December 28, 2018
Bonds are safe. Bonds are boring. These are some common refrains when it comes to investing in bonds, or “fixed income securities” as they are known in the industry. But are they really as boring as they seem? Even more importantly, are they really as safe as they seem? Let’s address these questions in order. Are bonds boring? Yes. Of course the caveat is yes they are boring if you are not interested in math, the time value of money, discounted future cash flows and the impact of minute changes in market rates on bond prices. If you are bored by terms like “duration” and “convexity” then yes, bonds most certainly are boring. But if you are trying to construct a portfolio to match assets and liabilities, to ensure you have adequate future cash flows to meet your need, then bonds could be a very efficient way to approach investing. Sure, equities get all the attention, and for younger investors it makes sense to go out further on the risk curve knowing that if you lose money in one particular year, you have many more years to make it up. But as you get closer to those ultimate goals, perhaps your daughter is now in middle school and you want to make sure her college fund has adequate cash to pay for tuition, room and board, you might not want to invest the entire portfolio in tech stocks knowing your time horizon is now just five years. These are the situations where buying a 5-year Treasury bond will help you sleep at night, knowing that at the start of her first year, your daughter will have the cash she needs to pursue her dreams.
Yes. That answer may seem counter-intuitive but let me explain. First there is the obvious risk, what professionals like to term “default risk.” Remember, buying a bond or other fixed income investment is really just making a loan to someone or some organization. We make loans many times, like the time we loan our snow blower to our neighbor. We know where he lives, and we can probably find him and our snow blower pretty easily if we need to. Then there’s your sketchy brother-in-law who wants to borrow $5,000 to start a new medical marijuana dispensary. Knowing that he would be most likely to personally consume the inventory of said business, this loan might never be repaid.
Just like these two individuals, companies and governments are similar in terms of the diversity of risk involved. Loaning money to the United States Treasury is probably the lowest risk akin to the good neighbor, since the Treasury not only has the power to tax it also has the power to print money to pay back their debts. That’s not to say treasuries are completely risk free, after all the power to print money necessarily involved the power to destroy, or at least diminish the value of said money. It's a safe bet that if you loan Uncle Sam $1,000 for 30 years, you’ll get your $1,000 back at the end, though what that will actually buy you is a matter for debate. There are other governments that you can loan money to, who may range anywhere between your sketchy brother-in-law or your upstanding neighbor. State and municipal governments may be all over the scale, while many emerging market countries with a history of multiple defaults are much more akin to the sketchy brother-in-law. Companies are similar, in that there are many different risk profiles which may change over time. I own a 100-year bond issued by the New York Central Railroad in 1897, a sure bet if there ever was one. Things went well for this leader of 19th century industrial America until that fateful day in 1971 when Penn Central went bankrupt. That bond still has all the interest coupons from 1971-97 attached and the $1,000 principal was never repaid. I’m sure someone invested $1,000 in that bond at one time, but I found it at an antique shop for a dollar.
Beyond default risk, there is another risk that is most often overlooked by investors: the inverse relationship between price and yield. All that means is that each bond is issued with a specific interest rate associated with it, for example it might be a 20-year bond with a coupon (interest rate) of 3%. Now if you’re happy to earn 3% on your investment for the next 20 years, you have nothing to worry about. But if something happens and you have to liquidate that bond before maturity, you may be in for a surprise. If interest rates go up, the value of the bond will decline, while if interest rates go down, the value of the bond will rise, this is the inverse relationship we mentioned earlier. The formulas are more complex in the real world, but let’s make a simplified example to illustrate the principle.
Suppose a bond with a $1,000 principal is issued with a 10% coupon. Current interest rates are 10%, so you should be willing to pay $1,000 for the bond which will yield you $100 per year in interest:
$100 ÷ 10% = $1,000
Now suppose interest rates rise to 12%, how much would investors pay for the bond? Well the constant is the $100 in interest you receive each year, so you should be willing to pay some amount that will equate to a 12% yield:
$100 ÷ 12% = $833.33
The bond that was previously worth $1,000 is now worth only $833.33 because interest rates rose from 10% to 12%. So what happens if interest rates go back down to 8%? Again the constant is the $100 annual interest payment, so you should be willing to pay some amount that will equate to an 8% yield:
$100 ÷ 8% = $1,250
As you can see, there may be quite a bit of variability in the value of bonds based on fluctuations in interest rates. Given that we have been in a secular down trend in interest rates for the past 35 years or so, it may not be prudent to assume that rates will continue to fall and bond prices will continue to rise. Given these dynamics, what are some strategies that investors can employ when it comes to fixed income?
Buying bonds directly is certainly an option. About six months ago, I bought a Treasury bond in my retirement account simply because I had some extra money in a money market fund earning a whopping 0.05%, meaning I could make more looking for discarded change on the sidewalk than I would earn from this fund. I began to look and saw that 2-year treasuries were yielding around 2.8%, so I bought a bond with 2 years to maturity with a coupon of 3.5% at a yield to maturity of 2.8%. I don’t have plans to sell it before it matures in 2 years, so my downside risk is limited, and I felt the likelihood of us encountering late 1970s levels of inflation between now and then are remote, so I took the plunge. Buying direct may be a way to go, but if your time horizon is longer and you don’t want to spend the time and effort to familiarize yourself with the technical aspects of fixed income investing, you might consider a bond fund. By utilizing a diversified portfolio of bonds, professional managers can provide attractive returns while mitigating some of the market risk that I took on when buying my single issue Treasury. You will pay a fee to the manager, but the good managers may well be worth every basis point.
Finally, there is another bond investment strategy that I think is ideal for longer term financial goals: buying zero-coupon bonds, or Treasury strips. These investments represent the principal portion of the debt, so in the case of a Treasury strip, the interest coupons are stripped from the bond and what remains is the principal to be repaid at maturity. Perhaps the most basic zero-coupon bonds are the savings bonds your parents or grandparent might have bought for you. Investors typically bought them for half of their face value and at maturity they would be worth the full face value of the bond. Suppose your newborn son is the apple of your eye and you want to make sure he has every advantage when he grows up, so you start a college fund. Sure you can invest in equities or various mutual funds but those might lose money right when he’s ready to head off to campus. Well, if you believe tuition and other expenses might be $25,000 per year when he heads off to school in 18 years, then you can just start buying zero coupon bonds or strips until you accumulate $25,000 in face value. Assuming a 4% yield to maturity, an 18-year $1,000 zero would sell for $493.63. You might implement a savings plan where you buy a bond once every other month. With that plan and assuming rates don’t change in our simple example, by the time your son celebrated his 16th birthday, he would have a $100,000 college fund ready for him to graduate based on your total investment of $68,337.44 over the first 16 years.
Fixed income investing can have an important position in your overall investment plans, which may become more integral over time. Just remember to appropriately assess the risks involve and develop a plan that will meet your long-term financial goals.