Is it better to bet on the high coupon or on the capital gain? – Corriere.it

2023, a turning point for bond investing. After almost a decade of rates close to zero and after the collapse of 2022 in the prices of bonds already issued due to the increase in interest rates, the year that has just begun offers interesting prospects. Gross yields on long-term BTPs, 10 years or more (but also on corporate bonds) rose more than 4%, a value that will soon be able to effectively counter a euro area inflation rate which is expected to fall below 3% by the end of 2023 (Eurotower Bulletin forecast at the end of March).
For savers burned by a 2022 in which fixed income recorded double-digit losses – not counting the erosion of capital due to a double-digit inflation rate – new opportunities open up. Let’s see them.

Two portfolios: high coupon and low coupon

We asked Valori Asset Management, an independent asset management company with offices in Milan, Lugano and Luxembourg, to develop two portfolios of five BTPs each, made up of securities with a residual life of 10-12 years. The average annual return of the two portfolios is very similar, around 4.2-4.3% because due to market arbitrages, securities with high coupons have higher quotations, above par (more than 100) on the secondary. Conversely, low coupon bonds are worth less and are traded below par (less than 100). The effective return is nearly identical for the two portfolios because the total cash flows including coupon payments and principal repayment at maturity are identical. However, the two baskets are very different in terms of the characteristics of the securities they hold and their behaviour, in terms of capital gain or loss in the face of a change in interest rates. The first of the 2 portfolios — in which we assume we invest 100 thousand euros, a sum divided into equal parts of 20 thousand euros for each issue — has a high coupon and all the securities have prices above 100. The second at very low coupon and all stocks have quotes below 100.

Maximize interest flows thanks to coupons

A high coupon portfolio obviously offers a high annuity. In the example, the average coupon is 4.75% while the yield to maturity is a little lower, equal to 4.3%. This is because whoever wants to buy these securities will have to pay them above par, therefore at a higher price than the redemption value. The difference given by the higher coupon flow. Based on the two example portfolios, the high coupon basket will offer a gross annual flow of 4,750 euros against an investment of 100 thousand euros. The one with a low coupon provides an income of 1,520 euros (the average coupon in this case of 1.52%). A wallet of high coupon bonds particularly suitable for those investors who plan to use the flows generated by the coupons for current spending and do not have to reinvest them. Furthermore, the quotations of high coupon bonds have precisely the “parachute” of the coupon which cushions losses in the event of an increase in market interest rates due to the increase in rates decided by the ECB, explains Nicola Maino, investment director of Valori Am.

In the example, against a 1% increase in interest rates the high-coupon portfolio loses 8.9% on average, with peaks of 10.8% for the BTP maturing January 2040 (13 years). Conversely an increase in interest rates of one percentage point on a portfolio made up of low coupon securities has a higher average loss of 1.4%, equal to exactly 10.3% (see table below). The BTP maturing in January 2041 and with a coupon of 1.80% depreciates in this scenario of a 1% increase in rates by as much as 13% of its value.

Objective: capital gain

A low coupon portfolio, like the one above, is attractive to capital gain investors. It is true that in the event of an increase in interest rates, the low coupon portfolio depreciates more than a basket made up of high coupon securities. However, the reverse is also true. If rates fall, say by a percentage point, the appreciation is greater, Maino points out. In the two examples shown, against a 1% decrease in interest rates, the low-coupon portfolio records a rebound of 11.7%. The one with a high coupon instead increases its value by 10%. The difference in favor of the former of a higher average gain of 1.7%. The BTP maturing in 2041 (see table), in the event of a 1% decrease in interest rates, even gains 15.4% in terms of price (the very long maturity, almost 18 years and this amplifies the fluctuations both upwards than downwards).

Interest rate strategy

Forecasts on the trend in interest rates still point upwards, at least for this year. But the interest rate cycle is rapidly approaching its climax. In the next 6-12 months the low coupon portfolio will lose again, but already in the medium term the gain will be higher than the high coupon basket because rates will start to fall again and these securities will benefit more from it, explains Maino. According to the strategist, low coupon portfolios have two additional advantages: they do not present reinvestment risk, precisely because the coupons are low, the risk of investing interest flows at a lower yield than in the past is reduced (you have collected less money, if even reinvest them at a lower rate, what do you care?) . A further advantage of the low coupon wallet that adapts to those with financial needs that have shifted over time. The 10-year BTP maturing in January 2037 is currently traded at a price of 66.1. With a current outlay of 6,610 euros, he will have a repayment of 10,000 euros in about 15 years. They could be useful for sending their children to university.

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