Wasmer, Schroeder & Company
Assessing True Portfolio Income
Income Analysis in a Low Rate Environment
OVERVIEW One of the biggest issues facing clients with funds invested in fixed income securities is trying to figure out how much income to take without invading principal. In a low rate environment, many securities in the marketplace have high coupons and therefore trade at significant premiums above par. This premium, along with calls, sinking funds and other structural differences make it difficult to accurately assess a portfolio’s true income. In an attempt to better understand various methods of determining income and the positives and negatives of each, we will look at a sample portfolio of municipal bonds. We assume that all positions are $100,000 in par value and that all of the bonds were purchased at market price. Table 1 shows the various positions in this sample portfolio and certain characteristics of each bond. BRIAN M. DIXON, CFA Municipal Trader TABLE 1 – SAMPLE PORTFOLIO (AS OF 7/8/11) DESCRIPTION State of WA A (Pre‐Refunded) Mckeesport B Area School Dist County of C Cuyahoga OH Massachusetts D Water Collier County E Florida Total CALL MATURITY DATE CALL PRICE PRICE
COST YTM YTW
ANNUAL CY INCOME DTW 6/1/2013 6/1/2013 100 108.54
$ 108,540 0.43% 0.43% 4.61%
$5,000 1.81 8/1/2013 8/8/2011 100 100.04
$100,040 1.98% 1.41% 2.00%
$2,000 0.07 1/1/2015 7/1/2013 100 109.04
$109,040 3.22% 1.32% 5.50%
$6,000 1.87 8/1/2017 n/a n/a 119.19
$119,190 1.88% 1.88% 4.40%
$5,250 5.19 100 104.18
$104,180 4.39% 3.61% 4.80%
$5,000 2.92 $540,990 2.36% 1.72% 4.30% $23,250 2.46 10/1/2019 10/1/2014 METHOD ONE ‐ ANNUAL INCOME While this method is simple and easily understood, it is inherently flawed unless a portfolio is comprised entirely of bonds purchased at par. This is a strategy that is difficult to implement in a low rate environment. Method One assumes the client withdraws $23,250 per year, noted under the annual income column. A potential problem arises for portfolios that contain securities purchased at a premium, as most of the income is principal amortization. With a par value of $500,000, the portfolio will only have $500,000 in principal when all of the bonds mature. However, the portfolio was purchased at a cost of $540,990 which means annually some of that cash income is actually a return of principal. If the owner of this portfolio spends all of this income every year, over time the initial portfolio’s principal value will diminish somewhat. April 2014
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1 ASSESSING TRUE PORTFOLIO INCOME METHOD TWO ‐ YIELD TO MATURITY Method Two, a relatively simple method, addresses some of the problems of Method One by accounting for principal amortization and taking into account certain actual yield calculations; however, this method also has its own limitations. Method Two takes the 2.36% yield to maturity (YTM) of the portfolio and multiplies it by the market value of the portfolio. The resulting $12,767 of income per year is lower than the income derived from Method One ($23,250). The drawback to this method, although superior to the first, is the fact that many securities have imbedded call options; therefore, the YTM is an imperfect measure due to the fact that some securities will be called at par or at a premium to par prior to maturity. The use of YTM overstates the portfolio’s true income because a portion of the portfolio will be called at an earlier date and result in lower yield to the investor. METHOD THREE ‐ YIELD TO WORST/CALL Method Three is arguably the most conservative method. Method Three compensates for imbedded call options and may understate income. This strategy calculates the income of the portfolio by multiplying the portfolio’s 1.72% yield to worst (YTW) by the account value which yields an annual income of $9,305. This method works well from the perspective of not invading principal because it takes into account the worst possible yield scenario (i.e. all bonds will be called ASAP) for each bond. However, most clients want to maximize spendable income and this method tends to limit spendable income. The primary advantage of Method Three is that it allows for maximum overall principal value preservation. METHOD FOUR ‐ ANALYSIS OF CALLS (COMBINATION OF METHOD TWO AND THREE) This method takes the YTM of non‐callable bonds, the YTW of callable bonds with a high likelihood of being called, and a number somewhere in between yield to call and YTM for those bonds which have a relatively low likelihood of being called. When analyzing the sample portfolio, bonds A and D are non‐
callable and YTM is used. On the other hand, bonds C and E, due to the issuer, size of issue, and coupon have a high likelihood of being called and YTW is used for each of these bonds. Bond B, according to our research, has a relatively low likelihood of being called in the next few years. An average of the YTM and YTW produces the most appropriate number. This final number of 1.84% is multiplied by the market value of the portfolio to yield $9,954 in annual income. This income, while still not as high as in Method Two, is higher than Method Three and more representative of the true income that the portfolio generates. This is not a perfect method due to the fact that a certain degree of subjectivity is required in assessing call likelihood; however, if this method is utilized and reviewed annually or semi‐annually and adjustments made according to bonds actually called or not called, over the long‐term, this method should be the most suitable for most clients. The downside of this method is that it is difficult to accurately ascertain and requires expertise in assessing the likelihood of individual securities to be called. METHOD FIVE – STRAIGHT‐LINE AMORTIZATION/ACCRETION All of the previous methods suffer from using market yields, not yields at cost or “book” yields. As we have stressed in the past, "safe" income changes over time as bonds mature or are bought and sold. However, the "safe" income of a bond is the yield the bond was purchased at, not the current market yield and doesn’t change over the investor’s holding period. This methodology amortizes or accretes premium or discount straight‐line to worst dates. Calculated in this manner, original principal is protected and income maximized regardless of if the bond was purchased at a premium or discount. Premium or discount is precisely amortized over the life of the bond leaving the “safe” portion of the coupon for the investor. 600 Fifth Avenue South, Suite 210
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2 ASSESSING TRUE PORTFOLIO INCOME EXHIBIT 1 – FORMULAS Non‐Callable Bond Annual Coupon Income – Premium or Discount Years between purchase and maturity Callable bonds purchased at a discount Annual Coupon Income – Discount Years between purchase and maturity Callable bonds purchased at a premium Annual Coupon Income – Premium Years between purchase and first call date SUMMARY It is important to understand the positives and negatives of each method in order to select the appropriate method for the client. One way to ease some of the burden of income calculations is the inclusion of zero coupon bonds that accrete towards par and ameliorate the impact on a portfolio containing premium securities. However, this strategy is not necessarily appropriate for all investors as the portfolio’s principal and return will be more volatile because of the inclusion of zero coupon securities. Also, no income is generated from zero coupon bonds and many clients care more for actual cash income than the overall yield on the portfolio. Lastly, two things to remember: 1) income assessment should be ongoing as the market changes and 2) this process is a mix of art and math (for taxable – mostly math). At Wasmer, Schroeder & Company, Inc., we consider the level of client income that an individual should be taking when constructing and managing their portfolio. For more complete information on the strategies, such as zero coupon bonds as a way to offset some of the premiums in a portfolio, please contact our client services team. Disclosure: The material provided is for informational purposes only and contains no investment advice or recommendations to buy or sell any specific securities. The statements contained herein are based upon the opinions of Wasmer, Schroeder & Company, Inc. (WSC), the data available at the time of the presentation which may be subject to change depending on current market conditions. This presentation does not purport to be a complete overview of the topic stated, nor is it intended to be a complete discussion or analysis of the topic or securities discussed. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. WSC does not accept any liability for any loss or damage arising out of the use of all or any part of this presentation. This report should not be regarded by recipients as a substitute for the exercise of their own judgment and may contain numerous assumptions. Different assumptions could result in materially different outcomes. Please contact Wasmer, Schroeder & Company for more complete information, including the implications and appropriateness of the strategy or securities discussed herein for any particular portfolio or client. About the Firm: : Wasmer, Schroeder & Company is an independent and employee‐owned investment advisor, specializing in fixed income separate account portfolio management for high net worth individuals, wealth management groups and institutions, including foundations, endowments and retirement plans, WSC has $4.50 billion in assets under management, as of 12/31/13. The Firm works with clients and their advisors to provide taxable and tax exempt fixed income portfolio solutions to meet their needs. Firm’s corporate headquarters are in Naples, Florida, where the tax exempt Portfolio Management team, Client Services, Operations, IT, Accounting, Compliance, Marketing and Administration reside; our taxable Portfolio Management team is located in Cleveland, Ohio; and Client Relationship offices in Exton (Philadelphia area), Pennsylvania and Portland, Oregon. 600 Fifth Avenue South, Suite 210
Naples, FL 34102
[T] 239.263.6877 [F] 239.263.8146
WASMERSCHROEDER.COM
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