Buy Bonds With Moving Parts

For the last few years there has been an inner voice telling bondholders "rates have nowhere to go but up." That's why skittish fixed-income investors stampeded into adjustable-rate-bond funds last spring when interest rates bumped up. But there is a smarter strategy than selling in panic or merely sitting on the sidelines.

You want bonds with moving parts. What are they? They're bonds that have some feature that adjusts with rates or resets at some future point in time. Examples are bonds whose yield changes with the slope of the yield curve, Libor-based bonds and bonds whose coupons adjust to a specific Treasury yield. Allocate 10% to 15% of your portfolio to them–and no more. They're all from financial institutions, and too much exposure to any sector is never a good thing.

Citigroup Citigroup has an attractive yield-curve steepener (implying that long-term Treasury yields remain higher than short-term yields). Buy the Citigroup 10.50% Coupon Bond Maturing Feb. 19, 2034 (CUSIP: 1730T0G78), callable Feb. 19, 2015 at par. The impressive 10.50% coupon is a "teaser" rate that changes in February 2016. This gives you nearly two years to bank that double-digit coupon. When the 10.50% coupon resets in 2016, the formula for computing the new coupon is: 6 x (30-year Treasury Swap rate)–(5-year Treasury Swap rate)–25 basis points.

Institutional investors can access these rates on data providers (like the Bloomberg terminals), but an easier way to get a bead on the new rate would be to substitute the 30-year Treasury (now 3.65%) and the 5-year rate (now 1.7%) instead of the swap rates in the formula. This bond, priced at 99.12, has a floor of 0%, and payments and resets are quarterly.

The Bank of Nova Scotia Bank of Nova Scotia, rated A+, AA–, also offers curve steepeners with high teaser yields. The Bank of Nova Scotia 10.50% Coupon Bond (CUSIP: 064159DF0) is callable Jan. 30, 2015 at par and is priced at 97. The terms differ from the Citigroup bond. This issue resets January 2015 and will yield 4 x (the 30-year Treasury swap)–(the 2-year Treasury swap)–25 basis points.

Beware: Some of these bonds with moving parts are small issues with little liquidity, and that may restrict a quick and easy exit. Before buying, search InvestinginBonds.com by CUSIP to verify that your bonds trade daily or at least weekly.

For nervous investors I recommend Libor floaters as a security blanket to calm your interest rate angst. Lloyds Bank Plc. rated A2, A has bonds with a minimum coupon rate of 2%. If three-month Libor plus 1.25% exceeds the 2% floor, then that's the new coupon. Lloyds bonds are shorties, maturing July 20, 2017 (CUSIP: 5394E8BC2) and priced at 100.

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