How To Lock In Higher Yields In Case Interest Rates Fall
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Walk in the money for the rest of us. This is a personal finance show on money, how IT works, how to invest IT and how to live without worrying about IT. I'm your host, David stein.

Today is episode four sixty three. It's title how to lock in higher yields in case interest rates fall. Last week in our free insiders guide email newsletter, I wrote about how the consensus of financial market participants is that casuals will fall.

Central banks are the entities that determine what cash yields are because the yields on cash, such as for cds, money market metro funds, are tied to central bank policy rates. Right now, the U. S. Federal of passing rate, also known as the federal funds rate, is in a range between five point two five percent and five and a half percent, and it's been that way since july.

The federal serve bank of publishes a chart where they look at expectations for the policy rate going out into the future, and market participants expect the first fund rate to be less than four percent by september twenty twenty four and will end the year around three point six percent. That's a one and a hf percent reduction in what we can earn on cash after sending out that email news letter, which you can sign up for money for the rest of us. Dot come one of our listeners route, given that cash ods are predicted to fall with bullet etf lock in current rates.

If so, why wouldn't investors who believe the falling yld prediction lock in current rates well into the future? That's what we going to discuss in today's episode how to go about doing that, including what's stability. Tf longer term interest rates are a function of expectations for future short term interest rates.

I just realized how the market expected short term interest rates cash els in the future, the policy rate to be lower by the end of twenty twenty four. And because an element of what determines interest strates is based on those future expectations, we have seen a longer term interest rates fall. U S.

trager. About to fAllen between a zero point eight percent and a zero point nine percent from mid october twenty twenty three through yesterday. And that's four bonds or between five and thirty years.

So that expectation of future short term rates doesn't fluence longer term rates. There are two other elements, though inflation expectations also determine long term interest rates. And what we can do is we can compare the yield and nal government bands to the yield on inflation index pose.

For example, the current yield ld on U. S. Ten year amal treasury bonds is four point one one percent.

The yield on ten year treasury inflation protected securities is one point eight percent. The difference is to point three one percent. Market participants expect inflation over the next ten years, the average two point three one percent.

If we go back to october nineteen, twenty, twenty three, those inflation expectations were two point five percent. That was the difference between namal ten year treasuries and ten year tips back then. That's the second element, inflation expectations.

The third element is sort of a catchall is called a term premium. It's additional compensation that investors want in addition to their expectations for short term rates in the future and inflation expectations. It's really a catch all to capture that uncertainty about what the central bank will do or what inflation will be.

It's also reflective of supply and demand. If there is much greater supply of bonds or issuance of bonds compared to the re, to hold those bonds, that can push up brakes and that would be captured in that term premium. If we look then at the the drop in interest rates since october, about zero point nine percent, a big component of that has been the term premium.

Back in october twenty twenty three, the term premium went positive. IT was around zero point three five percent. Now its negative zero point two percent. Term premiums aren't easy to see in the market this sort of estimated, but it's about a half percentage point drop in the term premium, and that's a big component of the zero point nine percent drop in interest rates in the october.

Inflation expectations have also declined about zero point two percent, and that leaves the future short term rates to drop in that expectation about zero point two percent. So those three elements, about twenty basis points for inflation, twenty basis points for future short short term m interest rates and a half percent for the term premium is why we're now seeing interest rates about zero point nine percent lower than they were last october. And last october was really the high we've seen an interest rates in many years before we continue.

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Is listeners asking them well, given casuals, while attractive at at five to five and height percent. And even though longer term yields have fAllen in and are lower than cash IELTS, shouldn't we lock in those higher yids? What does that actually mean to lock in a higher yield? Well, we do that by purchasing a bond and individual bond, which is a debt instrument.

You should, by government, a corporation or other entity, combine individual bond. Or we could buy tf that invest in bond and in this subs. So we're going to talk about particular type of etf called a bula etf.

But let's focus on individual bonds. Right now. Bonds are essentially loans and investors make to the issue or there's born to have a face value sometimes known as a par value. And that's the original amount that the bond was issued that, that the interest payment is determined.

So a bond will have a face value, a par value, and I will have a coupon rate, which is the interest rate used to calculate the interest payment on the bonds, and most bonds pay interest every six months, and that interest payment is a function of the coupon rate. Multiply by the face value. When we talk about locking in yields, part of that yield is that coupon rate.

But there's a second element that influences the yield, and that's the Price paid for the bond. An investor buying a bond may not pay that face value. They may pay a lower amount or buy the bond at a discount, or they may pay more than that face value and pay a premium.

Whether the band is sold at a discount or premium is a function of the coupon rate, but also prevAiling market interest rates. When we did talk about yield, we're really referred to something called yield to maturity and that's an estimate the total return for the bond if if held to maturity. And it's a function of the coupon rate and it's also a function of the discount or premium paid.

The difference between what is paid for the bond and what the face fail is a band that is selling at a discount to its face value have a yield maturity that's higher than the coupon rate, and that's because market interest rates are higher than the bond coupon rate, and because the market rate is higher, the value of the bond falls. Because if an investor can get a higher yield ld with a different bond, a new issued bond compared to the older bond that has a lower coupon rate, the Price of that older bond has to fall so that that investors are covalent mp between buying a more season bond and a new urban. So a bound that is selling at a discount to its face value or par value has a ultimatum ity that tighter than a cup on rate on that selling at a higher Price or premium to its power value.

We have a yelled to maturity that is lower than the coupon rate and that because market interest rates are lower than the stated coupon rate in the current environment, most bonds outstanding are selling at a discount, and that's because interest rates are higher now than they've been in a number of years. So many these bonds of lower coupon rates as interest have gone up the way of the season, bonds have fAllen to the selling at a discount bond Prices that will fluctuate as market interest rates fluctuate. We saw this in twenty twenty two.

If you were invested in A A body tf, such as a banker, total bond market etf takers B N D IT had a negative thirteen percent return in twenty twenty two, partly because interest rates rose, the value of Betty tf. Bon holdings fell and then those losses were partially offset by the interest payments received here today. We've seen interest rates go up a little bit this year.

For example, the ten year treasury inflation protected securities yelled for the U. S. At the beginning, there was one point seven four percent. Now it's one point eight percent. The overall bond market has reflected in the return of bnd has returned negative one percent here today.

And that because interest rates rose, when do we talk about locking in yields? What we mean is we want to benefit from a higher yield to maturity without worrying about Price fluctuations due to change in interest rates. We locked in yield.

We're gone to get back the principle or the face value of the bond at maturity. In the meantime, we're receiving the coupon payments, which we can spend or reinvest in other bond or other asset classes. The older maturity is an estimate of what the return of the bond will be if its held to maturity.

If we want to lock in a yield on ten year government bonds right now, a treasury bond, we can do that by purchasing a recently issue ten year bond with our broker, or we can do do IT on treasury direct, which is the government's website. And these government bonds can be purchased in the countries. Also, all countries issue government bonds.

And and if we purchase that bond and hold to maturity, we will earn the starting yet to maturity of the band. If we did pull IT until IT matures and we get the principle back. And by doing so, we don't have to worry about whether interested you going to go up or down because we're getting our coupon payment.

And if we bought the bond at a discount, that discount will narrow over time, and we'll have earned that starting yield to maturity. Many investors don't want to purchase individual bonds. They would prefer to invest in a mutual fund.

Or n etf and have a manager figure out which bonds to purchase bond. T, F firms have come up with a solution to that. They are etf that have a set maturity date, is are sometimes called bullet etf. Major providers in the U.

S, include invest co and I shares, and we can get a ability, T, F, which is an etf with over one hundred bonds in the case of corporate bullet E, T, S, and those bonds will mature in a certain year. And then at that point, the etf ends and sends back all the money. So it's like owning an individual bond.

But in an etf structure, bd, tf exist for treasury bonds, investment grade corporate bond, non investment grade bonds, which is what this listening I was asking about, sometimes called higher bonds. There are municipal bond bullet T S and issues recently began issuing bullet T F that invest in treasury inflation protection securities. Let's take a look at an example.

The investor bullet chairs twenty thirty corporate body T F. The ticker is B C S U IT owned over two hundred and fifty investment grade corporate bond. And if you go through the list of the bond to told their name brand companies that you would recognize the expense of this etf, a zero o one percent, the yield to maturity, or in this case, the S C C yield, which is an estimate of the ultimatum ity IT backs out that expensive.

That's four point nine percent. So that would be an estimate of the yield that an investor could lock in. The average coupon rate on the bonds held in that etf is lower.

And we know that because we can look at the distribution rate, the actual amount paid out as dividends to the shareholders of the etf, the distribution rate is four point two percent, because the distribution rate is less than the to maturity. We know that the C, T, F is, is selling at a discount to whatever that asset value IT was issued. That and that the bonds that the etf owns, most of them are selling at a discount.

This is important. And I had a discussion recently in our member forms on money for the rest of plus, a member had a question about this. They were looking at buying some bullet E T S, specifically the bus go bullet etf that invested in treasury bonds that was going to mature in december twenty twenty six.

The ticker is I B T G. The member looked and saw that the sec yield was four point four percent, but he also saw that the etf was selling at a discount to the issue Price. The etf was issued at twenty five dollars to share, but the the current Price of the tf was about a nine percent discount.

And because when the ability to s matures, IT will pay out its net acid value about twenty five dollars per share, the member was thinking, oh, i'm lucking in a year to maturity of four point four percent plus i'll pick up the narrowing of this discount, the nine percent discount in over three years. That's about three percent additional yields of my total return is going to be closer to seven point three to seven point four percent analyzed. Unfortunately, that's not how IT worked.

The yield to maturity on these ability tps factor in the the discount the discount on the individual bonds and the discount of the etf, its market Price relative to the issue Price. It's all the same math with this member. I I pointed out the holdings of I, B, T, G, and you can see that most of the underlying bonds are selling at a discount, and you could also see the coupon rate of these bonds, and most of them are at a coupon rate that's lower than prevAiling interest rate.

And that's why the underlying bond is selling at a discount and the etf is selling at a discount relative to its issue Price. And then over time, the discount of this underlying bonton narrow as well the discount of the market Price of the etf relative to the issue Price as IT approach maturity. This typically T F N will earn if someone buys IT, the return will be around four point four percent analyzed through december twenty twenty six, not the over seven percent analyzed that the member was expecting.

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Net sweet outcome slash David. Our listener then wrote about the investors bullet share, twenty thirty one high iee corporation order. Tf ticker is B, S, J, V.

He gave us an example as well, can't we lock in that higher yield then if cash rates are gonna fall and we can, the S. A C yield of that will. Etf is six point six nine percent.

Expensive is zero point four percent. So we add that back to the S C, C. That means that the bonds in the fund have an average child of maturity around seven point one percent.

We potentially then could earn six point seven percent analyzed between now and when this bullet etf matures in december twenty thirty one. Bad assumes there aren't any default on LG bonds if the r that will pull down the return. Why we lock in yelland, there's ways to do IT.

We can purchase individual bonds. We can purchase bill. T S.

We can see what the yet maturity is. The S C yield. We do IT because we're happy with the yield. ld. We're saving for retirement or or investing in retirement.

And we want to capture this returns and go out longer as opposed to just keep most of our fixed income and cash and seeing those yields drop over time. If the federal reserve, other central bank lawers rates, this is a way to continue to get a higher yield going out five to ten years or more. And that's why we do IT.

We can do IT with tips, something that we talked about and upset for fifty five, building a tips letter or a latter of treasures, inflation protected securities. And when doing a tips letter, when can use tips latter dot com, you buy an individual tips that mature in a given year, and then you spend the amount of interest received as well as any of the bonds of mature. And that's another way to do IT.

When we log in yields, we get some optionality. If interest rates fall, the value of the ability T, F, or the individual bond will increase, and then we have the choice of selling IT and capturing that game. If we do though, then we have to decide what to do with the money can spend IT or we have to reinvest IT.

And if reinvesting IT, we're now seeing that yields are probably lower because that's why the value went up. In the past couple years, i've locked in higher yields primarily using some individual treasury bonds as well as treasury inflation protection security. I've not invested in polity T S.

But i'm not opposed to IT. It's just that my other fixed income holdings closed and funds, that owner active mutual funds, they have a higher yield than I can get using ability T. F.

And so i'm content with the investments I have in that space, many of which are are credit or in IT, which we've discussed in episodes in, they're exposed to hide bonds, are exposed to bank loans or leverage loans as well as some private debt. But we lock in these higher yields for some piece of mine. So that were not dependent and worried about cash was falling and we're not getting as higher yield anymore even though we don't know exactly what it's going to be.

A function of central bank policy rates and expectations for that, but also inflation expectations and then uncertainty regarding supplying demand, what is reflected in the term premium in our premium membership community money for the rest was plus. We do a weekly q na episode with plus members and with the year and break kind had a backlog of questions. Some of the questions that we received are appropriate for this episode.

So here's here's a question that we got. Remember ask, I have a practical question about buying into long term non treasury bonds and municipal bands being and that issued by states and municipalities. We will talk about municipal bonds here a moment.

Member continues. From what I can tell most issuances from corporate bonds to government agencies are are called, and by cobble, they can be redeemed early in. The member ask, why would any investor purchase one of these bonds have could be called early and then be faced with having to reinvest the proceeds.

And he was looking for some guide and some type of formulate to decide whether to purchase the bond or not. Cobo bands have a measure call the yield to worst. We've talked about the yield to maturity, which is an estimate of the return combination of the coupon and our Price pay. That is kind of premium. It's a yield that we can log in and to maturity, but is also something called yield to worst, which is the yield estimate.

If the body is called early, investors were often purchase a bone that's collabone because the year to verst is attractive to them and they're okay if the bond gets caught early, some things that we can consider when deciding that is what Price do we get when the bond is culturally and how does that Price compare to what was paid. One member mentioned in our member form that is has some bands that are called and he's fine with IT because they are selling at a discount to the value that he would get if the bonds were called and redeemed early. And so he he would be fine because then he would pick up the difference between what he paid and what they will redeem the bond that so that's something to consider.

We can also consider how likely the bond is to be called. Corporations and government agencies only call bonds redeemed them early if there's some in senate to do so. And usually, it's because prevAiling market interest rates are than the coupon rates of the bonds that are outstanding.

And so by redeeming calling abroad early, the entity can lower its overall interest cost. So when considering purchasing A A bond that's cable, we, anna, be aware of what the coupon rate is. A bond with the lower coupon rate is less likely to be called if coupon rate is less than prevAiling interest rates.

Where is a bond that has a coupon rate that's closer to prevAiling interest rates? That bonds more likely to be called market interest rates fall. So in purchasing a caliban bond, we want to look at what the yield to worst is, look at what the redemption Prices relative to the current Price, and look at what the coupon rate is relative to prevAiling market interest rate.

And then when do you can decide whether we want to purchase this collabone bond or not? Another plus member route with treasure inflation, protected securities and other investments. I've started to think about the tax implications of these investments.

A large portion of our portfolio is in real estate, and one of the bigger advantages that i've seen with real estate investing is the ability to defer taxes via depreciation and ten thirty one sales. If you own real state, if you decide to sell the building, at least in U. S, you can transact those proceeds into another building and not have to pay capital gains tax on the sale of the original building.

And that's that's a benefit. And then there are also some appreciation benefit deduction that can be taken by owning real estate. The member is is asking on given there in a high tax bracket, is is is something similar tax sheltered for investing in bonds similarly to whats in real state and in the primary way would be municipal bonds.

Municipal bonds 2 sometimes refer to as munis。 They are exempt from federal income tax. And if you live in a given state and you purchase a municipal band that was issued in that state, those often also exempt from state income tax.

Now because of this tax exemption, the yield on the bonds are lower than namal. If you invest in a bond, that's not mean it's were born. The interest income, if it's held in a taxable account, it's taxable and selling abon, that again is taxable.

And so bonds are taxiing. They don't have the benefit, a taxi file that you see with real estate or other other classes. But most people own bonds for the income and they realize that the income is going to be taxable.

And then they have to decide, do we purchase a taxable bond or a initial band. And is part of that analysis, we want to look at what is the tax equivalent yield of a municipal bond. So we can compare apples to apples. And we calculate that by taking the yield on the bond, the other maturity or the S C C yield of an etf, and divided by one minus marginal tax rate, the individual, for example, the investigate bullet shares, twenty thirty one municipal T F taker is B S M V. IT has an S, C, C yield of two point seven three percent.

If an individual investor is in a marginal tax rate or has a marginal tax rate of thirty five percent and the marginal tax rate is is sort of the the highest tax rate that the individual will pay on their last dollar of income, let's say that thirty five percent. We can take the two point seven three percent sec yield and divided by one minus thirty five percent, which is point six five, and two point seven three percent divided by point six five is four point two percent that the tax equivalent yellow on this ability T F, that we can compare them to other options, such as the yield on seven ten year namal treasury bonds, four point one percent, so at a thirty five percent margin tax rate, investing in this municipal bond. B T F only has about ten basis points higher yield on a tax equivalent basis.

The pricing of initial bonds varies over time. There are times when municipal bonds, the tax equivalent yield is higher than comparable treasury bonds. Sometimes it's lower and IT depends on supply demand. Right now, it's about the same.

And so an investor can aside, well, I, I, I want to do the municipal city T, F, or I want to invest in treasure sponge conclusion, then we can look in higher yields right now because the market is anticipating lower. Casio ds this year will see inflation has to come down, but IT is likely the federal serve will cut policy rates at some point this year. Maybe not the extent that pricing the market right now, but because of that, we can lack in some higher yells by investing in some longer term bonds.

Given some examples of how to do that, you can do IT through ability. T, S. You can do IT through individual bonds.

There isn't a right answer because we don't know what's going to happen. We've talked about what influences those interest rates. But if most of your fifth income is in cash, IT would be printed to invest some of those proceeds.

And fixed income security is are etf that have longer term maturities do IT through individual bonds. You can do IT through ability, T, S. And in that way, you lack in those yields and benefit from the opponent.

If rates fall in, the value of those securities goes up. That's episode for sixty three. Thanks for listening.

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