By: Frank Armstrong
*As seen on Forbes
In theory at least bonds are priced relative to their duration and credit rating. Any risk over the zero risk asset should earn a risk premium of additional return. Of course, those risk premiums are based on a fully diversified asset class basis, so individual bonds or a limited number of issues in your portfolio may result in widely different risk and return results. And risk premiums are calculated as if there were no transaction costs, which is hardly a real world assumption.
Today after years of global government intervention there is little in the way of income in most fixed income instruments. But, giving into the temptation to “stretch for yield” dramatically increases risk without a satisfactory increase in return. So, staying on the short end of maturity and reasonably high quality may be the sweet spot for most of us.
A Deeper Dive into Bonds
A deeper dive into bond pricing and returns adds a few wrinkles you ought to consider as you manage your fixed income portfolio.
The bond market is huge. It dwarfs the world’s stock markets. But, it’s highly fragmented. Developed nation sovereign bonds are highly liquid with miniscule transaction costs. You can generally get quotes instantly and rely on minimum fees.
At the other end of the spectrum, small municipal bond issues from obscure cities, emerging market debt, or small corporate debt may be highly illiquid and carry huge transaction fees. Some if these issues may not change hands for months at a time so pricing and liquidity are problematic. What you see quoted may not be close to what you actually get. Rest assured as a retail holder of an illiquid bond those discrepancies generally do not work in your favor.
Dealers in illiquid issues have large bid-ask spreads, so a round trip may be painful indeed. Underwriting fees for obscure new issues are fat, so the temptation for a bank or brokerage house to stuff them in your portfolio are huge. To generate those underwriting fees, the brokerage houses have to actually sell them to somebody. As the holder of the bond, it may take you weeks to liquidate an issue. Meanwhile you see quoted prices that may have little relation to what you might actually net.
It shouldn’t come as a surprise to you that retail investors are never going to get close to institutional execution or pricing on their bond transactions.
Municipal bonds are often “guaranteed” by an insurance company against losses. They may assume the credit rating of the insurance company. So, what otherwise might be a junk bond may be touted as A rated. But, as we discovered in the financial crisis, the insurance company may not be able to cover losses either.
Sources Of Income And Collateral
Bonds may be backed by the full faith and credit of the issuer, or some lesser backing. Even US Government Agency bonds have a higher risk than a Treasury issue. Investors became painfully aware of the differences during the financial crisis when it wasn’t clear at all if Freddy and Fanny might be backed by the Government or if holders might be left holding worthless paper.
Railroad bonds might be backed by all the resources of the issuer, or the real estate, or the rolling stock or just one crummy aged caboose sitting on a siding somewhere molding in the rain.
Likewise, a municipality might issue bonds backed only by toll road collections, future property taxes on a new subdivision, or the full faith and credit of the city.
While it’s true that bondholders stand ahead of equity owners in a bankruptcy, they stand behind other creditors like pensions, taxes, or environmental cleanup claims. And your bond may be subordinated to dozens of other bond issues by the company. They get paid first while you stand in line for whatever is left over.
Foreign bonds may offer a diversification potential. But, before you jump into them, don’t confuse nominal yield with real yield. Countries with high embedded inflation rates must pay additional premiums to cover that inflation. If a country offers a nine percent coupon yield but has an 8% inflation rate, their real yield is only one percent. Or in the worst case, you might actually be losing money as you clip your coupons.
Foreign bonds carry currency risk which may dwarf any coupon advantage. Investors should perhaps only consider a foreign bond if after the cost of hedging currency for the issue the real yield is still attractive compared to a local currency bond.
Bonds may also contain embedded options. One of these is good, and the other is never good for the investor. The good one provides an upside which allows the bond to be converted to some number of equity shares at a fixed price in the future in the event the company does well and the stock appreciates to a higher value than the bonds.
On the other hand, call options benefit only the issuer. The option allows the issuer to simply pay off the bond at some date prior to maturity if they can refinance the bond at a lower rate. So, let’s say you have a 20 year bond at 5%, but six years after issue the company has the option to pay it off. After six years interest rates have declined. Of course, your bond is called. Now you have your face amount back without the appreciation you normally would have expected when interest rates decline. However, you can’t reinvest the proceeds in a similar issue at the original coupon rate due to the lower interest rate environment. Conversely , if interest rates climb above 5%, you are stuck with the lower coupon until maturity and lower market value than your face amount.
Whenever an existing bond changes hands all the above considerations factor into its price as well as prevailing interest rates along with any change in the perceived credit quality of the issuer.
Speaking of credit quality and ratings, I hope no one out there seriously believes in the integrity or competence of the credit rating agencies. That none of their executives are in jail shakes my faith in karma.
Once you leave the US Treasury market, bonds get much more complicated than stocks.
Given all the wrinkles that impact bond pricing and returns, retail investors should probably not try managing a bond portfolio at home. It’s highly unlikely that you can ever do enough research to compete on a level playing field. A very smart guy (or lady) with unlimited real time information will invariably be on the other side of your transactions. Bond traders are not fiduciaries. Your best interests don’t interest them. They manage their own portfolio to maximize their own profits.
Your best bet to capture most of the benefits that fixed income might produce will probably be a low cost index fund or ETF that matches your duration and credit preferences. That way you will get institutional pricing on transactions, broad diversification, management, prompt reinvestment of your interest payments, liquidity, daily pricing, and transparency at an exceptional value point.