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How Much Optionality Is Too Much?

By Jeff Goble
One of the main negatives for bond investors related to falling interest rates  is the fact that any higher-yielding bonds with call options you own may be called away, thus sharply reducing your bond income.

Bonds that possess these embedded call options usually fall into three security classes: callable agencies, mortgage-backed securities (pools and CMOs) and longer-term municipal bonds. Mortgage-backed securities are “callable” in that homeowners can prepay or refinance their home mortgages whenever they can lower their mortgage rate and monthly payment.

 

You can see in the pie chart below how the top-performing banks in the Country Club Bank peer group have diversified their investments and the average maturity/duration they have targeted at present to optimize bond income. The bonds in the top 10 percent peer group are sorted using total return, which includes the gain or loss in market value of each security, so it is apples-to-apples.  A total return of 5.73 percent is excellent (which means a gain in market value of 2.26 percent) and you may wish to compare your portfolio results to these.

While you have your portfolio percentages handy, you may wish to add the following security classes together: callable agencies, mortgage-backed pools, CMOs and municipal bond holdings (GOs plus revenue bonds) divided by two, as a shortcut. If you have over weighted longer-term munis, you may actually have more callable munis than 50 percent, as issuers of longer bonds prefer to have a refinance option down the road. If you have the time, you can sort your callable municipal bonds from the noncallable ones and use that more exact percentage instead of the 50 percent shortcut above.

I think a good range to target for this sum of all “callable” issues in your portfolio is 50-60 percent. You can also soften the income hit of bonds being called away if you avoid high premiums on securities with call options.  If you are significantly higher than this range with your overall callable percentage, this would be a very good time to consider reducing your portfolio’s overall optionality, as bond prices are obviously very high now, and more calls are probably ahead.

The top 10 percent’s total callable percentage is 57 percent. If your percentage is here or lower, you are probably smiling and enjoying the additional bond income.

 

Jeff Goble is chief market strategist in the Capital Markets Group at Country Club Bank in Kansas City.

 

 

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