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Bond Tightrope: Navigating Low Interest Rates and Crazy Times

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April 15, 2012

Stubbornly low interest rates and economic volatility can make bond investing a veritable circus.

Bonds. The debt securities that build stadiums and schools and replenish the federal coffers are purchased by investors looking for an income generator.

They’re buy-and-hold for most investors, but they’re not buy-and-ignore.

Current conditions are testament to that. How can yield-hungry investors make sense of Europe’s still perilous perch on the edge of debt implosion and a U.S. recovery that, while encouraging, is taking its own sweet time? Does current volatility and elusive yields mean investors should ignore bonds completely? No. There may be sweet spots to be discovered along the yield curve. Investors might focus on how to maneuver along that tightrope, keeping in mind that when a normal yield curve is in place, the farther you roam, the bigger the potential reward. And, the harder the potential fall.

To help make some sense of it all, we turned to TD Ameritrade’s Lee Stamper, director, Investor Solutions.

He’s been educating fixed-income investors about risk tolerance in the wake of the 2008 recession and European debt crisis. Since the real (or inflation adjusted) return among short-term debt securities is negative, some investors want to test their courage on the curve. “But in reaching for yield, know what you’re doing,” said Stamper. “The further out, the more volatility.”

FIGURE 1 The line that measures yields (and interest rate) in a “normal” growing economy, when the yield curve is ascending. For illustrative purposes only.

Be Wary Of Market Timing

Trying to gauge interest-rate changes has perhaps never been as tricky as it now. Ultra-loose global interest rates are necessary to lubricate the global economy according to the Federal Reserve and its counterparts. But for investors, this prolonged low-rate stance largely leaves them caught between the choice of waiting it out or jumping not knowing if there’s a safety net. Since most bond investors are looking for current and future income, they may be presently monitoring near-term deflation risks (generally a positive bond-price development; higher prices push down yields.). But investors also hope to catch the first whiff of inflation well in advance of its arrival. Why? Inflation chews up the income collected on bonds. The deflation/inflation tradeoff can leave some investors feeling like they’re dangling in mid-air.

Says Stamper: Bond investors should retrain their thinking; bonds are different from stocks. There will be price volatility for bonds and that can limit the returns of total-return bond investors (buy low-sell high bond investors). But for the majority of investors, they’re in it for the income stream. “You bought the cow for the milk. You don’t need to freak out when the price of beef goes up and down,” he said.

Sitting out of the bond market completely, however, risks opportunity cost. Some investors are waiting for higher rates. But even if rates could be predicted accurately, the interest income that is lost can only be made up if rates rise high enough to compensate for not investing early. Market timing is difficult for both equities and bonds. The difference is that fixed income investing allows the investor to immediately lock in an interest rate, and potentially benefit from cash flow. Keep in mind that while the amount of the interest payment in dollars stays the same, the value of the bond goes up and down with market conditions. A bond investor can see their bond’s value get hit, even as the cash flow continues.

Hey, Merlin

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Not All Bonds Are Created Equal

Next, investors can contemplate what kind of bonds might be a good fit for their portfolio. Some things to contemplate:  

• If you have an investing target, you might consider zero coupon bonds with maturity dates timed to your needs. Zero-coupon bonds do not pay interest during the life of the bond per se; they’re instead bought at a discount. To fund a four-year college education, you could invest in a laddered portfolio of four zero- coupon bonds, each maturing in one of the four consecutive years the payments will be due. The value of zero coupon bonds is more sensitive to changes in interest rates however, so there is risk of lost value if you need to sell them before their maturity date. 

• Or, a “bullet” strategy can also help you invest for a defined future date. If you are 50 years old and you want to save toward a retirement age of 65 you may consider buying a 15-year bond now, a 10-year bond five years from now, and a five-year bond 10 years from now. Staggering the investments this way may help you benefit from different interest rate cycles. 

• Total return is a different story. Using bonds to invest for total return, or a combination of capital appreciation (growth) and income, requires a more active trading strategy and a view on the direction of the economy and interest rates. Total return investors want to buy a bond when its price is low and sell it when the price has risen, rather than holding the bond to maturity

Need A Little Padding?

There can be even more fine-tuning. With one option, you can buy a potential “cushion” for your tightrope walk. Stamper offers this example, a “cushion” or “kicker” bond (the fixed income world is full of nicknames), which is a premium callable bond. 

First a little vocabulary lesson: Callable bonds can be redeemed by the issuer prior to maturity. Investors are compensated for taking on call risk by receiving a specified price at or above par for the bond. A premium bond trades above its par, or face, value. A bond will often trade at a premium when it offers a coupon rate that is higher than prevailing interest rates. This is because investors who want a higher coupon rate are willing to pay more for it.

FIGURE 2 If the cushion bond is called in three years, it would yield 2.84%. When we compare that to the 3-year non-callable bond yield of 1.27%, we net 1.57%. Now, if the cushion bond is not called, the yield will KICK up to 4.85% at maturity. If we compare this to the 13-year bond which is yielding 4.25%, we would pick up 0.60% in yield. In this example, we get a yield boost either way compared to the 13-year non-callable bond. For illustrative purposes only. Past performance does not guarantee future results.

Also, the cushion bond has a shorter duration, which means that it will be less volatile or less sensitive to interest rate movements. That means it price would not go as far up or down as the price of a longer duration bond, should rates change.

Cushions, bullets and targets are examples of bond strategies that are often used in portfolios. See a fixed-income specialist to determine what approach might make the most sense to consider for your individual situation.

In the meantime, rethink bonds. Fixed-income focus doesn’t have to be demoted to a sideshow just because of economic and interest-rate uncertainty. Protecting against future inflation while searching for yield across multiple markets or a range of maturities can help investors find the tightrope balance they need.

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