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Coupon Strategy: Reinvestment or Withdrawal?

As most equities pay dividends, the majority of fixed-income securities (excluding zero-coupon bonds etc.) pay coupons periodically to investors throughout the instrument’s life. However, fixed-income securities’ interest payments are non-discretionary compared to optional share dividends and failure to fulfil bond obligations (including paying interest) can have severe consequences including default, credit rating downgrades, trading penalties and adverse regulatory actions. This legal enforcement of debt interest is also partially why many income investors favour bonds over equities.

With interest payments to be received periodically (usually quarterly, semi-annually or annually), there are broadly two options for investors to deal with the payments: take as cash or reinvest. We do note that it can be difficult to make minimum subscription amounts for new bonds from coupon payments and especially so for investors (usually retail investors) with limited holdings in just a few securities.

That said, we explore theoretical coupon reinvestment in a little detail below…

With interest reinvestment the interest amounts grow consistently with the growing holdings of the underlying asset. Unlike the withdrawal option, investors who reinvest interest are entitled to the interest generated from the original capital base plus the “interest on interest” created by the coupon reinvestment. This effect is generally known as ‘compound interest’.

The effect of compounding is further demonstrated by NABHA’s accumulation index rising at an average annual 4.84% from Jan 2011 to Feb 2018, well ahead of the non-accumulation average annual growth of 2.54% (Figure 1). The 2.30% extra return was largely attributable to consistently growing interest amounts (as total capital holdings increased). This is especially relevant with interest payments being used to acquire capital units when prices were depressed (2011 and 2012) and below par. Early on, the short-term impact of reinvestment is notably less material with capital prices closer to par (just 1.50% accumulation growth in 2011 vs 0.96% of non-accumulation growth).

Figure 1. NABHA accumulation and non-accumulation index (Jan 2011 – Feb 2018)

Source: Bloomberg, BondAdviser

Outright capital returns, on the other hand, are achieved through a more risky processand are a mixed result of the macro landscape and fundamentals. Investors can obviously capture more upside benefits from the original capital outlay (plus interest reinvestments) when capital is appreciating but are then face extended periods to suffer capital losses should the underlying asset depreciate, which in fat tail events (like GFC), could more than offset all positive returns (including accumulation ones) as newly-injected capital grows negatively (worse than interest as cash). This can be illustrated by NABHA’s poor performance during the GFC (Figure 2), where the accumulation index dropped by 31.01% from March 2008 to February 2009 compared to a smaller 22.92% fall of the non-accumulation index.

Figure 2. NABHA accumulation and non-accumulation index (Jan 2007 – Dec 2010)

 

Source: Bloomberg, BondAdviser

Despite short-term market swings exposing investors to downside risks, relatively benign and stable long-term macro landscapes should generally always support investors and offer an extra return from interest reinvestment (Figure 3).

Figure 3. NABHA accumulation and non-accumulation return from July 2004 onwards

Source: Bloomberg, BondAdviser

Although reinvestment seems to provide more attractive returns over the long term, whether investors should roll interest into additional capital involves multiple other factors to consider as well, primarily including the fundamental landscape (issuers’ outlook, macro conditions etc.), additional trading costs, investors risk profiles and horizons and dependency on interest income. Additionally, when better alternatives present themselves, investors have few reasons to place additional funds into existing assets. In conclusion, although we are aware that reinvestment is more prevalent and offers more capital upside over a longer term in equity portfolios, we wanted to briefly explore the option for fixed income investors.