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The Benefits of Bonds
True financial planning involves more than just creating a document
 Why
Bonds?
1. Bonds, otherwise known as fixed-income securities, can help provide competitive,
if not superior, total returns in certain market environments.
2. Bonds diversify equity-dominated portfolios.
3. Bonds produce income streams.
Frequently, many investors overlook the benefits of bonds. Many times it
is not a deliberate decision, rather it is one of a lack of familiarity,
comfort or understanding of the great many benefits that bonds have to offer.
Everyone knows how to make money (or lose money) by investing in stocks - it
seems so basic: buy a stock at $10 per share and if it goes up to $13 you
have made a tidy little profit in percentage terms. Because it is not so
quick or transparent, the way to make money by investing in bonds is often
misunderstood. But rather than focus on the total return (trading for a gain)
aspect of bonds, maybe it is better to think about the bigger and more important
role of bonds in a portfolio and the tremendous benefits they offer. As one
study points out - "finance theory does offer a free lunch: the reduction
in risk that is obtainable through diversification. An investor who spreads
wealth among many investments can reduce the volatility of the portfolio..." Yet
we have found over the years that many investors take a pass on the free
meal.
We believe that well-balanced, diversified portfolios will offer superior
risk adjusted returns over time. One of the easiest and most common ways
to diversify an equity-dominated portfolio is through fixed income investing.
Fixed income investing not only helps reduce risk in a portfolio, it also
provides income that can be either taxable, tax advantaged or tax-exempt
and provide a way for investors to ride out otherwise unattractive investment
cycles and options that are inherently more volatile. An allocation to bonds
should be viewed as a component of a complete portfolio.
As for how much an investor should hold in bonds, that depends on a variety
of factors, including investment objective(s), time horizon, risk tolerance,
and other unique considerations.
A few commonly asked questions:
Q: What exactly is a bond?
A: A bond is essentially a loan and bondholders have a promise of repayment
from the borrower. It is a debt security, issued by a corporation or government,
with a stated interest rate (coupon rate) and fixed maturity date when the
principal must be paid back. The coupon payment dates usually occur every
six months. Typically they trade in denominations of $5,000 face value for
municipal bonds though Treasury, agency and corporate bonds have varying
minimum sizes.
Q: Why are bond yields low?
A: Bond investors generally take on a lot less risk than equity investors
and bond yields are reflective of those lower risks.
There are years when equities produce stellar returns just as there are
others when they produce stinging losses. The last big down year was
in 2002 for example.
The S&P was down 22% while bonds (Lehman Aggregate Bond Index) were up
10%. If an investor had a total portfolio of $100k split evenly between the
S&P and the Lehman Agg they would have lost a total of $6,000 that year
instead of the $22,000 the investor who was 100% in stocks would have lost.
Some investors have higher risk tolerances and accept the higher portfolio
risk for the chance to earn higher returns. For others, they know that they
are still participating in the equity market but with less total exposure
due to the diversification benefit realized by adding bonds to the mix.
Q: How are bonds traded?
A: Bonds trade on a yield basis first and then are converted to a dollar
price. When yields go up, dollar prices go down. When yields fall, prices
go up. Know that a five-year bond bid at a yield to maturity (YTM) of 3.00%
equates to a higher dollar price than the same bond bid with YTM of 3.20%.
Bond math can be confusing but understanding it all begins with this basic
premise.
If bond yields rise in the marketplace and you already own bonds, this
does not mean that you are losing income. Although your month-end statement
might show a decline in market value of your bonds, the income, which is
based solely on the face value, remains constant. Over the life of a bond
there are going to be times when the market value may be higher or lower
than what you paid. In the end, on the last day you receive the face value
back plus the final interest payment.
Q: All of this seems so confusing. Why not just keep my money in cash, CDs,
or money market funds?
A: It can be confusing at first. That is why it is important to understand
what you are doing when investing in bonds. Once you do understand and accept
characteristics of bond investing, you should be better suited for the commitments
you are making.
As for money market funds, bonds tend to offer much better returns than
a pure cash money market but should never be confused with or used in place
of one. Bond prices rise and fall and if an investor chooses to sell a position
before the bond's maturity date then he is subject to the price fluctuations
that are part of any market and investment cycle. Money market funds offer
dollar in, dollar out daily liquidity. While most bonds are liquid and trade
without limitation there can be periods when they don't trade. Bond
investors take on more risk than money market fund investors and receive
higher, locked in rates of return for that commitment.
In short, funds for short-term liabilities should be in cash. For long-term
investors, however, bonds offer higher total returns over time than cash.
Q: Will I get all my money back when I invest in bonds?
A: The odds are very high that an investor in high quality, investment-grade
bonds is going to see a return of all of his money - plus interest
of course, at a future date. Default rates in investment grade bonds are
very low – even lower in municipal bonds. Less than 1% of the muni
market (a market that is about $5.6T in total size) defaulted in a study
that goes back to 1980.
If a company were to declare bankruptcy then the capital structure hierarchy
is worth knowing. Bond investors get paid first. Senior bonds, then subordinated
holders follow them. Next come the trust preferred investors, preferred stock
and finally the common stock holders.
Q: What about bond ratings? What is good and what isn't?
A: The highest rating an issuer can attain is "AAA". Generally
the higher the rating the more secure the bond is thought to be. Investment
grade rated bonds carry a rating of "BBB-"or higher. Bonds rated
below this level are considered to be speculative and carry more risk.
Answering what is "good" is a bit more involved because good
is a matter of perception defined by the individual investor. Bonds do carry
ratings from a number of raters but the two biggest and well known tend to
be Moody's and Standard & Poor's. Less risk averse bond investors
might feel comfortable with a single "A" rated bond while others
may prefer only the highest quality available and settle for nothing less
than "AAA" rated bonds. Of course, the investor in the "A" rated
bond will likely receive a higher yield than the investor in the "AAA" rated
bond.
Q: How have bonds performed in recent years?
A: Bonds have performed very well over the past 10 years. Our table below
shows just how well over the past ten years on an annualized basis. Hopefully
this dispels the perception that bonds "always" under-perform
equities. Of course, past performance is no guarantee of future performance
but we remain bullish on the diversification benefit bonds add.
Q: If bonds reduce portfolio volatility in multi-asset portfolios, exactly
how do bonds "correlate" with other investments? A: "Correlation" is a statistical measure how two securities
move in relation to each other. Perfect positive correlation (+1.0) suggests
that as one security moves, either up or down, the other security will move
exactly in the same direction. Perfect negative correlation (-1.0) meanwhile,
means that if one security moves in either direction the security that is
perfectly negatively correlated will move in the opposite direction. Obviously,
greater diversification benefits can be realized from lower, if not negative,
correlations. Do realize, however, that correlations are dynamic and change
over time.
The correlation table below demonstrates how un-correlated high quality
/ investment grade rated bonds are to equity indices. The negative correlations
of the major fixed-income indices are the primary take-away point that stands
out from the information below. (Note: there is nothing special about the
beginning date of September 2001 – this was the point where our data
begins for the Lehman Brothers TIPS Index).
Q: What about "premium" bonds? Why would I ever pay above $100
for a bond when it will mature at $100? Won't I be taking a loss? A: This is the next step in understanding bond math. Once again - bonds
trade on a yield basis first. If a five year muni bond with a natural "AAA" rating
is worth a rate of 3.00% then that is the first characteristic to focus on.
If it is offered with a yield of 2.90% know that it is over-priced. If you
can find one offered at 3.10% know that it is a good bargain.
Premiums do not necessarily mean losses. Any premium paid will be paid
back to the investor gradually over the life of the bond if held to maturity.
It comes back to you bit by bit every six months in the form of interest
payments. The reason the bond trades at a premium dollar price is because
its coupon is higher than its yield to maturity. You pay the premium in order
to receive higher coupon payments. Often times the investor in a premium
dollar priced bond will pick up a little extra yield to help compensate.
Premiums need to be understood. If an investor is withdrawing all of the
income the bond produces then that is effectively spending down the principal
by the amount of the premium paid.
Q: What are "callable" bonds?
A: A callable bond means that the issuer holds an option, at their discretion,
to redeem the bond at a date prior to the stated maturity date. Usually they
would do this if their cost to borrow money in the bond market falls.
Think of it this way: If you had a 30-year home mortgage at 7.00% and rates
fell a year later to 6.00% you could refinance your loan, pay a lower rate
and realize and interest expense savings. Bond issuers have the same ability
to refinance and lower their borrowing costs. However, bond issuers do typically
have to wait a period of time before they can "call" bonds. In
the muni market new issues typically come to market with a standard 10-year
call protection agreement for the investor. This means that if you invest
in a new issue bond with a fifteen-year maturity that you are guaranteed
that the issuer won't call the bond for at least ten years.
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