By Craig Bishop, Sr. U.S. Fixed Income Strategist, Global Wealth Services Portfolio Advisory Group U.S. Fixed Income Strategies

Transcription

1 Page 1 of 8 Strategy for Year End: Making the Recent Market Selloff Work for You Bond Swaps By Craig Bishop, Sr. U.S. Fixed Income Strategist, Global Wealth Services Portfolio Advisory Group U.S. Fixed Income Strategies It s a Long Path to Rate Normalization The Federal Reserve s recent decision to push back the start of tapering its monthly QE3 purchases as well as forward guidance lower on economic growth and interest rates has allowed bond markets to stem the bleeding from what has been a volatile five-month period. The shock and awe from the beginning stages of rate normalization since May 1 have had a dramatic effect on various asset classes. From their lows of early May to the highs set in early September, yields on Treasuries, A-rated Corporates, and AAA-rated GO Munis rose approximately 140 basis points (bps), resulting in an average price decline of about 9%, although certain more-credit-challenged sectors experienced even steeper price declines. Selling pressure from mutual funds, sparked by investor redemptions, created volatile, illiquid market conditions. But, in the final weeks of September, these sectors began to perform better due to a number of factors, most importantly the slowdown in mutual fund sales to meet investor redemption demands. Although outflows will likely continue to play a factor in the near term, the slower pace of redemptions is a welcome event. The rate normalization process will likely continue, but based upon Fed guidance should do so at a slower pace over a period of years rather than months. With improved and more-stable markets, investors now have a good opportunity to assess whether they can use the recent damage done to portfolios to their advantage. Asset Class Yield Comparison 10-Year Maturities ( ) June 2007 June 2008 June 2009 June 2010 June 2011 June 2012 June 2013 n 10-Yr T-Note n 10-Yr AAA GO n 10-Yr A Corp Source: Bloomberg A division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC. There s Wealth in Our Approach.

2 Page 2 of 8 Recent Losses, Sure; but There are Still Gains As mentioned above, the move toward interest-rate normalization in recent months has had a dramatic impact on investors fixed income holdings. The move has overshadowed the fact that even with the recent volatility, many investors still have gains in their bond portfolios. As the chart above shows, investors who opportunistically took advantage of the higher yields available in recent years in munis and corporates due to significant credit events still have profits in those holdings. While bonds have produced disappointing results this year, equity markets have been on a tear with stocks producing near 20% gains in 2013 alone. However, if you look back to the depths of the Great Recession, the gains since then have been even more spectacular, approximately 130%! It is subject to some debate, but chart patterns indicate markets may be setting the stage for the beginning of a longer-term bull market move. If so, investors may ask, Why sell now and leave money on the table? The answer is that within any market move there will be sectors that may have experienced strong moves already. As a result there are likely some stock market sectors that have benefitted greatly from the market s rally; moving to an underweight in these sectors would allow an investor to recognize gains which could be offset by losses elsewhere in the portfolio. In our opinion, it doesn t necessarily make sense to sell all of your equity winners or bonds with high, attractive coupons, but by selectively harvesting gains in either asset class and using losses from underwater bond positions, could represent the foundation of a widely used year-end tax planning strategy bond swaps. Equity Index Comparison ( ) June 2007 June 2008 June 2009 June 2010 June 2011 June 2012 June n DJIA n S&P 500 Source: Bloomberg

3 Page 3 of 8 Bond Swaps Tying it All Together What are They? The recent challenging environment has left many fixed income investors with portfolio losses. These paper losses only become realized losses upon sale, so, in most cases, when a bond will be held maturity, it doesn t make sense to sell. There are instances, however, when it can make sense to sell and swap into another bond to improve the overall position of a portfolio. A bond swap is simply the sale of bonds from an investment portfolio and the subsequent purchase of replacement bonds. Investors often engage in bond swaps close to year end in order to realize tax benefits by taking a loss on the sale of a depreciated bond and using that loss to offset capital gains on their tax returns, thus avoiding the tax. Potential Benefits n Realize loss for tax savings by selling a bond below current holding (book) value; n Recognize gains in bonds or other parts of the portfolio, equities for example, then use losses to offset these, reducing tax liability; n Improve portfolio credit quality by swapping into a higherrated security; n Increase portfolio yield and boost income by swapping onto higher coupon issues, as the higher income helps to recover any losses; n Take advantage of steep yield curves by selling short maturities and buying longer maturities; and n Enhance liquidity and diversification by buying larger, more widely traded issues across a variety of sectors or states. Be Aware of IRS Policies/Procedures Relating to Swaps When a loss from a swap is realized, the IRS procedure is to first offset short-term losses against short-term gains, then offset long-term losses against long-term gains. Finally, these two net results are combined to produce a final net gain or loss. This final gain or loss is subject to different tax treatments, however, which investors should be aware of when executing bond swaps. Losses: All short- and long-term losses from the sale of bonds can be utilized to offset any short- and long-term capital gains. An investor who has losses on bonds held more than 12 months must use the losses first to offset any long-term capital gains; long-term losses in excess of long-term gains can be applied to short-term gains. Similarly, losses on bonds held for 12 months or less must first be applied to any short-term gains. Gains: An investor realizing a final gain will experience different tax implications, depending on whether the gain is a net short- or long-term gain. Short-term gains are taxed at the same rate as ordinary income, while long-term gains are taxed at a maximum 20% rate. Avoid Wash Sales: If your goal is to reduce taxes with bond swaps, one point to remember is to avoid wash sales, which would void your tax loss. Wash sales occur when a bond is sold, and within 30 days, before or after the sale, the same or nearly identical bond is purchased. (In this case, the IRS considers that you sold the bond simply for the tax write-off.) Generally, you can avoid a wash sale by ensuring two of the following three characteristics of the new bond are different than the sold bond: issuer, coupon, and maturity. De Minimis Rule and Original Issue Discount are items investors, especially those purchasing secondary market discounted municipal bonds, need to be mindful of to avoid the potentially surprising tax consequences from their taxexempt investment.

4 Page 4 of 8 Bond Swap Examples Extension Swap Sell Buy $100,000 Par Value $100,000 Municipal Bond Issue Municipal Bond 5.13% Coupon 5.00% 9/1/2014 Mty 6/1/2035 Call 0.64% YTM 4.67% 0.64% YTW 4.43% Price Aa1/AA+ Rating Aa2/AA Comments 1. Take advantage of the steep muni yield curve sell rich short issues and buy cheap intermediate issues; 2. Cushion-Kicker structure on Buy increases yield and income with 10 years of call protection; 3. Investor books gain of $2,300; 4. Credit quality little unchanged; and 5. Net additional money needed from investor is small. Quality Maturity Annual Income YTM Original Par Results Slight decrease Extend by 21 years -$125 for 1yr/ +$5000 thereafter Increase by 403bps $100,000 Gain/Loss Gain of $2,300 Total Net Money Source: RBC Wealth Management $2,275 Add from Investor

5 Page 5 of 8 Book Profit, Increase Yield Extension Swap Sells Buys $100,000 Par Value $100,000 Corporate Bond Issue Corporate Bond 3.63% Coupon 4.13% 4/15/2015 Mty 8/15/2023 NC Call NC 0.92% YTM 4.06% 0.92% YTW 4.06% 104 Price A2/A+ Rating A3/A Comments 1. Maintain exposure to strong U.S. Bank and experience little change in credit quality by moving from Sr. to Sub. Structure; 2. Take advantage of the steep yield curve sell short rich bond, buy cheap longer issue; 3. Increase yield and coupon; 4. Investor books profit; and 5. No additional money needed investor takes money off the table. Quality Maturity Results Slight decrease Extend by 8 years Annual Income Increase by $500 YTM Original Par Increase by 314bps $100,000 Gain/Loss Gain of $4000 Total Net Money Source: RBC Wealth Management $2889 takeout for Investor

6 Page 6 of 8 Book Loss, Increase Yield and Credit Quality Swap Sell Buy $100,000 Par Value $100,000 Municipal Bond Issue Municipal Bond 4.00% Coupon 4.00% 11/15/2043 Mty 3/1/ /15/22 Call 3/1/ % YTM 5.57% 5.81% YTW 5.57% Price A1/A+ Rating A/A Comments 1. Book loss, which can be used to offset gains; 2. Coupon cashflow maintained, call protection extended; 3. Improve liquidity by moving into a larger issue Buy issue $99.50MM issue size/$ mm deal size vs. Sell issue size $32.82MM issue/$70.00mm deal size; 4. Discount price provides total return opportunity in event of lower rates; and 5. Net additional money needed is small Quality Maturity Results Slight decrease Shorten by 8 mos Annual Income $4000 YTM Original Par Decrease by 24bps $100,000 Gain/Loss Loss of $25,613 Total Net Money Source: RBC Wealth Management $1,824 Add from Investor

7 Page 7 of 8 Book Loss, Increase Yield, Utilize Zero Coupon to Significantly Increase Holding Period Earnings Swap Sells Buys $100,000 Par Value $245,000 Municipal Bond Issue Municipal Bond 3.125% Coupon 0.00% 11/15/2033 Mty 12/1/2033 6/1/22 Call NC 4.90% YTM 5.81% 4.90% YTW 5.81% Price AA1/AAA Rating A Comments 1. Book loss, which can be used to offset gains; 2. Increase yield; 3. Increase par amount at maturity; 4. Increase total holding period return to the 2033 maturity Sell issue returns $202,151 (principal, total interest earned, and earnings on reinvested coupon) vs. Buy issue which returns $245,000; and 5. Maintain strong structure Sell issue is Unlimited GO, Buy issue is a Sewer & Water Revenue (essential purpose). Quality Maturity Annual Income YTM Original Par Results Decrease Maintain Decrease Increase by 91bps Increase by $145,000 Gain/Loss Loss of $22,230 Total Net Money Source: RBC Wealth Management $1,544 takeout for Investor

8 Page 8 of 8 Conclusion Bond swaps are an effective strategy for investors to make their portfolio work for them by taking advantage of recent market volatility and the resulting opportunities, as well as improving the overall structure of their portfolios, while possibly reducing their tax liability. The swap examples represent current recommended strategies from the RBC Wealth Management Fixed Income Strategies Group and RBC Wealth Management Fixed Income Trading. They may represent current market offerings and as such prices and availability are subject to current market conditions. Investors should consult with their RBC Wealth Management financial advisor and their tax advisors to determine if these strategies are appropriate for them. RBC Wealth Management U.S, Fixed Income Strategies Group The information contained in this report has been compiled by RBC Wealth Management from sources believed to be reliable, but no representation or warranty, express or implied, is made by Royal Bank of Canada, RBC Wealth Management, its affiliates or any other person as to its accuracy, completeness or correctness. The material contained herein is not a product of any research department of RBC Capital Markets, LLC or any of its affiliates. Nothing herein constitutes a recommendation of any security or regarding any issuer; nor is it intended to provide information sufficient to make an investment decision. All opinions and estimates contained in this report constitute RBC Wealth Management s judgment as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S., and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, the securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice. This material is prepared for general circulation to clients and has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither RBC Wealth Management nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of RBC Wealth Management. RBC Wealth Management is a division of RBC Capital Markets, LLC, member NYSE/FINRA/SIPC, which is an indirect wholly-owned subsidiary of the Royal Bank of Canada and, as such, is a related issuer of Royal Bank of Canada and part of the RBC Financial Group. Additional information is available upon request RBC Capital Markets, LLC. All rights reserved (10/13)

9 Page 1 of 2 Time for a Frank Conversation About Interest Rates They Will Rise, Eventually not Imminently By Craig Bishop, Sr. U.S. Fixed Income Strategist, Global Wealth Services Portfolio Advisory Group U.S. Fixed Income Strategies Published June 18, 2013 With concern building over a potential rise in interest rates, we feel it is important to have an informed discussion about the current market environment. It is far too easy for the media to warn of the dire consequences of higher rates without providing any context of when rates could begin to rise, what would cause them to do so, and how high they could go. Any discussion of a rise in interest rates must begin with the Federal Reserve, which is well into its open-ended commitment to do what is necessary to stabilize the U.S. economy. The centerpiece of its plan has been purchases of Treasury and mortgage-backed securities currently running at a combined $85B monthly pace. Federal Reserve Chairman Ben Bernanke recently testified before Congress that the Fed is considering tapering (reducing) these purchases; however, his message was clear that the tapering would be driven by consistent (rather than mixed) improvement in a number of economic indicators, most notably employment. The tapering, once begun, will likely be an uneven process, driven by monthly economic reports; so at best, we are months away from the monthly purchases ending. Much has been made of the Fed s 6.50% unemployment rate target and what will happen once reached. The unemployment rate currently stands at 7.50% and if the current trend in monthly payroll growth continues, the Fed s target level could be achieved approximately one year from now. There are, however, some important things to keep in mind. First, much of the recent improvement in the unemployment rate has come from people leaving the labor force, discouraged over the lack of job prospects. Mr. Bernanke, in referencing the low labor force participation rate expressed his concern, suggesting the low rate means the underlying employment rate is actually higher than the official 7.5% level. Pay attention to the comments regarding the labor participation rate going forward, as it is possible it will allow the Fed to become more nuanced in its discussion of the target employment rate. Second, this target rate is just that, not a trigger point which once achieved will prompt the Fed to begin raising rates immediately; it will want to be sure the economy is on a strong, sustainable growth track, not the slow, muddling-along pace of growth we are currently experiencing. It is also important for investors to be aware of global issues as well since the Fed has been joined in its open-ended commitment to easy monetary policy by many other major central banks. The European economy remains mired in recession, Chinese economic growth continues to disappoint and Japan just embarked upon a massive stimulus plan to shake decades of rust off its economy. As a result, these central banks will not be raising rates in the near future. In our opinion, given an accommodative Fed concerned with setting the economy on a strong sustainable growth track, a U.S. economy which is showing signs of improvement, but still struggling to grow at over a 2% annual rate, and global economic issues, current low levels of interest rates could likely persist for the next two to three years. Additionally, it is important to note that when the Fed begins to tighten, it will likely do so in gradual incremental steps, judging the impact of the rate increases on the economy. Some calling for rising rates like to cite 1994 as an example of what could transpire the Fed raised short-term interest rates three percent within one year, crushing bond prices. We don t believe this will happen at this time. A division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC. There s Wealth in Our Approach.

10 Page 2 of 2 Time for a Frank Conversation About Interest Rates They Will Rise, Eventually not Imminently, continued We think 2011 can provide some context as to where rates could move to; it was a time when global economic conditions were on a firmer footing and issues in Greece had yet to play out. In the spring of 2011, 5-year Treasuries peaked at 2.32%, 10-year yields hit 3.58%, and 30-year yields reached 4.66%. These yields are approximately % above current levels but the extent of the aforementioned global challenges ensures that rate increases to these levels wouldn t happen overnight. Managing Interest Rate and Duration Risk As with any type of financial investment, bonds include some degree of risk. It is important for investors to determine their risk tolerance; this is crucial in order to determine the appropriate securities used in building an investment portfolio. Credit Risk should certainly be an important focus for investors, especially as many have moved down the credit scale in search of higher yields. However in the current environment where investors are unsettled over an eventual rise in rates, interest rate and duration risk should be primary concerns. Interest rate risk, or market risk, is the risk that rising interest rates will cause a bond s price to fall and decrease the value of an investment. However, how much a bond s price will move for any 1% change in interest rates will depend on many factors such as its credit risk, time to maturity, coupon rate, and supply and demand conditions. Bonds that have longer maturities or lower coupon rates have a greater percentage change in their price with a move in interest rates. Bonds that have shorter maturities or higher coupon rates tend to have more price stability. Duration risk, usually signifying Modified Duration, is not simply a measure of time; it also refers to the sensitivity of a bond s price to a one percent change in interest rates. The higher a bond s duration the greater its sensitivity to changes in interest rates. Variables such as coupon rate, call features (if any), yield, and length of time until maturity all play a role in the duration calculation, but suffice to say, the higher a bond or bond fund s duration, the greater its price sensitivity to interest rate changes. For example, consider that the duration of the current 10-year T-note, 1.75% of 5/15/23, is A one percent rise in interest rates will result in approximately a 9.05% decrease in the price of the note. The duration of the current 30-year T-bond, 2.875% of 5/15/43, is A one percent rate increase would result in a price decline of approximately 19.49%. In recent years, with interest rates moving to all-time lows, many investors purchased longer-dated bonds for higher yields. In doing so they extended the maturity, and hence duration of their portfolios, possibly to imprudent levels, unaware of the potential price volatility resulting from rising rates. As a result, we recommend investors review their holdings to get an idea of the portfolio s overall duration; then, if possible, stress the portfolio to see how individual holdings might perform under different rate scenarios. This analysis will show which bonds would be most impacted by a rise in rates and decisions could then be made as to whether to swap the bonds for shorter, more defensive issues that might be less impacted by a rise in interest rates. While we feel that a sharp rise in rates isn t an imminent threat, it nonetheless pays to be proactive with regard to rebalancing a portfolio in anticipation of future market developments. Investors should contact their RBC Wealth Management financial advisors for assistance in this portfolio review and rebalancing process RBC Capital Markets, LLC. All rights reserved (06/13)