Oran Hall | Re-investing the proceeds of a matured bond in another

Recently, my friend shared with me that his wife wanted to know what to do with the proceeds of bonds she owned that were due to mature soon in light of calls she had received from her investment adviser about investing the proceeds in new bonds coming to the market.

Deciding what to do with such funds is not a light matter, for personal conditions and needs and market conditions today are hardly likely to be what they were when she purchased them.

The investor’s age would have increased – perhaps significantly, if they were purchased many years ago. The investor’s personal and financial circumstances could also have changed in terms of family, employment status, and health, for example, giving rise to a change in needs and priorities, goals, and objectives, or changes in the timeline for previously determined goals and objectives.

Changes in the investor’s situation, important as they are, cannot be isolated from conditions in the financial markets and wider economy, for example, changes in interest rates, inflation rates, laws impacting investment income and pensions, and changes in the range and features of financial instruments.

Against the background of existing conditions, the investor should determine what is the best strategy to realise existing or new goals. Major considerations could be the need for regular income, the need for capital preservation or capital growth, the need for protection against exchange rate depreciation, and the need to position to take advantage of likely changes in interest rate movements if economic conditions suggest possible instability in interest rate movements in the years ahead.

Future movements in interest rates cannot necessarily be predicted with absolute certainty but are very important because of their implications for the re-investment of coupon payments, that is, the interest payments made semi-annually or quarterly as the case may be. Investors take on re-investment risk because of the possibility of interest rates falling below the coupon rate, meaning that the invested coupon payments would earn a rate lower than the coupon rate.

On the positive side, if general interest rates increase, the investor has the benefit of earning a return which is higher than the coupon rate.

Expectations of changes in interest rates can influence whether re-investment is made in short-term or long-term bonds. Expectations of increases in interest rate levels in increments would make shorter term bonds more attractive to facilitate investing in new bonds at likely higher rates over time. On the other hand, embracing longer term bonds would be best if interest rates are not expected to increase further.

The term of a bond is significant. The price of a long-term bond is more volatile than that of a short-term bond, meaning interest rate changes will cause a greater level of price fluctuation. This is of little or no consequence when the instrument is held to maturity.

It is a different matter, though, if it becomes necessary to sell before the maturity date. If interest rates increase, the bond price can be expected to fall, causing a capital loss. Happily, bond prices generally increase when interest rates decline, thus generating a capital gain. The longer the time to maturity and the lower the coupon rate, the sharper the price swing. In any case, the term of any new bond should align with the needs of the investor.

The need for cash flow can also bear on the re-investment decision. If regular cash flow is the priority, re-investing in a bond that pays interest semi-annually when quarterly interest payments are more suitable is not the best decision.

The investor may also be faced with whether to re-invest the funds in bonds denominated in the same currency as the maturing bond or in another currency, depending on what is deemed to be best in the new market situation, or in the investor’s needs.

Investing in bonds denominated in foreign currency does hold out the prospect of yielding exchange rate gains in the event of the depreciation of the value of the local currency and does provide for diversification, but being distant from the source of the issue and often not being able to access information readily may raise the risk of loss, as has been the experience of some local investors.

An important factor which cannot be ignored is the quality of the bond into which the maturing funds may be invested. Although it may carry a higher interest rate to compensate for the higher risk, the investor has to consider whether it is worthwhile to take on higher risk and raise the prospects of losing capital in the event of default.

The maturity of a bond presents an opportunity to re-evaluate an investment portfolio. It may come at a time when it is prudent to adjust the asset mix, or to effect re-balancing. Depending on the results of the re-assessment, it may not be necessary at all to re-invest the proceeds in bonds but in other asset classes. Beyond that, and depending on whether the initial investment was made to fund a specific goal, it may not be necessary to re-invest the funds from the matured instrument.

Re-investing the proceeds of a maturing bond is not automatic. It requires evaluating the risks and benefits, changes in the investor’s circumstances and needs, and changes in economic and financial conditions. This is a decision which may require independent and impartial guidance.

Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.finviser.jm@gmail.com