Which contract would you take?

Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.

Pretend you’re a professional athlete in the prime of your career and you just entered free agency. You have two offers on the table. The first is a one-year contract for $25 million. The second is a 10-year contract for $200 million. Which one would you take?

While it might not be unanimous, I would guess that a vast majority of people would opt for the $200 million contract which locks in a $20 million annual salary for the next decade. Why? Because the overall contract is worth a great deal more by locking in an attractive annual salary for a decade. Yes, the one-year contract would earn a higher dollar amount for the next year but a year from now you will be back on the free agent market. By choosing the one-year contract you are hoping that you will be worth the same or more a year from now. If you have a good season, you might be able to negotiate a longer term contract worth $25 million per year compared to the $20 million per year that you were offered last year. Or maybe you choose to take another one-year deal with the hopes that you have an even better year next year and can increase your annual salary even more.

The other side of the coin is that maybe you have a bad year. Or maybe you get injured. Or maybe due to new data analysis, teams have determined that your particular skillset isn’t worth as much as they previously thought, so even though you had a good year, teams have decided that you aren’t worth as much as they previously thought. If you get injured or have a bad season, you’ll probably be kicking yourself for not taking the $200 million contract last year, as that would have locked you at $20 million per year for the next 10 years regardless of your on-field performance or health status. Yes, you made $25 million last year but now you are not likely to earn anything close to the $200 million that you could have locked in last year.

This is essentially the decision that fixed income investors are faced with today. Substitute the one-year contract for a one-year bond and the 10-year contract for a 10-year bond and the situation is nearly identical. The 1-year contract and 1-year bond both come with considerable near-term “reinvestment risk”. When you purchase a bond that has a lifespan of just one year, you are only locking in the yield that it earns for the next year. When you purchase a bond that matures in 10-years, you are locking in an annual return for the next 10 years. Just like the athlete that might have a bad year or get injured, bond yields could be lower a year from now meaning that investors who chose to purchase the one-year bond would have to reinvest into lower yielding investments next year. The investor who purchases the 10-year bond has locked in a yield for the next 10 years, regardless of any changes in interest rates.

What are interest rates going to be a year from now? Just like trying to predict an athlete’s performance for the upcoming season, we can make educated guesses but when it comes down to it, no one really knows. What we do know is where things sit today. The athlete knows they have an offer to pay them $200 million over the next 10 years and can choose to lock that in right now. Investors today know that yields across the fixed income space are at some of the most attractive levels that we have seen in the past 10-15 years. The opportunity to lock in attractive yields for an extended period of time may not last. For many investors, it might make sense to sign that 10-year contract today rather than take the 1-year deal and re-enter the free agent market a year from now.

The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.

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To learn more about the risks and rewards of investing in fixed income, access the Financial Industry Regulatory Authority’s website at finra.org/investors/learn-to-invest/types-investments/bonds and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) at emma.msrb.org.