Find out when it’s worth exchanging a fixed income security to take advantage of a higher rate – 12/02/2023 – From Grão to Grão

There are 10 days left for the Monetary Policy Committee (Copom) of the Central Bank (BC) to reduce the Selic rate by another 0.5%. With this reduction, the Selic rate should fall to 11.75% per year. For 2024, the trend is for the movement to continue until the Selic reaches 9% per year. In this sense, it may be interesting to evaluate the extension of some fixed income securities that mature next year, taking advantage of the even higher rates now.

Many investors who purchased fixed income securities from 2020 to 2021 face a dilemma right now. At that time, interest rates were much lower than they are today. I remember that I wrote a few weeks ago that in June 2021, economists expected that the Selic in 2022 and 2023 would not exceed 6.5% per year.

Thus, the bonds purchased during that period, despite having excellent rates at that time, today have a low return relative to alternatives. The dilemma faced is: is it worth selling a fixed income security even with a loss to invest in another with a higher interest rate?

The decision to sell is not easy, as it involves an undesirable element for any investor: loss at this time.

Yes, the feeling of making a loss can leave the investor paralyzed and, thus, actually miss the current opportunity to lock in higher rates for longer.

Although it is not an easy decision, it is simple to make. I illustrate this decision in the figure below.

The figure involves a simple example with bonds referenced to the IPCA and without coupon payments, but it can be used for other types without compromising the direction of the decision.

To make the decision, you need to have the interest rate and maturity date of your bond at hand. Additionally, four other factors are needed to decide:
1 – The interest rate for selling your current security;
2 – The interest rate of the desired or target security;
3 – The maturity date of the target security;
4 – The interest rate you expect to reinvest when the current security matures and has the same maturity date as the target security.

All this data is marked in yellow in the figure.

The figure above presents four tables with decision situations:
– Table 1 shows the profit or loss on the sale of your current security.
– Table 2 indicates the profit you will have when investing the resources obtained from selling the current security at the highest interest rate.
– Table 3 shows the profit you will obtain if you hold the current bond until maturity.
– Table 4 describes the profit when reinvesting the current bond maturity at the interest rate you expect to exist in the future and with the same maturity date as the target bond in Table 2.

There are two decisions to be made which I call Strategies 1 and 2:
Strategy 1 – Sell the current security and switch to the target security. This strategy is the composition of tables 1 and 2;
Strategy 2 – Keep the current security and, upon maturity, reinvest in a new security with a similar maturity to the target security. This strategy is the composition of tables 3 and 4.

The profit from each of these strategies is shown in the last line of the figure. You should adopt the strategy that results in the greatest profit.

Strategy 1, that is, selling your security today and reinvesting gives you the visibility of a certain profit. Despite having a one-off loss on the sale, there is a programmed recovery, that is, this loss is reversed into profit, as you reinvest at a higher rate.

In strategy 2, the investor must live with the uncertainty of reinvesting his security in the future with a much lower interest rate. Market expectations indicate that Selic should approach 9% per year in 2024 and reach 8% in 2025.

Therefore, if you wait to reinvest in the future, you may end up investing when the bond matures in another with a rate as low as the one you currently have in your portfolio.

Therefore, you would miss the opportunity for today’s higher rates.

For example, consider that you purchased a CDB fixed in 2021, with a face value at maturity of R$1,000, with a rate of IPCA+5% per year and which matures on 12/02/2024. This is the one we call the current title in the figure above.

Suppose that the current bond is sold on the secondary market with an interest rate of IPCA+9% per year. In this case, the loss in this operation would be R$35.08 per security in relation to its current price.

Consider that you can exchange it for another with maturity on 06/15/2033 and a rate of IPCA+ 7% per year net of IR, which is equivalent to a bond that yields IPCA+9% per year gross of IR. Therefore, we will consider this gross IR rate to have the same basis for comparison.

Note in the figure that Strategy 1 of selling and exchanging results in a profit of R$ 1,130.24 per security.

Alternatively, you can wait for the current bond to mature in 2026 and, at that moment, reinvest in another bond also maturing on 06/15/2033, but with an interest rate of IPCA+7.5% per year gross income tax which is equivalent to approximately IPCA+5.8% per year net of income tax.

In Strategy 2 of maintaining and reinvesting the expected profit is 899.08.

In this example, the best strategy is to sell and trade first, as it results in the highest profit. However, it won’t always be the best.

Strategy 1 will be more advantageous the higher the interest rate you apply now and the longer the maturity of the target security to be purchased in the exchange.

The risk in choosing Strategy 2 is that the estimated rate will be wrong and it will be much lower than expected when you reinvest.

Therefore, exchanging fixed income securities in your portfolio should assume that you are comfortable with a loss initially with investing in long-term securities.

Michael Viriato is an investment advisor and founding partner of Investor’s House.

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