Understand the four factors necessary for the decision to exchange fixed income with low interest rates – 03/06/2023 – From Grain to Grain

Everyone who bought fixed income bonds from 2020 to 2021 faces a dilemma right now. At that time interest rates were low. Thus, the securities purchased in that period, despite having excellent rates for that moment, now have a low comparative return. The dilemma faced is: is it worth selling a fixed income security with a loss to invest in a security with a higher interest rate?

The decision to sell is not an easy one, as it involves two undesirable elements for any investor: certain loss and uncertainty about gain.

Yes, the decision is to leave investors paralyzed. Anyone who thinks they know exactly the correct answer is either convinced of the bet they are making or is unaware of the risk.

Although it is not an easy decision, it is a simple one to make.

To make it easier, I provide a simulation worksheet and it is with it that I will exemplify.

The worksheet involves a simple example with fixed-rate securities and without coupon payment, but it can be used for other types of the same characteristic without jeopardizing the direction of the decision.

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

All these data are marked in yellow in the spreadsheet (at this link) and in the figure below.

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

There are two decisions to be made which I call Strategies 1 and 2:

1 – Sell the current title and switch to the target title;
2 – Keep the current security and, at maturity, reinvest in a new security with a maturity similar to that of the target security.

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

The result of selling your bond today and reinvesting is a sure result. It should lead to an injury this instant. However, as you reinvest at a higher interest rate, this loss is reversed into profit over the years.

The uncertainty concerns the estimated interest rate for reinvestment in Strategy 2. There is no way to know for sure what this rate will be in the future. So if you get it wrong and it turns out to be higher than you thought, you might make a mistake in switching the title today.

Let’s go to the example. Consider that you purchased a fixed-rate CDB in 2021, with a face value of BRL 1,000 at maturity, with a rate of 8% per annum and which matures on 06/15/2026. This is what we call the current title in the picture above.

Assume that the current bond is sold on the secondary market at an interest rate of 16% per annum. In this case, the loss in this operation will be R$ 153.98 per security in relation to its current price.

Consider that you can exchange it for another CDB maturing on 06/15/2029 and a rate of 14.5% per annum.

Note in the figure that Strategy 1 of selling and exchanging results in a profit of R$ 648.49 per security.

Alternatively, you can wait for the current security to mature in 2026 and, at that moment, reinvest in another CDB maturing, also, on 06/15/2029, but with an interest rate of 10% per annum.

In Strategy 2 of hold and reinvest the expected profit is 537.61.

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

The decision is not an easy one, because if, by chance, the reinvestment rate at maturity is 13% per year or higher, instead of the estimated 10%, Strategy 2 is more advantageous.

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

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

Therefore, switching fixed-income bonds into your portfolio should assume that you are comfortable with a first-time loss with investing in long-term bonds and that you believe interest rates will drop enough to compensate.

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

Talk directly to me via email.

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