or other products. These products are offered through many but not all broker-dealers. This information does not constitute an offer to sell or a solicitation of an offer to buy the securities, nor shall there be any sale of those securities, in any state or jurisdiction in which such an offer, solicitation or sale would be unlawful. Certain products are offered by prospectus or offering circular only. Product suitability must be determined for each individual investor. Some Risk Considerations concerning BABs include: Liquidity Risk, Interest Rate Risk, Credit Risk and Subsidy Risk.

Incapital's John Radtke: Are investment-grade corporate bonds still a good value?

Mon, 08 Mar 2010 06:00:00 GMT

http://www.investmentnews.com/article/20100308/FREE/100309904

Over the last 12 months, highly rated corporate bonds have clearly benefited from the flight to quality and a migration from equities and money funds into fixed income. However, is it too late to find relative value in high quality corporate bonds?

A strong case can be made that while the bargains are gone, highly rated corporate debt will likely be very much in demand in 2010.

In late 2008 and early 2009, corporate spreads to U.S. Treasuries were at historical extremes. During the last few months, spreads have settled into ‘normalized' ranges (see nearby chart of corporate spreads to Treasuries).

Will normalized ranges continue to shift in favor of even tighter spreads and greater flows into corporate debt issues?

Many economists have opined that the credit crisis-induced volatility in 2008 and first half of 2009 was likely to be once-in-a-generation phenomena. After unprecedented Fed intervention in the credit markets, high quality corporate issues have gained favor with a wide range of investors.

However, a consequence of the fallout has been bloated government deficits worldwide. As a result, diversification out of government-backed debt may be increasing as bond investors seek opportunities in well-managed corporations with strong balance sheets.

Reducing sovereign credit risk has become a common theme as many portfolio managers see long-term risks in excessive portfolio concentration in any sovereign or government-backed issuer. Market participants are taking note that while a government can print money to pay its bondholders at face value, it cannot do so without raising the risk of future inflation and credibility as a debt issuer.

While high quality corporate bonds are not likely to yield less than their corresponding government bonds over extended periods of time, a recent report from Bianco Research in Chicago points out the following:

A corporation's capital structure is not fixed and can mutate as needed. Debt at risk of default can be restructured, forgiven or converted into equity as the need arises and as bondholders consent.
While a corporation has equity shareholders, a nation's citizens are stakeholders but not shareholders in the government. While citizens may be creditors, there is no possibility for conversion into equity interests.
Many private corporations are quite simply better credit risks than many governments. Corporate entities cannot run open-ended deficits or engage indefinitely in money-losing operations.

For fixed income allocations, absolute interest rate levels may be a larger consideration than relative spreads. While outguessing the timing of the next round of Fed tightening may be doable for a few rock star portfolio managers, the timeless strategies of laddering maturities, credits, and industry sectors will serve most portfolios well.

Bond funds and bond ETFs are liquid and offer instant diversification for smaller portfolios. But for larger portfolios, individual bonds may be a better alternative for steady income and meeting defined goals.

Is it too late to participate in the spread tightening? Are yields too low, and too tight to Treasuries? Perhaps, but an equally good case can be made that the fixed income world will be adjusting to the credit crisis shock for many months to come, with highly rated corporate debt still a good relative value.

John Radtke is the president of Incapital LLC, a securities and investment banking firm based in Chicago. Incapital underwrites and distributes fixed income securities and structured notes through over 900 broker-dealers and banks in the US, Europe and Asia.

New issue bonds: Features & Risk Considerations

Tue, 09 Feb 2010 06:00:00 GMT

Bond ETFs are gaining a substantial following among portfolio managers and investors. ETFs based on fixed income instruments are now about 20% of the total ETF market and bond ETF issuance has increased significantly in the last year.

Bonds ETFs offer instant diversification and tradability. But for many long term investors, Bond ETFs are still an unproven newcomer on the bond block. Bond mutual funds and individual bonds continue to make up by far the greatest percentage of current fixed income allocations.

Owning individual bonds in a portfolio may seem like ‘old news' for some persuaded by the appeal of ETFs. However, many financial professionals do not consider bond ETFs or bond funds to be true fixed income instruments.

Individual bonds are designed to return principal at maturity or call date. This is not the case with bond funds or ETFs, which have no stated maturity. Bond funds and bond ETFs typically have a ‘rolling' average maturity date or duration, with no certain maturity value. In practice, they are not by definition fixed-income securities.
Unlike bond ETFs or bond funds, individual bonds are typically purchased for a stated stream of cash flows.
With individual bonds, the adviser and investor control which bonds are held in a portfolio. With bond funds and ETFs, an ever-changing assortment of securities is under the control of the fund or index manager.
Additionally, interest rate risk tends to decline as a bond nears maturity. This may make individual bonds less vulnerable to changes in interest rates than bond funds and ETFs.

John Radtke, President of Incapital LLC.

When considering individual bonds for fixed income allocations, new issues are often recommended. What are the potential advantages of new issue vs. secondary market bonds?

In many bond sectors, the new issue market offers investors an entry point which can simplify portfolio decisions with tax efficiency and clarity. While municipal bonds may be more difficult to purchase as new issues, several corporate and US Agency issuers offer bonds consistently in the new issue market.

Pricing clarity: New issue corporate bonds are typically offered at a par amount of $1,000 per bond. Secondary market bonds normally trade at discounts or premiums to par, with accrued interest. With no discount or premium pricing on new issue bonds, the coupon on the bond will equal the yield to maturity.

Tax considerations: At maturity a new issue bond will not incur capital gains or losses. Secondary market bonds almost always have more complicated tax consequences.

Underwriting fees: When buying a new issue bond, all underwriting fees are disclosed in the offering documents. Issuance fees typically range from 50-150 basis points on non-callable bonds, depending on the maturity and structure.

Consistency: For issuers offering a regular program, new postings are set each Monday. In most cases these offerings are available until the following Monday. This allows advisers and investors time to make an informed decision. The price (par) and coupon remain constant throughout the week, with all investors receiving the same yield to maturity when the issue closes.

Liquidity: While designed for buy-and-hold investors, liquidity is provided by numerous market markers. In the event of a market dislocation or credit concerns with respect to a specific issuer, bid-ask spreads can be wide. However, secondary issues normally trade in an orderly market and are reported on TRACE (see SIFMA's site investinginbonds.com).

New issue bonds can offer real advantages for the ‘slow and steady' portion of a portfolio. All major custodians and broker-dealers offer new issue bond platforms in the corporate and US Agency sectors.

Incapital LLC is one of the largest distributors of new issue medium term notes. Corporate bonds, whether purchased on an individual basis or through an ETF or a fund, contain credit and other risks. New issue bonds may only be sold pursuant to the applicable offering documents. For a list of Incapital’s current offerings, including offering materials and corresponding risk disclosures, please visit internotes.com.

John Radtke is the president of Incapital LLC, a securities and investment banking firm based in Chicago. Incapital underwrites and distributes fixed income securities and structured notes through over 900 broker-dealers and banks in the US, Europe and Asia.

Bond Ladders in a Rising Rate Environment

Tue, 19 Jan 2010 06:30:00 GMT

http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20100118/FREE/100119907/1094/INDaily01

Legendary investor Benjamin Graham wrote in The Intelligent Investor that the proportion of an investor's portfolio held in bonds should never be less than 25% or more than 75%.

If interest rates rise in 2010 and beyond, which bond strategies might work best? Is Ben Graham's rule of thumb still valid?

For fixed income allocations, building bond ladders has stood the test of time – even in rising rate environments.

Bond laddering in its simplest form involves owning a number of bonds that will come due over a period of years (e.g. from 2 to 10 years). When the earliest maturing bond comes due, it's typically replaced with a bond of an equal amount at the longer end of the maturity ladder.

Proponents of laddering say it lowers reinvestment risk and minimizes the guesswork in playing the yield curve. For income-oriented investors, bond laddering is often a 'compromise' solution for maximizing yields while reducing interest rate risk.

John Radtke, President of Incapital LLC

Among many advisors, it's assumed that fixed income portfolios of greater than $200,000 can benefit from laddering individual bonds. For smaller portfolios, bond funds and bond ETFs diversify credit risk. And while bond funds & ETFs don't mature, they can in effect be laddered by average duration.

But what if rates move higher? Longer term bonds expose a portfolio to greater volatility and potential losses if sold prior to maturity. Laddering proponents argue that while the total portfolio might generate a below-market return in a rising rate environment, the maturing bonds can be reinvested at higher rates.

Here's one guideline that has worked historically:

When the yield curve is flat, allocations should be focused shorter term - often from one to ten years.
If the yield curve is ascending and steep (as currently), allocations often are extended to build a five to twenty-year ladder.

Are higher long term bond yields worth the risk? The chart below outlines the sensitivity of total returns for various maturities over a one year holding period, given both rising and falling yields. These hypothetical yields correspond roughly to where many A-rated corporate bonds are currently trading.

Sensitivity of Total Returns to Interest Rate Changes over a One-Year Holding Period

Maturity	Hypothetical Initial Yield	-2%	-1%	0%	+1%	+2%
2-year	2.75%	4.6%	3.7%	2.8%	1.8%	0.8%
5-year	3.75%	11.4%	7.5%	3.8%	0.1%	-3.3%
10-year	5.00%	20.6%	12.5%	5.0%	-1.9%	-8.2%
20-year	5.75%	32.7%	18.1%	5.8%	-4.9%	-13.9%
Note: Shows approximate total return (income plus price change) over a one-year holding period for the given change in yields for a non-callable issue, assuming the coupon rates shown. Source: Incapital LLC

While interest rate exposure should always be considered, specific portfolio goals typically override guessing the Fed's next move. For investors in individual bonds, a bond ladder creates a steady stream of cash flows. Especially when timed to meet expected needs, laddering is a strategy which can be customized not only by maturity, but by varying amounts, credit ratings and call features.

New issue bonds often offer an estate feature or death put, typically called the survivor's option. For estate planning purposes, this feature allows heirs to redeem the bonds at par, subject to certain limitations.

Bond laddering tools are available on several sites, including SIFMA's investinginbonds.com and Incapital's internotes.com.

While the yield curve and other factors play a role in bond allocation decisions, bond ladders should continue to be an effective strategy in almost every rate environment.

John Radtke is the president of Incapital LLC, a securities and investment banking firm based in Chicago and Boca Raton. Incapital underwrites and distributes fixed income securities and structured notes through over 900 broker-dealers and banks in the US, Europe and Asia.