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Posted on JAN 26, 2018

Johnson Bank Wealth Weekly Investment Commentary | Friday, January 26

This is part of an ongoing series of Weekly Commentary articles published by Johnson Financial Group.
This week's issue is written by Brian Andrew, SVP, Chief Investment Officer.

Clipping Coupons

When I was in college, I had an internship with a large national bank in their corporate trust department. This area was responsible for processing bond issues. In short, when a corporation wanted to raise capital by issuing debt, someone had to keep track of who owned that debt and should get paid interest on it, and also return principal when due. That's corporate trust.

Physical certificates (bearer bonds) were issued to owners, and keeping track of ownership was done manually. Today, all of that takes place electronically, which is a good thing because bond investing has become much more complicated than it was in the bearer bond days.

Let's sort through some of the complexities amid the hue and cry about a bond bear market and discuss what bond investors should know today.

End of an era

My internship was at the end of the bearer bond era, when the certificate represented ownership. Attached to that certificate were coupons that needed to be cut off and turned in to receive your interest payment. You could go to a bank teller, give them the coupon and get your interest payment.

The job entailed implementing a computer system that would convert the manual process to an electronic one. There were 15 people in the department, most of who had manually done this for a decade or two. I was asked to learn the electronic system, then teach them how to use the system that would eventually eliminate their jobs. A tall order for a college intern, and a valuable lesson in adapting to new technology.

Today's market

There are many ways to invest in bonds today. You can buy them directly, through a mutual fund, or through an exchange‐traded fund. Each of these methods provides advantages and disadvantages to the investor. We use them all when constructing portfolios for our clients. Investing directly in individual bonds allows you to control what maturities you own, what credit risk you want to take and how to generate income over time (income comes from the interest payments—the coupons are gone but the regular interest payments are not). However, to efficiently buy individual bonds, you need to be able to buy in large “block” sizes in order to get the better yield on your purchase.

For investors who need diversification and don't have as much to invest, a bond mutual fund or exchange‐traded fund can be a good idea. You can make a $10,000 investment in a portfolio that may include hundreds of bonds from different issuers, providing diversity of credit quality and maturity. Often the fund pays income monthly so you aren't waiting for the next interest (coupon) payment on just one of your bonds to receive income.

The challenge with investing in funds is understanding what the fund's objective is, what it owns, and what the characteristics are. The objective tells us how it will be managed. For example, a fund can have an objective to maximize income by investing in lower credit quality bonds with higher yields and long maturities. Another fund may focus on total return rather than just income by investing in the global bond market, including corporate and government‐issued bonds. There are funds with the objective of buying government, corporate, mortgage‐backed, asset‐backed or high‐yield bonds. In other words, there is a bond fund for just about anything, depending upon what you want to accomplish.

The characteristics of a fund refer to its average maturity, duration, income and yield to maturity. Matching clients' investment objectives with a portfolio of bonds or a fund or group of funds is the job of our client portfolio managers and fixed‐income management team.

What if interest rates rise?

There are two things to know when owning bonds. First, when interest rates go up, bond prices go down. Second, bonds often perform differently than stocks. One of the most important aspects of owning bonds is the potential protection they offer in an environment of declining stock prices. This difference in performance can be referred to as correlation. In a portfolio, you want things that perform differently at different times in a market and business cycle to reduce the volatility of the whole portfolio.

We are in an environment where economic growth has accelerated, and the Federal Reserve Bank has decided it doesn't need to provide as much help. It is thus raising short‐term interest rates and, as a result, many bond investors are concerned about what will happen to their bond portfolios. We have said for some time that investors should be more excited about the fact that interest rates are rising (and so too will their income) instead of being concerned about lower bond prices. Here's why.

Bond math

Our typical bond portfolio has an average maturity near 4.5 years. This means that about half the bond portfolio will mature and be available for reinvestment over the next four‐plus years. That's good news when interest rates are rising because the portfolio's cash flow can be reinvested at the new, higher interest rates. Now let's understand how price sensitive the bond portfolio is.

Bond investors use “duration” to measure a portfolio's price sensitivity to changes in interest rates. If our portfolio's duration is 4, then a 1% increase in interest rates means that the portfolio will go down in price by 4% (and vice versa—if rates decline by 1%, prices rise by 4%). Our portfolio's average yield (the income it generates) is nearly 3%. That income could be reinvested into things earning higher interest rates throughout the year. If interest rates rose by 1% over a year, our portfolio's price would decline by 4%, we would earn 3% in income, and our portfolio total return would be less than ‐1% for the year.

Here is a simple example:

Beginning market value $1,000,000
Unrealized loss due to 4% decline in market value ‐$40,000
Income (3% earned on $1 million portfolio) $30,000
Income on income (if yields rise from 3% to 4% then our $30,000 will generate additional earnings) $525
Ending market value $990,525
Portfolio net return ‐.990525% or slightly less than ‐1%

Current interest rate environment

The 2‐year Treasury has risen to 2.05%, reflecting investors' belief that the Fed will raise interest rates at least two more times in the next two years. The 10‐year Treasury note yield has risen to just over 2.65%, a new 52‐week high. As you can see, the difference between the two is only .6%. The Fed is raising short‐term interest rates to move away from their zero interest rate policy because the economy has improved and they need to have some dry powder for the next recession (they usually lower rates when that hits). However, intermediate‐term bond investors don't see the signs for significantly higher inflation or runaway economic growth, so they don't believe interest rates need to move a lot higher.

We manage this environment by maintaining an intermediate duration and producing as much interest income as we can, within our risk parameters, so that we have cash flow to reinvest as rates rise, raising the yield of bond portfolios. We don't expect much in price improvement in 2018; however, we do believe that we'll continue to generate more income from bond portfolios.

While bond investing has become more complicated than it was back in my early corporate trust days, it has also become easier to manage income cash flow and risk, at least for those with the expertise. Our experienced bond team, in conjunction with the many outside bond managers we work with, provides that expertise.

Brian Andrew
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy
to provide consistent, actionable investment solutions for our clients.

This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security. Opinions expressed herein are as of the date of this report and do not necessarily represent the views of Johnson Financial Group and/or its affiliates. Johnson Financial Group and/or its affiliates may issue reports or have opinions that are inconsistent with this report. Johnson Financial Group and/or its affiliates do not warrant the accuracy or completeness of information contained herein. Such information is subject to change without notice and is not intended to influence your investment decisions. Johnson Financial Group and/or its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Certain investments, like real estate, equity investments and fixed income securities, carry a certain degree of risk and may not be suitable for all investors. An investor could lose all or a substantial amount of his or her investment. Johnson Financial Group is the parent company of Johnson Bank, Cleary Gull Advisors Inc. and Johnson Insurance Services LLC. NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE

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