Neutral: Top Corporate Bond vs. High Yield Bond

Finance Portfolio Research & Analysis for Sept. 8-12, 2008
From our foundational USA research division and the subsequent USA strategy analysts, the following financial analysis excerpts are from revisions recently completed on USA based investment portfolios:

SCR Step 1 - Analysis: From No. D1 (USA) Financial Portfolio Research Revision - [iShares] G. Sachs Invest Top Corporate Bond (LQD) vs. [iShares] High Yield Corporate Bond (HYG):

(1) Observation - Relative Strength: Results in the relative strength analysis of LQD versus HYG indicate that the Top Corporate Bond (LQD) is outperforming / neutral to High Yield Corporate Bond (HYG) on a relative basis. This is a continuation that began in late July. The importance of this relative strength change is that it is with a positive / neutral price path for LQD. The increase in relative strength during much of June and July was from the price path of LQD simply not dropping as fast as the one for HYG.

(2) Observation - Regression: Comparison of the linear regression to the time-series that has a 3-period forward shift finds the following formation: Both the price path and the linear regression is equal to the time-series. Since the linear regression provides the "best fit" to the price path, this has neutral implications for Top Corporate Bond (LQD). However, and of concern, is the weakness of some of the indicators.

(3) Observation - Price Performance: Top Corporate Bond (LQD) shows a continuation of a neutral price path (producing a fairly flat overall slope) on weak indicators.
[Reference Charts: D1-1 (relative strength); AD1A-1a (regression); AD1B-1b (price)]
SCR Step 2 - Implication & Strategy: (1) Possible Implication: The summary of the stated observations for LQD is Neutral, and has Neutral implications.

Additional considerations: First, for most investors, a diversified investment portfolio approach combining stocks, bonds, money market securities, etc., is optimal. While financial diversification cannot protect against a loss from a declining market, it can reduce the volatility of the overall portfolio.

Second, with the globalization of information technologies, college education becomes a prerequisite to most careers. Thus, a goal of successful investing in a variety of assets becomes crucial in providing the upper level education necessary for the future of your children. In consideration of that goal, studying the information available on this site, which has been kind enough to host our research in this article, will help. At www.StrategicCapitalResearch.com, we provide additional finance educational materials to what you find here in both investment books and videos. Between the two sites, you should be able to find enough information to get started toward achieving your education investment goals.

Third, to the above analysis excerpt, the usual disclaimers apply. Since all Strategic Capital Research publications provide research that is conducted using historical data, a reminder needs to be made that the analysis of past market reactions cannot predict future market actions. In particular, no amount of historical data can predict the sudden changes that occasionally occur in financial markets. Finally, the reference chart numbers refer to both the portfolios and their completed auxiliary analyses that are located at
www.strategiccapitalresearch.com/research.html.

The SCR Analysts represent the collective voice of the researchers at Strategic Capital Research (SCR). We provide global financial analyses, and subsequent strategies, from countries to companies. Copyright 2007-2008.
[SCR] Research & Analysis with Free Excerpts at Strategic Capital Research, LLC.

Top Bond and Finance Books

Call Protection - Bond Call Date

Bonds that are callable carry more yield risk or reinvestment risk if they are called. This is because most bonds are called when interest rates are lower. Call protection is the period of time between when the bond is bought to when the first call date occurs.

The longer the callable date ism the greater the period of call protection to the bondholder. This will usually result in a higher price - lower yield to purchase than a bond with a fast call date approaching. The risk is greater on the near date bond and so the market will price that in with a cheaper price. Both of these features has a place in most portfolios.

The bonds with longer call protection will give an investor more predictability and stablity but yield will be lower vs. non-callable fixed income securities. There is always a risk to price component to the investor and the issuer.

Issuers would prefer to have shorter protection periods as it limits their refinancing ability when they would want to call a product back.

Yield to call and yield to maturity would be based on more than the protection period. The redemption price the issuer is paying and the price the investor paid for the issue would have to looked at to truly determine if the yield to maturity would be higher or lower than call yield.

Bond Investment Books

Accrued Interest - Bond Yield Accrued

Bonds pay interest at the coupon rate on a set schedule from issuance through maturity. The interest cycle can be monthly, quarterly, semi-annually, annually or at maturity. When a bond is sold in the secondary market, it is uncommon for the settlement to take place exactly on an interest payment date (Semi-annual example: there are two interest payments per year). At settlement, the buyer pays the seller the purchase price PLUS interest earned (“accrued”) by the seller from the last interest payment, up to, but not including the settlement date. This is referred to as the “accrued interest”.

BOND YIELD discussion

Step Up Agency Bond - Step Up Adjustable Bonds

A STEP UP Agency debenture is a bond that has a fixed coupon rate for a period of time. It is then available to be “called” (redeemed @par) by the issuing Agency. If the note is not called, the coupon will then STEP-UP (adjust) to a new coupon rate. These various coupons and the amount of time between the step dates are established at the issuance and will not be changed over the life of the bond. (A Step-Up Bond is not considered a true floating rate security because the coupons are pre-determined at issuance and do not “float” against a market index).

Keep in mind that each STEP-UP bond will have its own specific call features and coupon step-up features. Some recent issues have had multiple step-up dates with the coupon rate changing each year through maturity if he bond is not called. In any event, the best method of evaluation is to examine the effective yield to each available call date (taking into account the multiple coupons) and then comparing to alternative investments.

Book Recommendations

The Handbook of Fixed Income Securities

Bond Interest Rates - Government Backed Bond Pricing

Bonds are guaranteed by the issuer. The issuer promises the payment of timely interest and the return of your principal at the end. The end date is called the maturity date. Barring any unforeseen default by an issuer which is rare, your principal and interest is secure. Bonds do not have to be held by an investor for the full term. There is an active trading market with bonds. Bonds can be bought and sold in the market resulting in profits or losses. Bond prices fluctuate just like any security does.


The current and future price of a bond depends on a few factors. The most important factor is interest rates and whether they have gone up or down since a bond was purchased. For instance, if you buy our 6% bond for 5 years today and you paid $1000 par value for 1 bond, your hope is that interest rates decline after the bond is bought. If interest rates declined to 5%, your bond will be valued higher and thus trade higher in price. New issues of bonds would only be coming out at 5%. Your 6% bond will be worth more. Conversely, if interest rise to 7%, your 6% bond will be worth less and thus will trade at a discount. These fluctuations in price are mostly relevant only when a bond may be sold. If a bond is bought and held till the maturity date, regardless of interest rate movements, your rate of return is fixed.

Tax Free Municipals

There are many factors that effect a bonds price and value. Bonds have credit ratings on them. Ratings agencies will rate a bond issue so an investor knows the credit quality of an issue. Standard and Poors (S&P) and Moodys are the 2 main ratings companies. A U.S. Government bond will have a AAA rating automatically. These bonds will typically not yield as high of a return as lower rated bonds. AAA is the highest, but you can buy lower rated bonds without really worrying about the credit quality of an issuer, to a point. Bonds that are rated Baa/BBB and higher are considered “Investment Grade”. These bonds, although not AAA are hardly “Junk Bonds” and thus should pay off fine. The length of the bond will effect the price as well now and in the future. If the investment is long term, it will be more susceptible to interest rate movements and thus change in price more often. The longer term bonds will provide a greater rate of return because of these risks.

Bond Trader

US Treasury Trading - Treasury Notes, Bonds

The following are trading examples of treasury notes, bonds , strips and other US Government based securities trades.

A customer places an order to buy ten 4% US Treasury Notes on Monday August 3rd for regular way settlement. This trade will settle on:

A) Monday August 3rd
B) Tuesday August 4th
C) Wednesday August 5th
D) Thursday August 6th

B: All US Government Securities, including Treasury Notes, settle on the next business day. This trade will settle on Tuesday August 4th.

Treasury Notes pay interest:

A) Monthly
B) Semi annually
C) Quarterly
D) At maturity


B: Treasury notes and treasury bonds pay interest semi annually. Treasury bills are non interest bearing and pay par value at maturity.

A customer wants to invest in a bond that has the least amount of reinvestment risk. Which of the following would be the most appropriate?

A) Treasury bond
B) Treasury note
C) Treasury STRIP
D) None of the above

C: Reinvestment risk occurs with income paying investments that are reinvested into lower paying vehicles. Treasury STRIPs are zero coupon bonds issued by the US Government. They do not pay any income or interest during the term of the bond. There would be no reinvestment risk, since there is no income to reinvestment.

Bond Investing Books

Callable Bonds, Accrued Interest, 0 Coupon

Assuming all of the following bonds from the same issuer are callable now, which one would most likely get called first?

A) 8% maturing 1-15-2016
B) 8% maturing 1-15-2006
C) 4% maturing 1-15-2012
D) 4% maturing 1-15-2006

A: Bonds with the highest coupon rates would be the first to most likely get called. The issuer will look to issue new debt at a lower rate. Since there are two 8% bonds, the one that would most likely get called, would be the issue with the longest maturity. This is because the bond is potentially more expensive with the amount of years it has compared to the shorter one.

A customer sells a 6% corporate bond on Tuesday October 4th for regular way settlement. The bond pays interest on July 1st and January 1st. How many days of accrued interest is this customer owed?

A) 98
B) 97
C) 96
D) 57

C: Accrued interest is the interest that is due a seller of a bond since the last day they were paid. Corporate bonds pay on a 30 day month/360 day year. They also settle on the 3rd business day following the trade date (T+3). The trade settles on Friday October 7th. The last pay date was July 1st. The customer is owed 30 days for July, 30 days for August , 30 days for September and 6 days for October. You do not include the settlement date of the 7th.

Which of the following debt securities are direct obligations of the U.S. Government?

A) GNMA
B) FNMA
C) Commercial paper
D) Secured corporate bonds


Correct answer is A: Government National Mortgage Association (GNMA) is a direct obligation of the Government. FNMA is a private agency. Commercial paper and all corporate debt are only guaranteed by the issuing company.

Which of the following securities have initial maturities of one year or less?

I Treasury notes
II Treasury bills
III Commercial paper
IV Treasury stock

A) I and IV
B) I, II and III
C) II and III
D) I, II and IV

C: Treasury bills have initial maturities of 1 month, 3 months and 6 months. Commercial paper has maturities of 270 days or less. Treasury notes have maturities out to two years. Treasury stock is not a debt security and has no maturity.

Zero coupon bonds pay interest:

A) At maturity
B) Semi annual
C) Monthly
D) None of the above

D: 0 Coupon bonds do not pay interest at all. The rate of return is based on the discount price that is paid, and the par that is received at maturity.


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Yield Curve - Positive, Inverted Treasury Bond Curve

The current yield curve measures where short term and long term interest rates are currently trading. This curve is comprised of US Treasury securities.

A positive or ascending yield curve is when short term yields are lower than long term treasury yields. This normally how an interest rate curve shoudl look during most normal economic conditions

Inverted

Sometimes interest rates may be trading where the yield curve is inverted. This means that short term interest rates are trading higher than longer term yields.

If the Federal Reserve Board (FRB) agressively tightens short term money (lowers interest rates), then short term rates can rise - creating a possible inverted curve.

Most other bonds and debt securities are proced off of current treasury rates. Corporate and other bonds are priced "above treasuries". Treasuries have the least amount of credit risk, so other bonds will always trade higher and above the current yield curve, creating a yield spread.