Toward the end of this commentary, I am including terms and their applicable definitions that I have used and / or may give you a better understanding of bonds, the risks involved, and the strategies employed by different bond-fund managers. The list of terms and their applicable definitions is by no means complete, but I hope it helps give you information and insight on bonds.
The need for income, economic uncertainty and stock market volatility are various factors of why investors have flocked to bonds. Bonds can have a place in many investors’ portfolios; however, there is an old saying that too much of anything isn’t good for you. This is also true as it relates to bonds.
At the beginning of 2000, stocks were the investment du jour and now 10 years later bonds are. Oftentimes, greed and fear are the primary driving forces and all other fundamental analysis of various investment sectors is ignored. Along these lines, bonds can provide income, but obtaining the highest income possible should not be the overriding factor. We need to consider the quality / rating of the bond (i.e., what is its perceived risk of default – see Credit Risk definition below) and the length of time (e.g., how many years) until it matures.
As it relates to credit risk, lower quality, high-yield or “junk” bonds can be an attractive option for some investors. The term “junk” bonds is the result of Michael Milken’s infamous role, as a bond trader with Drexel Burnham, in the development of the market for high-yield bonds during the 1970s and 1980s and manipulation of it as well. For example, let’s look at two sets of 10-year bonds. The first set being U.S. Treasuries (high quality / minimal default or credit risk) paying 3.0%/year. The second set being a group of high-yield (lower quality / higher default or credit risk) bonds paying 8%/year and bought at a discount (see definition below) to their par / maturity value (see definition below). An additional 5% is tempting, and investors may be willing to allocate some of their money, take a very calculated risk of default and go for the higher yield as offered by the second set of bonds. In addition there is the potential for appreciation if the high-yield bonds increase in value as they come nearer to maturity or the underlying company’s financial situation improves and the bonds’ ratings are upgraded. Remember, one man’s trash is another man’s treasure. That being said, it would be foolhardy to allocate the vast majority of a portfolio to a bond sector that is known for a higher potential risk of default / losses.
Fixed income / bond analysis can be quite challenging; however, there are bond fund managers who are very astute at finding these bargains and include high-yield bonds in their portfolios to increase the overall yield for their shareholders. A small percentage of a fund’s overall portfolio allocated to high-yield bonds can noticeably improve the overall yield of the entire fund.
Also, it is important to remember that bond prices and interest rates have an inverse relationship (See chart below titled Relationship Between Bond Prices and Yields). If interest rates go up, bond prices go down and vice a versa. This change in the daily price of a bond does not impact the interest it is paying to the investors that currently own it. Also, it may not be a factor if the plan is to hold the bonds to maturity. However, if price fluctuations are a concern or there may be a need to sell the bonds prior to them maturing, then this is something to take into account. Because the longer a bond or bond fund’s maturity and duration (see highlighted definition below), then the greater price impact (positive and negative on the bond).
That being said, bonds have been in a long-term bull market due to declining interest rates over time. Since interest rates are at historic lows (See last chart in this commentary titled History of Interest Rates), it may be helpful to focus on why duration becomes an important component when reviewing the bond portion of a portfolio. Essentially, a bond or bond fund’s duration is an indicator how it will be affected price-wise by interest rates. I firmly believe that if inflation and higher interest rates are a concern, then consideration should be given to bonds and bond funds with shorter durations to lower your interest rate risk (see definition below).
The following equation is a simplistic view of duration’s impact on the value of a bond / bond fund (average duration x % change in interest rates = % change in bond fund’s value). For example, it may be tempting to invest in a bond fund (A) yielding 9.0% with duration of 10 versus bond fund (B) yielding 7.0% with duration of 4.0. However, let’s consider all the facts. If interest rates increase just 1.50% over the course of a year, then bond fund (A) would see its share price drop approximately 13.50% (9.0 * 1.5%) versus bond fund (B) would see its share price decline approximately 6.0% (4.0% * 1.5%).
Thus, focusing only on current interest income or yield can be deceiving. This is why I have tried to be diligent in finding bond funds with what I perceive to have decent yields, a good overall mix of bonds, but also reasonably moderate to shorter durations. I am concerned that at some point in the future (maybe 12 to 18 months) we may see interest rates begin to creep up, and we want to be in funds that are able to better weather this. Also, let’s not forget the plus side of higher interest rates in that new bonds being issued will pay higher interest, which means more income or cash in hand for the investor. The higher income from the newer bonds purchased offsets some of the price decline of the overall value of the older bonds within the funds (i.e., you’re getting more income monthly, but the net asset value / price per share of the fund is declining in value). However, for many investors this positive is often lost when they see their principal go down in the meantime.
Bottom line, under our current interest rate environment, moderation is important. As such, government agencies, mortgage backed securities, corporate bonds (high grade to high-yield), foreign government bonds and convertible bonds should all be considered for income-oriented investors, along with shorter to moderate average durations for the bonds being held individually or in a fund.
Definitions
Lehman Brothers Aggregate Bond Index: This index is to bonds what the S&P 500 is to stocks. It is the most widely quoted bond index and provides a good approximation for the performance of the U.S. bond market as a whole. Not all funds should be judged against the index though, as fund portfolios and strategies can differ dramatically from those of the index.
Credit Risk: The risk that a bond will default prior to its maturity. If a bond defaults, bond owners may receive far less than they would have received had the bond matured. And even if a bond doesn’t actually default, its value can rise and fall in the marketplace based on investors’ concerns over that eventuality. In general, lower-rated bonds carry more credit risk than higher-quality issues, but often pay a higher yield to compensate for the greater likelihood of a default. Bonds that are rated BBB and higher are typically considered investment grade, while bonds rated BB and below are considered high-yield, or “junk,” bonds.
Interest-Rate Risk: The risk that a bond or bond fund’s value will decline in a rising-interest-rate environment. A bond that pays a 5% yield is going to be worth less if interest rates go to 7% than if interest rates go to 3%.
Duration: A measure of a fund’s sensitivity to interest rates, duration is expressed in years. For bond mutual funds, duration provides a rough estimate for a fund’s change in value given a 1% change in interest rates. A fund with duration of 6.0 years, for example, would be expected to gain roughly 6% if interest rates dropped 1%, and lose 6% if rates increased 1%.
Yield: In its simplest form, yield is the amount of annual income paid by a bond or bond fund divided by the bond or bond fund’s current price. Investors may come across other yield-related terms, including SEC yield, current yield, and yield to maturity. SEC yield refers to the annualized yield paid by a fund during the most-recent 30-day period (it is calculated with a formula that requires information on the fund’s individual holdings), while current yield and yield to maturity typically refer to yields on individual bonds.
Par: Par value, also known as face value, is the amount a bond owner receives when a bond matures. Most bonds have a par value of $1,000.
Premium/Discount: A premium bond trades at a value greater than its par value, while a discount bond trades at a price lower than its par value. If current interest rates are lower than a bond’s coupon rate, the bond will typically trade for a premium. If current interest rates are higher than a bond’s coupon rate, the bond will typically trade at a discount. Premium bonds are generally less sensitive to interest-rate changes than discount issues, particularly if the borrower has an option to refinance (i.e., the bond is “callable”; see below) at some point in the near future.
Callable: A callable bond can be redeemed or repurchased by the borrower prior to maturity, usually at a slightly higher price (the bond’s call price) than the bond’s par value. For example, if interest rates fall dramatically after a bond is issued, an issuer may choose to call the bond and reissue a new bond with a lower coupon rate. That would serve to cut the issuer’s borrowing costs. A noncallable bond doesn’t preserve the same option for the borrower. As a result, noncallable bonds tend to be more sensitive to falling interest rates than callable issues, as their upside potential is not capped by a call price.
Charts
Quotes
“Increased borrowing must be matched by increased ability to repay. Otherwise we aren’t expanding the economy, we’re merely puffing it up.”
Henry C. Alexander, banking executive
“Remember, diamonds are only lumps of coal that stuck to their jobs.”
B. C. Forbes, financial journalist
“We are all manufacturers-making good, making trouble or making excuses.”
H.V. Adolt
Tony Moeller, President
Integrity Investment Advisors
12721 Metcalf, #202
Overland Park, KS 66213
tmoeller@iia-kc.com
913-897-2074
The information listed in this commentary is a compilation of various publicly available sources and is for informational purposes only. It is not a recommendation or solicitation of any particular investment or strategy. A risk of loss is involved with investments in the stock and bond markets.
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