Latest / The Issue at Hand by Madison Investments / Don’t Judge A Bond By Its Coupon
Transcript
- speaker-0: I don't even know what that is. That is two heads in the middle of a lake right now that are surrounded by green moss. Like there were boys swimming and they popped their heads out. Let's not pay attention to that. speaker-1: Mm-hmm. speaker-0: Welcome back to the issue at hand. I'm Chris Alamon, and I with me as always Mike Sanders. As you all know, our goal of this podcast is to provide relevant and timely information regarding bonds and bond characteristics. One of the most basic characteristics is bond coupon. And over the last five months, treasury yields have increased approximately nineteen percent. Over the last four years, they've gone up about 166% since 2022 to now. With all that movement though, the same question continues to come up, at least the questions that I'm getting is why is my coupon lower than the current rate? Clients see their statements and they see a coupon lower and oftentimes significantly lower. So what do we need to do about this? But when they look at their bonds or their bond portfolio, coupon is only one way to look at things. A low coupon can be an attractive investment and a high coupon doesn't always mean the best return. What we'd like to share in this episode is an understanding, I guess, of the balance between price, income and coupon and how it impacts total return. So Mike, I think let's begin. Let's start with the basics before we dig a little deeper. What is a bond's coupon? speaker-1: Yeah, thanks, Chris. So yeah, ⁓ the bonds coupon is just what the stated return of cash is on your investment. That's not necessarily the total return of your investment, but it's how much cash the ⁓ the issuer is gonna pay you back. And obviously your return is gonna be based on how much you pay for those that cash getting returned to you. So two different things, but ⁓ the return and the and the coupon. But obviously very, very important and you know, you can look at it different ways. speaker-0: ⁓ makes sense. And I think what people have I think st I guess trouble kind of comprehending is the difference between our yes current yield, price yield relationship, that sort of thing. Can you go into I guess a little bit of the details between those two? Sure. speaker-1: Sure. So so at at a basic level, ⁓ you know, your current yield is the coupon divided by the price you pay for it. So in in simple terms, you know, you have you pay a hundred cents on the dollar for a bond, it pays a five percent coupon, it's a five percent current yield. Now, again, as interest rates move to kind of your point before and interest rates move up down and move up, and then those prices move up and down. You know, your current yield going to shift around and then your yield to maturity, yield to to to what you earn is kind of again what equates the price you pay with the coupons you receive. So, you know, you can look at it a couple of different ways when you're trying to assess a a fixed income security. Current yields one, it kind of gives you maybe the upfront cash you're gonna receive in the near term, but then the yield is what's gonna kind of show what you're gonna get over the longer periods of time. speaker-0: Yeah, and I think for those who are who are just listening in, we have a chart that's essentially explaining the seesaw effect of what Mike is trying to illustrate. If interest rates rise, the bond price is going to be at a discount or it's going to go down. If interest rates fall, you're gonna pay a little bit of a premium. Is that fair to say is I guess if ⁓ in my simplistic terms, Mike? speaker-1: Correct. And just to be clear, it's it's the interest rates rise and fall. It's a premium or discount relative to the coupon payment on the bond. So that's the key is the coupon doesn't change. It's the price that you pay for it is what changes. speaker-0: ⁓ okay. I think this kinda goes back to one of the first things that you had said ⁓ way back when was there are no bad bond just bad bond prices. speaker-1: Correct. Yeah. Yeah. Again, it's it's you know, lots of different ways to look at fixed income. ⁓ you know, it it there's no right or wrong way. I guess it's just personal preference. But you know, you do have to know the differences between what your current yield is gonna be and your yield of maturity 'cause those are gonna tell you much, much different ⁓ measures of performance and total return over various periods of time. speaker-0: Well that's I think that's actually a p an important part that you said was one of the things that I think you need to focus on a little bit more, yield to maturity. Like why is this important in terms of how a client or how clients should ⁓ or financial advisors should talk to their clients with regard to bonds? speaker-1: So it's important because it's taking what you pay for it and then the actual pulling to par going the bonds always are gonna go to par, hundred cents from the dollar, if you will. ⁓ it's equating that pull to par and the coupon you're receiving into one number that kind of shows you the total return. And so again, versus what the current yield is, which is just the amount of income versus what you pay. You know, that changes over time as the bond pulls to par in essence, because the bond's gonna go if it's if it's higher than a hundred, then it's gonna go towards a hundred. If it's below, it's gonna go up. So those numbers change a little bit. But I it in my opinion and you know, as somebody that's in fixed income, I guess the truer sense of what you're gonna re get on as a return in your fixed income security is gonna be your yield to maturity, yield to worse, kind of the same the same context. It's it's equating ⁓ what you pay for it and the coupon payments you receive into one number versus the other numbers kind of change. speaker-0: So then one of the important things you're saying there, and I hope everybody paid attention to that part, was that not just looking at coupon, but looking at yield to maturity, so that way you can compare apples to apples, I guess, when you're looking at different bonds. Is that fair? speaker-1: Correct, correct. Yeah, it's it's it's a it's a it's a much easier way to ⁓ compare two securities to ⁓ the same measure that have them a long term ⁓ reflection of what performance will be. speaker-0: I think when I'm having conversations with advisors, one of the things that I that helps me to illustrate this and I think we're gonna throw this slide up is the difference between what a price is ⁓ for a higher coupon versus a lower coupon, even though they have the same maturity. Do you think you can go through that example please? speaker-1: Yeah. Yeah. So if you look at this chart, you know, we have three different securities on this this chart. And it just kind of gives you a context of what happens when you buy a bond at a premium and then what happens as you buy a bond at a discount and which happens to be buy a bond bond that's at par, hundred cents from the dollar, and how the price changes over time when you have different coupons, right? So I if you buy a a five year bond with a seven and a half percent coupon and the interest rate in the market is five, you'll be paying a premium for that. And conversely if it's two and a half, you'll ha you don't have to pay as much for that. But as you can see, because you've paid that premium for the seven and a half percent coupon, that bond's price is gonna be eventually be a hundred in five years, is the same way as the bond that's at, you know, eight eighty nine. is going to be at a hundred. So in order to calculate the total return, you have to take you the income that you're receiving for both, but then you have to adjust it for price over time. And so again, that's why yield to maturity is the preferred measure in fixed income to look at. ⁓ because it it equates, you know, buying something for 89 cents or buying something for 111 cents almost and how that kind of balances itself out over time as you approach the bond mature speaker-0: Yeah, for those just listening in, so one of the things that we're trying to illustrate is that even though you paid for a higher coupon bond, you paid a hundred and ten. That's eventually gonna fall back down to a hundred versus the two and a half percent coupon that's at eighty-nine, that's eventually gonna rise to a hundred at w as it approaches maturity. That's what we need to factor in when we're talking about this total return. And I hope everybody can understand that because one of the other issues that I think that Mike just mentioned is I think we're always overwhelmed with a lot of the terminology. that's thrown out there. So one of the things that you mentioned, Mike, was a a yield to call, a yield to worst, a yield to maturity. How should an advisor know when to utilize those, when to look at those? speaker-1: Yeah, I mean it I I think in general, I think yield to maturity and yield to worst. If yield to worst, there's the bonds sometimes have would have a an option to get called away early. And so you really need to understand it's kind of the worst case return for a security that can get called away from you. So ⁓ I think in general, yield to call, yield to worst kind of the same thing, and yield to maturity should be your main main focus when you're analyzing the the the the return profile for fixed income. Current yield is is useful if you want to get a sense of maybe how much income might get generated from a portfolio in the near term. But if you're looking at a total return over multiple periods, the yield to call, yield to worst, yield to maturity would all be the preferred method. Again, it takes into consideration the other factors that are important when you're investing in a fixed income security. Now that's not everything to focus on in fixed income, right? Because you know bond is bond bond prices and yields, you know, it's just math. And so there is slightly different risks in terms of the sensitivity to interest rates if you own a low coupon bond or a high coupon bond. And you know, as a manager, you know, ⁓ of of a fixed income portfolio, you know, it's our job to kind of take that in consideration when build speaker-0: Let me stop you. Let's let's let's not let's flip this on you and not go theoretical. When you are buying a bond, how do you decide whether to look at low coupon, high coupon with the same maturity? What are the things that you're considering? What else are you looking for? I I like this conversation. Go ahead. speaker-1: Yes. Yeah, so it really, you know, it's issuer specific risks, right? So ⁓ obviously if you have a ⁓ the same issuer that has a low coupon and a high coupon, and you know, I'm looking at it from an investment perspective, you know, ideally I'd like to be paid more yield, have more spread if you have the same maturities. ⁓ and you can manage the other risks in terms of duration of your overall portfolio or interest rate sensitivity. ⁓ with other securities in the portfolio. So we're trying to maximize the yield for the portfolio, making sure we're not doing that in a very risk aware kind of framework. So from our perspective, ⁓ you know, it's about maximizing the yield. And so sometimes, you know, in certain scenarios, you know, a higher coupon bond might have a slightly different yield than a low coupon bond. But as long as we're comfortable You know, we're kind of in from the credit quality perspective. ⁓ you know, either one of them could be good fits in an overall portfolio. ⁓ it might be slightly different if you're buying, you know, individual bonds for somebody, but I think when you think about it on a portfolio context, both of them have a a place in a portfolio. Another thing to consider would be if if there's if the client wants more cash flow up front, maybe you'd be focusing on You know, bonds that are near mature, you know, near par or slightly higher versus discounted bonds that get more of their performance from the price change, right? Because the yield to maturity is both the coupon and the price. If you're holding the bonds to maturity or holding them for a while, you know, you really can't can't spend the price increase, if you will. So you want the cash from the coupon. So to make it too complicated, but you know, both of them have their place. speaker-0: ⁓ makes sense. speaker-1: I think it's really about maximizing it for that. speaker-0: I think the other thing is I think this ties all back to the importance of portfolio construction, wouldn't you say? speaker-1: Correct. Correct. It's about, you know, fi investing in general, in my opinion, is is as much about understanding the risks that you're taking as it is in finding, you know, attractive bonds. You know if if all you do is chase yield, and we've discussed this in the past, is I think that's where you can get into trouble. And so you really have to understand ⁓ the risks involved when you're purchasing any security, but especially bonds, because there's multiple different ways to look at it. speaker-0: So let me see if I can bring it all back. Coupon, not the same as return. Price matters. And when comparing bonds, compare yield to maturity as a starting point. Is that all fair? speaker-1: That's yeah, I would agree with that. speaker-0: Well, I think that that sums it up. I think we're still gonna get a lot of questions on that, but I think that's a general base for where everybody should say. So thank you, Mike, for joining. As you may or may not know, we do actually here at Madison have a brief paper on this topic as part of our bond concept series. So we'll put a link in the show notes along with any of the charts that we referenced in this episode. So please feel free to use with your clients when you're having your discussions. And for more insights and additional disclosures, visit Madison Investments.com. Don't forget to subscribe and thanks for tuning in. Take care.