Bond Investing: Is Following Conventional Wisdom Always Best?

When it comes to bonds, the old adage, “they ain’t what they used to be,” may hold good wisdom in this challenging economic climate. Bonds are essentially loans that investors make to domestic and foreign corporations, U.S. and foreign governments, as well as state and local municipalities. As such, they represent a wide spectrum of investment opportunity. Some, particularly U.S. Govt., higher rated corporate and municipal bonds, have been traditionally viewed as a “safe haven” and buffer against stock market volatility. Others, such as high yield and international, may offer greater risk with varying degrees of upside potential. Bonds have also been sought for their diversification and for reliable competitive interest rate returns.

However, in this environment of low interest rates, sovereign and municipal debt uncertainties, some of these long held beliefs are being called into question. Clients, perhaps more than at any other time over my nearly 30 years of advisory experience, are raising issues that I thought would be helpful to address:

Are bonds not a safe investment that should be part of every investor’s portfolio especially as they approach retirement? Bonds are traditionally used to provide predictable income, diversification, and a buffer against portfolio volatility. That is why so many investors flocked to bonds in the aftermath of the Financial Crisis. In fact, “… since January 2007, average net new money going into bond mutual funds each month has been roughly four times greater than net outflows from equity funds.”

However, the correlation between bonds and stocks is seen as getting closer to the point whereby they may no longer offer the kind of diversification as they once did. And, the low interest rate environment has offered disappointedly low income opportunities when compared with other options such as dividend paying stocks.

Many economists point to the increased volatility of bond markets and that bond losses can be greater and continue for longer periods than those of stocks. For example, the bond markets experienced a 67% decline (in real terms) occurred Dec. 1940 – Sept. 1981 for 20 year U.S. Treasuries. In fact, they did not return to their 1940 level until 1991.

Of course the definition of a “safe investment” will vary between investors. For those who define it as stability of principal, it is important to fully understand the risks posed by bonds at a time when market rates are low and perhaps poised to rise.

Are bonds a good investment when interest rates are low? Traditional (i.e. fixed coupon) bonds have their maturity and interest rates set at the time of issue. As such, they can be viewed as contracts, many of which are bought and sold daily. Because interest rates are constantly changing in the market place, the value of those fixed contracts will fluctuate as well. For example, if a bond is issued at a 5% rate and the next year market rates rise to 6%, investors are less attracted to the 5% bond. Consequently the price could fall. Conversely, if rates should fall to 4% the next year, the bond becomes more attractive and the price could rise. Because of this, the price of bonds is said to be “inversely related” to interest rates. So when market rates have been low and begin to rise, we could expect to see bond values fall. Investors need to be aware that buying many types of bonds in a low rate environment could cause their bond portfolio to decline in value when rates rise.

Should I buy bonds at a premium? A low interest rate environment often makes bond prices rise on the secondary market resulting in the trading price exceeding the bond’s par value. Problem is, when that bond eventually matures, it is the par value and not the cost that gets redeemed. An income investor who spends the interest generated along the way could end up with less than the purchase price when the bond is redeemed.

Proponents of premium bonds may argue they can be effective when the interest is reinvested instead. However this “Total Return” strategy can present some challenges. First, reinvestment of interest payments can be difficult if the amounts are too small to purchase additional bonds. If reinvestment is impeded, the return on those interest payments will be limited which will reduce overall performance. Second, premium bonds can experience greater volatility as interest rates rise. Even investors who are planning to hold bonds to maturity can become unnerved to see their account values fall abruptly. Bottom line, purchasing premium bonds can pose greater risk than what may be apparent and should be considered carefully.

Should I buy bond mutual funds? Mutual funds offer some very positive advantages: Diversification, reduced costs when compared to individual bonds, professional management, simplicity, liquidity and convenience. There is of course a very broad spectrum of bond funds, varying by bond type, maturity, strategy, open versus closed end fund, etc. It is important to keep in mind that individual bonds typically have a return of par value that is guaranteed by the issuer. When we invest in open end bond funds, we are buying into an existing portfolio of bonds that is perpetual. This implies that as bonds within the portfolio mature, the proceeds are usually reinvested in additional bonds. So, to that extent, we lose the predictability of maturity that individual bonds provide, which may create additional uncertainty and risk factors.

Also, bond funds may be advertised for their relatively high yields, modest average portfolio maturities and average investment grade. Bond funds, like all mutual funds, are hardly transparent. We typically do not know the current portfolio holdings until 3-6 months after the fact, a practice funds use to prevent “front running.” The key is to remember that “average” means there are just as many bonds below as above the figures. So if a fund’s yield seems too good to be true, it is likely being raised by inclusion of lower grade and/or longer maturity bonds that are being masked within the averages.

Finally, bond funds typically charge 0.50-1.5% in annual management fees. Especially in a low rate environment, managers are particularly challenged to deliver sufficient value that can compensate for their fees. Certainly there are opportunities to add value, especially when dealing with more aggressive segments of the bond markets. For example, the managers that are somehow able to help their investors profit from the European sovereign debt crisis could be worth their weight in gold! Similarly, those who can successfully navigate the challenging waters of municipal debt and high yield “junk” bond could potentially deliver exceptional value that more than offsets their fees. But many of these could be considered speculative and only suitable for the more aggressive investor. For more moderate risk investors seeking a “safe haven” and reliable income, many bond funds can be highly challenged in a low, potentially rising rate environment to earn their keep and more challenged to protect their investor’s principal.

If inflation should rise, what would this mean to my bond investments? Inflation can be a dirty word where bond investors are concerned. The reason is and as was noted above, most bonds provide a fixed income stream for their lifetimes. When inflation rises, of course, the purchasing value of such fixed income streams can erode. So even the very hint of rising inflation can cause volatility in bond markets as bond investors will often sell their holdings and move to cash. Of course, there are exceptions, such as “floating rate,” “Treasury Protected Inflation,” and “high yield” bonds, which, if properly managed, may have a greater potential to perform. These aside, in our current environment, where many economists fear that greater inflation may be coming and that the U.S. Govt.’s official inflation indices may not be accurately tracking inflation increases , bond investors should be wary.

Should I be worried about talk of a “bond bubble? Certainly in the aftermath of the financial crisis, investors poured inordinate amounts of money into individual bonds and bond funds as they sought “safe haven” from the stock market declines. This was particularly the case but not confined to just U.S. Treasuries. Jeremy Siegel, renowned author and finance professor at Wharton, has continually warned of bond bubbles developing in 2010 and 2011. “Now bond bears say the latest rally is setting up the bond market for an even bigger crash (than that of stocks in 2008-09) once interest rates start to rise again.” It is almost axiomatic that when we see investors move money at greater than normal rates into a given investment sector, there is cause for concern. Especially given the cyclical nature of markets, there is certainly enough data to, at the very least, cause concern.

Longer maturity bond have higher yields; should I invest in them? Yield-hungry investors are often tempted by advertisements promising higher interest rates. Mutual funds may also use longer term bonds to help increase their stated yields. It is important to realize that these higher yields come at a price which is often in the form of greater volatility. The fact is price sensitivity can be affected by a bond’s “duration.” This is a calculated figure based on several factors including the bond’s interest coupon and its length of time until maturity. It is widely accepted that “… the greater the length of the bond’s remaining term, the more sensitive it will be to changes in interest rates.” Simply put, higher duration and/or longer maturity implies greater price sensitivity, which translates to increased risk. Investors should be mindful of this in considering whether longer term bonds may meet their needs.

Which types of bonds are most at risk should interest rates rise? Historic trends also give us some sense of priority and also risks:

• Treasury Bonds provide a reliable return when held to maturity, so they historically exhibit the greatest price decline when market rates increase.

• Corporate Bonds, because they offer higher yields, can be less sensitive to rising interest rates.

• High Yield Corporate Bonds, because they are typically below investment grade, usually offer higher interest rates. However, since their fortunes are based more on the issuer’s performance, these can move more in sync with the stock markets and may be the least sensitive to rising rates. “…the problem is that the correlation between high yield bonds and equities has demonstrated a nasty tendency to spike upward just when it is most important for it to remain low – for example, when equities are experiencing negative returns. Again, this is because much of the return of high yield bonds is a result of risk premiums associated with equities, not debt.”

• Treasury Inflation Bonds are designed with the goal of maintaining relatively stable principal during rising rate environments. Whether they do or not depends on many market factors and upon who the issuer is. “One market that now makes no sense to us is the popular Treasury Inflation Protected Securities (TIPS), where … the yield on the benchmark 10-year TIPS turned negative for the first time in history….”

• Floating or Adjustable Rate Bonds are loans that financial institutions make to businesses that are often below investment-grade credit quality. As such, they have a high debt-to-equity ratio and typically generate yields that are greater than investment-grade bonds. Analysts and financial regulators alike have expressed concern to the point of issuing an investor alert, as “… investors may not realize that they could be taking on more risk if they invest in products with higher returns.” The alert was prompted by the four-fold influx into floating-rate loan funds between 2008 and 2011.

All said bonds values can decrease sharply when interest rates rise. For example, Treasury yields need only rise 0.3% over one year on average to produce a loss on the Barclays Treasury index, according to a First Pacific Advisors study. Their advisors see interest-rate risk as at the greatest it has been since the 1950’s. Further, the 10-year Treasury yield is projected to rise to 3.8% by year end, according to the median estimate of 70 economists and strategist surveyed by Bloomberg News.

Conventional wisdom suggests that traditional fixed income instruments, including bonds of various types, have an important role to play in most investor’s portfolios. However, in our current low interest environment where the uncertainties are great, many analysts do not see an attractive reward potential to offset the myriad of risk involved in significant bond investing. In fact, some see bonds as almost impractical on a risk/reward spectrum. It may very well be that on a longer term basis, we certainly embrace bonds in most clients’ portfolios. But at a time of so many potential risk exposures, it may be prudent to consider other strategies that can help control portfolio risk and provide predictable cash flow when needed.

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