“Higher interest rates, por favor” – 1st quarter, 2018
I find myself spending more and more of my day wishing the fixed-income portion of our Growth & Income Portfolios would decline (I can hear your collective gasp now). I mean it! I was recently on a beach in Mexico and couldn’t help but dream about coming back to the office to find the bonds we own priced much lower.
What’s the logic behind this strange desire? It gets down to how bond investing works
The fine print on coupons
A bond represents the debt of its issuer, typically a government or business. That just means that on specific dates, as bondholders we’re paid interest based on a bond’s fixed coupon rate. When a bond matures, we get back our original investment.
Coupons and maturity dates make bond investing attractive – our returns are scheduled. We know exactly when we’re supposed to get our money back when we buy a bond. And we try to use coupons and maturities to our full advantage by keeping our coupon rates high (easier said than done) and maturities near. So why on earth am I craving a decline in our bonds? Counterintuitively, it’s so that we can generate higher long-term returns for our investors.
Keep your businesses close and your maturity dates closer
Let me throw some numbers at you. At the beginning of the year, EdgePoint Canadian Growth & Income's fixed-income portion yielded 3.8%. If we assume that our yield equals our bonds’ average coupon (true for us but not always the case) then every $100,000 invested generates no less than $3,800 in annual interest income. But wait, there’s more!
Because we tend to buy much shorter-term bonds than our peers, about one-quarter of our holdings will mature within 12 months. On $100,000, that’s another $25,000 for us to invest. Including the aforementioned $3,800 in interest income, we’re talking $28,800 big ones. And to grow your investment, all that cash needs to be reinvested!
So, an investor who held EdgePoint Canadian Growth & Income at the beginning of 2018 thought they had a 3.8% yield. But embedded in the far-too-complex-for-a-Mexican-beach 3.8% calculation is the assumption that the $28,800 gets reinvested at that same rate. If by some majestic Mayan power I could will bond prices lower by the time of my return to the frigid North, inversely related bond yields would go up and offer returns in excess of the initial 3.8%. While the price move could mean a negative return in the short run, anyone with an investment horizon longer than a few months (hopefully all of our investors) will be the ultimate beneficiary as that $28,800 would earn a higher return.
Sometimes wishes do come true. It’s just sometimes it happens slowly.
Slowly but surely, we’re seeing rising interest rates both in Canada and the U.S. That’s probably been the dominant fixed-income theme through the first three months of the year (other than three or four days of crazy volatility that may have been fun to watch but was short on great opportunities for us). Yields on five-year government bonds are up about 10 basis points (bps) in Canada and 40bps in the U.S. so far this year*. And that’s helped our return prospects. While our fixed-income performance was slightly less than anticipated over the past three months, our overall yields improved to 4.1%.
Of course, it isn’t only interest rates that can cause bond prices to fall, and general risk off markets that can cause credit spreads to widen (there I go getting technical on you again). Sometimes idiosyncratic events with little bearing on a company’s long-term prospects negatively affect its bond prices. All of these scenarios can create opportunities to reinvest at wholesale discounts. Maybe I’ve had too much sun (I do look like a tomato), but we welcome them all.
The benefits of long-term relationships
And why not? We’ve taken a long-term view and buy bonds issued by businesses with wide competitive moats in industries characterized by stability and good growth prospects. We look for businesses that generate cash or have unique, high-value assets relative to modest outstanding debt. We can be wrong in our analysis; however, within the context of our original thesis, we embrace rather than scorn any short-term hiccup or noise surrounding our holdings.
We believe the bonds we own offer a higher return than those issued by other businesses of comparable quality and financial standing. We own them because we know the businesses well having followed them for a long time. Most importantly, we think the bonds are good value. Once we buy, it’s all the more beneficial if the bond’s price continues to fall. It’s better to buy an already undervalued bond when it gets even cheaper than it is buying a fairly valued bond when it finally starts getting cheap. More so when you’ve got that $28,800 to put to work as there’s no sense reinventing the wheel every time one of our bonds matures.
Short-term pain, long-term gain
We invest the proceeds from coupons and maturities in existing holdings at what we believe are attractive relative returns and buy them by the bucket when they offer something more. This is about as simple as it gets in our business. Over the past year, we added to existing holdings and bought many bonds that were attractive enough for a small initial position that we’ve rarely been able to make a full weight. This includes new names that we researched thoroughly and constantly monitor that we’d love to add to. Buying more would require limited incremental work on our part.
Investors today are staring down the barrel of what look to be poor prospective returns in almost all asset classes. Doesn’t make it impossible to earn an attractive return, but generally speaking, such returns will be harder to come by.
A concept the average investor doesn’t fully understand is how a price correction today can enhance long-term returns. This concept holds true even for the fully invested. To illustrate, here's an example of a hypothetical collection of bonds similar to our fixed-income holdings (4.1% yield, 1.8 year duration):
|Day 1||Year 1||Year 2||Year 3||Year 4||Year 5|
|Day 1||Year 1||Year 2||Year 3||Year 4||Year 5|
Although highly improbable and unrealistic, and assuming no other variables change, we can evaluate the effect of a sudden 5.0% rate increase on the very first day of a $100,000 investment. The immediate impact is awfully painful. If a bond investor’s time horizon is one day or even two years, then they’ll be worse off with a 5.0% rate increase. But for us (and hopefully our partners), we can look out beyond the two-year mark and see how much that 5.0% actually benefits returns over time. Our near-term maturities give us the flexibility to take advantage of opportunities.
Sometimes the best ideas are originally drawn in the sand
So now you know – crazy beach ideas aren’t so crazy once they’re laid out on paper. I recommend you take a vacation, tune into some Jimmy Buffett (who, incidentally, is rumored to be related to Warren Buffett) and start hoping for lower stock and bond prices. If you get back from vacation and nothing has changed, why not add to your investment and revisit the beach? You’ll enjoy the fun in the sun and your investment will have the potential to enjoy higher returns.