Sell long term debt for short term debt

Please note below a reply to a clients question on why it may be of interest to reduce exposure to long term debt and increase exposure to short term debt. The reply is not supposed to be a precise statement, but to raise awareness of the characterisitics of short and long term debt.

To place the answer into context let me provide a simple overview of the maturity profile of the bond portfolio in question (note total adds to bond portion of the portfolio. Remainder in cash and equities):-

less than 2 years 0.0%

2 - 5 years 25.2%

> 5 years 32.0%


CLIENT QUESTION: I am not sure I understand the reason for selling bonds which have maturities of more than five years with YTM of over 3.0% and buying shorter dated bonds with YTM of 2.66% and incurring the costs involved. How would I be better off?

You reduce your duration risk. A bond that matures in 2017 (like Anheuser Busch 2017 8.625%) will be considerably more sensitive to perceived future interest rate changes or an increasing inflation rate expectation. The AB 2017 has a YTM of 3.82% at the moment. The GE 2013 offers 2.66%. If you believe that the interest rate could increase more than 1.2% (ie the difference between 3.82% - 2.66%) between the years 2013 and 2017, it makes sense to make the exchange. If you don't, I understand it seems silly to reduce duration risk.

Lets look at some numbers.

Bond Price Aug 2010 Price Mar 2011

Anheuser Busch 2017 8.625% 134 124
GE 3.5% 2013 104 101.5

We can see the volatility is considerably larger for the longer dated bond. This is because its pricing is considerably more sensitive to perceptions in future interest and inflation rates. If you believe interest rates are not likely to increase in the next 6 years the current YTM of 3.82% offered by the AB bond can seem interesting. If you don't believe that. It does not, and I would consider off loading the bond.

Note a bonds return can be reduced to contributions from various risk components. The primary risks are credit and duration risk. I am happy with taking on the credit risk of selected companies (i.e. GE) to generate a yield greater than cash rates or government bond yields. But I am extremely worried about taking on duration risk at the moment.

Note, the benefit of the AB bond is that it has a large coupon. A similar maturity bond with a smaller coupon would be even more sensitive to perceived future changes in interest or inflation rates.

Indeed, we could say the yield of the AB bond is suggesting the base interest rate could be the following over the next 6 years:-

2011 2012 2013 2014 2015 2016 2017

1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 6.0%

However, the value of money reduces over time. Let us discount the money at the rate we believe it will be for that year. The cumulative interest will now not be 27%, but 25.8%. Furthermore, we expect to receive a premium for taking on the credit risk of AB relative to cash rates on a bank account. We would expect a credit risk premium of at least 1% per annum.

Consequently:-

1. If we were to assume the above mentioned rates for the EUR during 2011 to 2017
2. Assume a 1% per annum credit risk for taking on an AB bond relative to keeping cash in the bank
3. Discount the interest received at the rate of interest for that year
4. We would require a yield of 5.7% per annum rather than 3.82%.
5. Hence, you assume interest rates will be lower than what is suggested above, or you are willing to receive no premium to cash for taking on the credit risk of AB

If you do require a 1% premium per annum, I would estimate you are assuming the following EUR rates if you decide you are happy to continue holding the bond with the current YTM it offers:-

2011 2012 2013 2014 2015 2016 2017 Average

1.0% 2.0% 3.0% 3.0% 3.5% 4.0% 4.0% 2.9%

*Please note this exercise has limited accuracy and is produced for the benefit of using it as a thought experiment and to stimulate further discussion*.

(Add 1% per annum to the 2.9% average to add the credit risk. We assume discounting is negliable. It isn't. You are actually assuming slightly lower interest rates)