Bonds can be broken down into several categories including taxation, issuing entity etc. Here we have separated them by taxation, and then by type of issuing entity.
Tax free bonds are usually issued by municipalities, the federal and state governments have allowed their interest payments to be tax free so that towns and certain other types of entities can get access to credit at a lower cost. States will tax bonds that do not originate from a town within the state for example, NJ will tax bonds that originate from a town in Texas. Because they are “mostly” tax free, municipal bonds usually have a lower interest rate than taxable bonds, and historically they have had a very low default rate. Taxable bonds include treasuries, government agencies, CD’s, corporate bonds etc. They are all taxed at the federal and state level except for treasuries which are tax free on the state level. One point to consider; there is such a thing as taxable municipal bonds and they usually pay a higher rate of interest that tax free municipal bonds so they may be a good bond to hold in an IRA in some cases.
In the taxable bond category bonds can be further characterized by type of issuer, government, or corporation. This is an important distinction since most government bonds are considered “riskless” and in fact all types of bond have a yield “spread” that is always compared against treasury bonds which are issued by the federal government. Corporate bonds nearly always provide more yield than treasury bonds, government agency bonds and CD’s since they have an additional risk that does not exist for those other categories, that is the risk of default. (CDs are generally nearly risk free since they are insured by the FDIC with limits).
Alternative Bond Types and Substitutes
In chapter 1 of this series, we discussed knowing the role you want bonds to play in your portfolio. We discussed the fact that yield generation might not be their sole purpose. However, some investors continue to seek high yield in their bond portfolio and therefore they give up the ability to achieve diversification and capital preservation, the key reasons to hold bonds in the first place. When seeking yield, investors unwittingly make this trade-off when they invest in three types of securities”?
The first is High Yield bonds:
Thirty percent of corporate debt is considered junk (Rating BB or below). In our mind “High Yield” is just a euphemism for junk. What was considered always junk was renamed in the 1980’s to “High Yield” to make them more palatable to investors and thus make it easier for companies with poor credit to obtain capital. While junk bonds do provide much higher yields than the best rated bonds, they have a much higher risk of default. In part three of this series, we will be talking about risk in some detail.
The High Yield market is severely bifurcated. The weaker positions are highly leveraged and have great risk and the default rate can be great. In 2009 the default rate hit over 15%. Presently (April 2021) the S&P global ratings service expects the default rate to be greater than 10-13% over the next 12 months. Many lower investment grade bonds have tipped into this junk territory.
The second is preferred stock:
Preferred stock really is not a bond at all, but it has bond-like characteristics and is often considered a hybrid investment since it offers a higher claim to assets than common stock in the event of liquidation and a steady income stream due to higher dividend payments. Preferred stock really is not a good bond substitute since there is no contractual agreement with guaranteed obligations to pay the coupon and the principal back at maturity. In fact, they do not have a fixed maturity, they are much more correlated with stocks and they have much higher credit risk than bonds. Because they are not guaranteed, issuers have an option of deferring payment without considering a default. A recent example of this is Chesapeake Energy (CHKAQ) who declared voluntary bankruptcy in June 2020 and has not paid dividends on its preferred shares since April 2020. In addition to the cessation of those dividend payments it is expected that shareholders will receive no value for their shares once the bankruptcy is complete. So preferred stock has much of the risk of equity but without the potential upside and it is bond like without bond guarantees it is truly the worst of both worlds!
The third is floating rate loan funds:
Floating rate loan funds hold bonds and loans made to corporations. While many of these funds to pay higher yields than what is currently available for most highly rated bonds, they are not really a bond substitute since they have risks that do not exist with the safest bonds. We will be discussing this in more detail in future parts of this series.
So, What Should You Do?
Again, it is important to have an overall investment strategy and to know the role your bonds play in your portfolio. Once that is defined you can select the appropriate types of bonds to achieve your long-term goals. Understanding the real purpose of bonds and fixed income will also help you avoid the temptations of trying to get yield in a low yield environment by investing in bond look alike that have a lot more risk,