The video that accompanies this blog is here:
Over the past month, Laura has been quoted several times in news articles related to bonds. It seems bonds have become a popular conversation again; providing real yield for the first time in years. Therefore we will delve into a series of bonds-related videos, culminating in an in-person meeting in January, where we will discuss how to buy bonds.
In one of the recent articles, “What to Know About Buying Bonds in a Rocky Market, she discussed some of the mistakes everyday investors make. See the article at this link:
Many individual investors have a basic understanding of bonds and their role in a portfolio. They recognize that bonds provide diversification and are generally less risky than stocks. Additionally, they know the fundamental rule in investing in credit: when yields go up, bond prices go down.
The inverse relationship between bond yields and prices can be perplexing. When referring to “bonds being up” or “bonds being down,” we usually discuss different aspects. The bond yield (to maturity) represents the annual return as a percentage of the initial investment, and it fluctuates with changes in interest rates. If new bonds or bank accounts offer higher yields due to rising interest rates, existing bonds with lower yields become less valuable on the secondary market and they become “discount bonds;” they sell for less than their issue value normally $1,000 per bond (typically quoted as $100 in bond markets).
However, going deeper into the intricacies of bonds can be challenging for many. Here’s a breakdown of some of the mistakes people make.
- Assuming Bonds are an adequate diversifier by themselves
- Selling/Trading Bonds instead of holding to maturity
- Holding Bond Funds or ETFs instead of Individual Bonds
- Chasing Yield and Ignoring Quality
- Not understanding how callable bonds work
- Not realizing that some bonds change over time
- Not considering Taxes
Bonds as a Market Diversifier
As we discussed in prior videos, a portfolio that just holds stocks and corporate bonds only holds one underlying risk, which remains concentrated in U.S. corporations. The portfolio mix is heavily exposed to a single type of risk, and the correlation or relationship of their price changes between these two asset classes is not static. Over the past 150 years, the equity-bond relationship has experienced significant periods of both positive and negative correlations. Changing correlations makes bonds an adequate diversifier at times when they are negatively correlated and inadequate when they are positively correlated, so we need to include other asset classes in the portfolio to offer diversification when bonds are unable to do the job.
If you intend to sell a bond on the secondary market before it matures, its value can change based on interest rate movements. This is where competition comes into play. Higher yields in new issues can devalue older bonds with lower coupon payments.
In the face of declining bond prices, investors may wonder whether they should sell bond indexes or adjust their investment allocations. We typically advise against drastic actions. The dynamics that cause bond prices to fall when interest rates rise often work in reverse when rates decline.
Individual bonds can be more advantageous than bond funds, especially when managing your investments within a taxable brokerage account, a trust, or an IRA. Unlike bond funds commonly found in 401(k) accounts, individual bonds offer certain benefits.
One significant drawback of bond funds is their vulnerability to interest rate increases. As interest rates rise, the prices of bond funds tend to decline. Investors may need to hold onto the fund for an extended period to recover losses through interest payments.
The critical issue with bond funds is their lack of an ending maturity date. These funds consist of a continuous pool of bonds with varying maturities. When the value of bond funds decreases, investors tend to withdraw their investment. This forces the bond fund manager to sell bonds, even those that might have been held to maturity under different circumstances. Unfortunately, the manager is often compelled to sell higher-quality bonds for better pricing, leaving the remaining investors with lower-quality bonds.
This pattern has been observed repeatedly over the years and can pose challenges for investors.
Investors should exercise caution when pursuing bonds with exceptionally high yields, especially in the corporate bond market. Such high yields can be a red flag, indicating that the issuing company may be distressed financially. Companies facing financial difficulties may offer higher yields to attract investors, but they also carry a greater risk of defaulting on their bond obligations. Distressed companies run high default rates, especially during economic downturns. I
Investors need to balance seeking yield and managing risk within their investment portfolios. Most importantly, consider the role you want your bonds to play in your portfolio. If you want your bonds to provide stability when the market misbehaves, then high-yield (aka junk bonds) may not be appropriate.
Not Understanding Callable Bonds
Callable bonds give the issuer the right to redeem the bond before its maturity date, typically when interest rates have fallen. They provide issuers with flexibility but can be less advantageous for investors due to
- Reinvestment Risk – Investors may receive their principal back earlier than expected, potentially leading to reinvestment risk. If interest rates have declined since the bond was issued, investors may struggle to find similar-yield investments.
- Liquidity Risk – Callable bonds sometimes have lower liquidity than non-callable bonds. Finding a buyer or seller for these bonds in the secondary market may be more challenging, impacting the ease of trading and pricing.
- Callable bonds are usually called when interest rates drop and the issuer can refinance their debt. As the investor, you may suddenly be faced with a loss of both the purchase price if the bond is called a at value less than the price you paid, and you will not get the return on investment you expected.
One advantage of callable bonds:
- Lower Duration and Volatility Risk – Callable bonds often have higher coupon rates than non-callable bonds of similar credit quality. This decreases duration and volatility risk as interest rates fluctuate. This is an advantage but it may be overweighed by the disadvantages
In many cases the disadvantages far outweigh the advantages. Investors need to consider both yield-to-call and yield-to-maturity when assessing callable bonds. The yield-to-call reflects the potential return if the bond is called, while the yield-to-maturity represents the return if the bond is held until maturity. These yields can differ significantly, impacting the investor’s overall return.
Some bond yields change over time, mainly if linked to inflation.
For example, I bonds were popular when their interest rates were almost 10%. Many people read the articles and put their $10,000 into I Bonds online and didn’t realize that the interest rate moves every six months. Now, bond interest rates are at 5.27% (November 2023 through April 2024). Investors are restricted from selling Ibonds in the first year of purchase, and if they sell in the first five years, they will lose interest from the prior three months. For many, this was not the ideal investment, but it depends on your goals.
Not Considering Tax Implications
Different types of bonds have varying tax implications. Corporate bond income is usually taxed at all levels, government bond income primarily at the federal level, and municipal bond income is often untaxed at both federal and sometimes even the state levels. This means that the apparent yield of a corporate bond may not translate to higher after-tax returns compared to a municipal bond.
In summary, individual investors must grasp the significance of bonds in their portfolio and maintain a disciplined strategy for their allocation. A well-diversified portfolio that incorporates bonds can ultimately yield more favorable long-term results.
Closing: Most of our clients have a basic understanding of bonds and their role in their portfolios. They recognize that bonds provide diversification and are generally less risky than stocks. Some people dismiss them or think they are boring. We find bonds to be an exciting and necessary asset class that belongs in most portfolios. Watch for our other videos on bonds, and RSVP if you would like to attend one of our in-person meetings.
- Date: Thursday, January 4, 2024,
- Time: 5:30 pm – 8:30 pm
- Where: Laurel Oaks Country Club, 2700 Gary Player Blvd, Sarasota
- Date: Wednesday, January 24, 2024,
- Time: 6:00 pm – 8:00 pm
- Where: William Patterson University Library Auditorium 300 Pompton Road Wayne, NJ 07470
- RSVP: 201-347-3110
While these meetings are for our clients, you are welcome if you are watching this video and are not a client. We will not serve a steak dinner or sell anything; we will offer an education and build relationships. We hope to see you there.
Advantages of Municipal Bonds
Historically munis have provided significantly higher credit quality than Corporate Bonds when analyzing Indexes.
Much of the investment grade Corporate universe is at the bottom of the range, while the vast majority of investment grade muni area is A- AAA.
Types of Municipal Bonds
There are 20 times more municipal cusips in the marketplace than corporate bonds.
While corporates, agencies and Treasuries have very large maturity sizes (geared towards institutions), municipals typically have small maturity sizes and are retail dominated.
There are almost 1 million individual muni cusips outstanding. Of that number, approximately 3% have maturity sizes over $3 million.
95%+ of the muni marketplace has a maturity size of $10 million or less.
Only 2% of muni deals are above $300 million, the threshold required to be index eligible.
Types of Muni Bonds that We Buy
The goal is to maintain quality as high as possible and to also maximize yield where we can. In this endeavor we will strive to keep a A/AA overall credit quality in most portfolios and focus on the muni sectors that have historically had the most favorable yield and least downgrade/default risk:
General Obligation bonds – backed by taxing authority/ad valorem taxes
Essential Service Revenue bonds – Water, power, sewer, etc.
Large teaching hospital bonds
Major tollways, ports/airports, etc. – We avoided many of these during the depths of COV-19.
Large college systems
Some housing bonds depending on structure/premium component.
Limited stadiums/convention centers – again avoided during the COV-19 outbreak.
Insured bonds, bonds with State Aid, school support programs (PSF, QSBLF, QSCB, etc.)
Double barreled bonds – Those with multiple revenue sources.
Pre-refunded bonds – backed by Treasuries or Agency programs.
The goal is also to maintain duration within a defined short to intermediate term range and to provide systematic, defined cashflows, with consistently maturing principal (to reinvest into the market at levels that exist in the future). With this we will buy a combination of:
Callable Bonds – typically with a couple of years call protection unless inside of a short-callable strategy.
Sinking Fund bonds – random lottery calls. Yield to Average Life.
Premium bonds – natural lowering of duration and trade cheaper than par bonds.
Zero Coupon bonds – trade at discounts, accrete up to par at maturity.
Typical ladders will have 2-15 year maturities, but can be tweaked based on current markets, etc.
Yield curve analysis goes into final investment decision.
Target duration is in a band of traditional intermediate term muni benchmarks.
Duration can be brought in or extended slightly based on market/economic hypotheses.
Presentation – Buying Bonds on Auction