By Charles Ross, Contributor 
Ross
HOW BEST can the trade-off between risk and return be achieved? That is one of the key issues that investors have to evaluate and make a determination on when deciding which securities to purchase or where to place their investments. Most investors would like to maximise their returns but few are willing to enter into investments that include the risk of losing some of their principal. In Jamaica we have, over the last eight to 10 years, become accustomed to quite high nominal returns on our money market and bond type investments. It is only when we start to consider cross-border diversification that the risk and return trade-off hits us squarely in the face.
In general, the higher the credit rating of a bond issuer, the lower is the yield or coupon that is offered on its bonds. This is so because the higher credit rating is indicative of a lower risk of default; hence a lower return is offered to the investor for buying or holding that issuer's bonds. The converse is true for bond issuers with lower credit ratings. To illustrate the point, an investor might be confronted with a choice between the following 10-year bonds: a B- rated bond yielding 12.7 per cent, a BB rated bond yielding 8.25 per cent, an A-bond yielding 5.9 per cent and an AAA bond yielding 4.65 per cent. The market may see all these bonds as offering a fair trade off between risk and return, but for the Jamaican investor who is accustomed to yields at the upper end of the range, will he or she be comfortable accepting the lower yields on the securities with the higher credit quality?
Fortunately, there are bonds that combine the highest credit quality with the high coupons that are normally associated with the bonds of B or BB rated issuers. One example of such a security is the Range Bonds that are issued by the Federal Home Loan agencies in the United States. These US government agencies - such as the Federal Home Loan Mortgage Corporation and the Federal Home Loan Bank - manage huge mortgage portfolios and are rated AAA/Aaa by Standard & Poor's and Moody's. Default risk on their bonds is therefore minimal. However, from time to time, these agencies issue 10-to-15-year Range Bonds that currently pay coupons of between 7 and 10 per cent, whereas their standard bonds of similar duration may pay coupons of 4.5 to 5.5 per cent. The reason for the extra coupon on the Range Bonds is that these instruments carry an interest rate rider that links the accrual of interest to the London Inter Bank Offered Rate (LIBOR) remaining within a particular range.
These bonds are issued in very small quantities and form part of the Agencies' interest rate hedging strategy. A typical Range Bond will have a particular range associated with it - say 0-7 per cent - within which say six-month LIBOR must remain for the bond to continue to accrue interest. For any days on which LIBOR should go above the specified range of seven per cent, in this example, the bond will stop accruing interest. However, it will resume the daily accrual of interest once LIBOR falls back within the range. The coupons are paid quarterly and the bonds are also callable at par on the coupon dates. Essentially, the Range feature introduces an interest rate risk for which the investor is receiving the extra coupon.
Although the structure of these bonds may seem unusual, they are very attractive at the present time as there is only a fairly remote possibility that LIBOR will get outside the ranges within the next year or two. Six-month LIBOR is currently about 1.3 per cent and little upward movement is expected within the next six to nine months. In practice the bonds are most often called within three to six months of their issue and the call feature ensures that they do not fluctuate much in price in the secondary market. Range Bonds therefore offer a rare combination of excellent credit quality and high coupons that can provide very attractive returns for the discerning investor.
Charles Ross in managing director of Sterling Asset Management Ltd. Send feedback to sterlingasset@jamweb.net
