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All About Bonds by Paul A. Merriman Publisher and Editor
Some investors tell me they would never have a portfolio that includes bonds. And sometimes I’ll run into an experienced investor who confesses that he or she has never been able to understand bonds. This always surprises me, because the basics of bonds are quite easy to figure out. In half an hour, an investor can learn enough to put bonds to work either as part or all of a portfolio. And on the other hand, there are enough wrinkles and nuances of bond investing to keep some people occupied for a lifetime trying to master all the fine points.
Sooner or later, most investors will own bonds or fixed-income instruments that I think of as bond alternatives. For many people, that should happen sooner instead of later.
In the first part of this article, we’ll go over the basics of bonds: How they benefit investors, the different types of bonds and the merits of individual bonds vs. bond funds. In the second part, we’ll make recommendations on how to use bonds to increase your income, stabilize an equity portfolio, get a decent yield on your emergency funds and manage your regular cash flow.
THE BASICS OF BONDS
What are bonds?
Whenever I have the opportunity, I talk to high school students about the basics of investing. It’s always pretty easy to get them to comprehend what bonds are and how they’re different from stocks.
One of the most fundamental decisions every investor makes, I tell these students, is whether to “own” or to “loan.” I ask them to imagine that in the mid-1980s, Bill Gates comes to their classroom and asks for help raising money to build his small software company. He offers them a choice: Loan me $100, and I promise to pay it back with interest after five years, or give me $100 and I’ll give you three shares of stock in my company – but no promises that you’ll ever get back your $100.
This, of course, is the difference between a bond and a stock. All the students know the “right” choice in the case of Microsoft 15 years ago. But if the offer had come from one of Microsoft’s larger rivals at the time, for instance a now-forgotten software company named Ashton-Tate, an IOU would have been the better choice.
As you know, a stock represents ownership, and it’s worth only what somebody else is willing to pay for it. But a bond is a promise to pay you back on a specified date in the future, called the maturity date, as well as interest payments twice a year in the meantime. Therefore, if your priority is to make as much money as you can because you believe in a company’s prospects, you should buy the stock. But if your priority is to be repaid, with interest, and to minimize the risk of losing your principal, you should buy a bond.
Bond Prices
One thing every bond investor should understand is how prices fluctuate on the secondary market. In a nutshell, bond prices go up and down in the opposite direction from interest rates. Here’s a simple example. Suppose a company issues a $1,000 bond that pays 8 percent interest, with payments of $40 every six months. Then imagine that one year later, interest rates have risen very sharply and new bonds of comparable quality must pay 10 percent, or $50 every six months, in order to attract buyers.
Nothing has changed about the 8 percent bond, which still pays $40 every six months. The company will still pay back the $1,000 at maturity. But now, investors expect to get a higher yield, and they won’t pay the face value of $1,000 for an 8 percent bond when they can buy a new one that pays 10 percent. If you own the year-old bond and want to sell it, you’ll have to sell it at a discount that makes it competitive. Mathematically, the 8 percent bond’s interest payments would have a current yield of 10 percent only if that bond could be bought for $800, so investors are likely to offer you something in that neighborhood for that bond. The “price” of the bond has just fallen by 20 percent, and an investor who sells it in the secondary market will take a big loss.
On the other hand, if you keep that bond you’ll still get your $40 every six months and your $1,000 at maturity. This leads to a rule of thumb that says you don’t lose money on a bond if you hold it to maturity.
But now let’s see what would happen if interest rates changed the other way and new bonds were being issued at only 6 percent. What do you think happens to the secondary market value of the 8 percent bond? Right! Those 8 percent bonds are now worth more. Mathematically, they should sell for $1,333.33 in order to produce a 6 percent current yield. The investor who sells that 8 percent bond at this price makes a nice profit.
But there’s one little wrinkle in this scenario. The investor who makes that profit has to reinvest the money. And with new bonds paying only 6 percent, the whole $1,333.33 must be reinvested in order to achieve the same yield as before. That doesn’t leave a thing for paying the capital gains tax on that profit of $333.33.
Why Buy Bonds
Some people buy bonds in order to speculate on the future course of interest rates. If you believe strongly that interest rates will fall, and if you are right, you can make money by buying bonds and selling them later. But this activity is speculation, not investment, because the future direction of interest rates is never certain, and if rates go up instead of down, you can lose money instead of make it.
Most bond investments are made for one (or a combination) of three reasons: liquidity, stability and income.
Bonds provide liquidity because they allow you to get your money back on short notice with relatively little risk of losing your principal. This is even more true of bond-like instruments including money-market funds, certificates of deposit and checking accounts.
Bonds provide stability to a portfolio because they are normally less volatile than stocks. Our studies show that, based on the past 30 years of history, an all-equity portfolio split equally between U.S. and international stocks would have experienced a worst-12-months loss of 36.4 percent. But converting half of the portfolio to bonds would have reduced the worst-12-months loss to 15.9 percent, a reduction of 56 percent. (The compound rate of return would have fallen from 16.1 percent to 12.4 percent, a reduction of 23 percent. For risk-averse investors, that was a good deal.)
And of course bonds provide income, usually twice a year. Some investors like to structure their portfolios so the interest checks come in every month or every quarter, providing a reliable source for their living expenses. If a bond portfolio gives you an assured regular income that meets your needs, you don’t need to pay much attention to the fluctuations in the prices of those bonds on the secondary market. Similarly, if you own your home and it provides the living space you need, you don’t have to pay much attention to its current market value.
Types of Bonds
There are many kinds of bonds, but the two most important differences involve maturity and quality.
Maturity simply means how much time remains before a bond matures. Term labels are arbitrary, but in general a short-term bond has up to two years left to maturity, an intermediate-term bond is two to 10 years away from maturity and a long-term bond has 10 or more years to go before it matures.
In general, longer-term bonds are more volatile and have higher yields than shorter-term ones. This reflects the increasing certainty about interest rates as the maturity date grows nearer. And of course it also reflects the fundamental principle that higher risks bring higher rewards. To use extreme examples, there’s very little risk in bonds whose maturity date is one week in the future; but if the final payoff is 15 years away, it’s a different story.
Quality differences among bonds reflect the likelihood that the corporation or government agency that issued the bond will be able to make the interest payments and pay the principal at maturity. The bonds of federal agencies and blue-chip companies have the highest quality ratings and are often called high-grade bonds. That means they have below-average risks and below average yields.
At the other end of the spectrum are high-yield bonds, often known as “junk bonds,” which are issued by companies that are distressed and somewhat less likely to be able to redeem their bonds at maturity. Because of the extra risk in such bonds, investors demand higher yields, hence the name high-yield bonds. High-yield bonds are very risky when bought individually. If a company defaults on its bonds, the loss to the investor can be 100 percent. But purchased in funds, which typically own 200 or more bonds, a total loss of one or two issues does not have severe effects.
Between the high-grade and high-yield categories is a large spectrum of choices, with the usual tradeoffs at every step between quality and yield – when one goes up, the other goes down.
Bonds can be further divided between corporate bonds and government bonds, taxable bonds and tax-exempt municipal bonds. Another variation is convertible bonds, a hybrid investment that combines elements of stocks and of bonds. Zero-coupon bonds pay no current interest and are sold at deep discounts, with all their income coming in the form of appreciation at maturity. And of course there are international bonds as well as U.S. bonds.
Individual Bonds vs. Bond Funds
As with stocks, you can invest in bonds by buying individual issues or through a mutual fund. We believe most investors will be better off with bond funds than individual bonds, for several reasons.
Bond funds give investors lots of diversification, vastly reducing the risk from a default of any individual bond. Bond funds provide lots of convenience, with check-writing privileges in some cases and monthly income available if desired. Funds provide automatic reinvestment of interest payments for investors who don’t want regular income. And funds provide professional management to stay on top of interest-rate developments and other factors that affect the bond markets.
To compare bond funds with individual bonds, let’s look once again at the three objectives for which investors use bonds: liquidity, stability and income.
For liquidity, funds are the hands-down winner. If you need $750, a bond fund lets you write a check or request a withdrawal for that exact amount. In a fund, you will always redeem your shares at net asset value, and you can let the fund figure out what bond or bonds to sell. If you own individual bonds, you probably can’t sell one for exactly $750. You’ll also have to figure out which bond to sell, and of course you’ll have to pay a commission.
If you’re seeking stability, individual bonds and bond funds will work equally well to tame the volatility of an equity portfolio. However, if you want to keep track of your portfolio’s value regularly, it’s vastly easier to look up the prices of a few bond funds than to find prices for a portfolio of individual bonds.
If you are seeking a fixed income that does not eat into your principal, individual bonds are your best bet. Each bond will pay a fixed amount every six months. You can assemble a collection of bonds that will let you receive interest checks every month. When one of those bonds matures, you’ll receive the full face value. However, to retain the same income you had before, you of course will have to replace the matured bond with another one that pays interest during the same months.
If you can tolerate fluctuations in your monthly bond income and you want at least some protection against inflation, choose a fund. Because the fund is constantly buying and selling bonds, its income is not constant. As interest from older bonds is replaced by that from newer ones at higher or lower interest rates, the fund’s income – and thus its monthly dividends – gradually move up and down in a way that follows the trend of interest rates.
If you need a fixed income and you’re willing to sometimes dip into your principal in order to achieve it, a bond fund is for you. If, for example, you need $2,000 each month, a regular withdrawal from a fund can include both income and principal, as needed. You can have the fund send you a check – or transfer funds into your money-market fund – every month for exactly what you need. You can’t do that if you own individual bonds.
Types of Bond Funds
Bond funds are usually divided first by the source of the bonds they invest in. For example there are government bond funds that invest in obligations of the federal government, corporate bond funds that buy (naturally) corporate obligations and municipal bond funds that buy obligations of state and local governments. Within each of these categories, there are differences in quality (from high-grade to high-yield) and duration (from short-term to long-term).
In general, higher quality bonds have lower yields, and vice versa. Every bond fund will have its own mix of quality, best measured by average ratings of the bonds in a portfolio. That information is available at www.Morningstar.com. Even high-yield bond funds are not all alike; some stick to the high-quality end of this type of bond, while others dip much deeper into the well of trouble in search of higher returns.
Municipal bond funds are appropriate for investors in high tax brackets, as the interest paid on those bonds is exempt from U.S. income tax and (in some cases) state income taxes.
Bond Alternatives
Some fixed-income investments are not strictly bonds, but they have some of the same characteristics and uses. I consider them bond alternatives.
Checking accounts, savings accounts and certificates of deposit issued by banks and credit unions are usually insured by the federal government. They pay varying rates of interest – and some checking accounts pay none.
Money-market mutual funds are not federally insured, though some invest solely in securities issued by the federal government, making them all but insured. These funds are usually priced at $1 per share, and no individual investor has lost money in one. Their interest varies daily and almost always exceeds the interest paid on bank savings accounts.
Bank money-market deposit accounts are covered by federal insurance, but they usually pay significantly less interest than non-insured money-market mutual funds.
Income-producing stocks are sometimes substituted for bonds. These include utility stocks and real estate investment trusts, which typically pay relatively high dividends and have relatively high volatility.
U.S. savings bonds are issued by the federal government. Some pay regular interest, some simply appreciate gradually toward maturity. A new variation, the “I Bond,” guarantees a fixed basic interest rate of 3.6 percent for as long as the bond is held plus an inflation rate that is calculated twice a year and tied to the Consumer Price Index. The current combined rate is 7.49 percent. Interest is tax-deferred until the bonds are cashed in.
RECOMMENDATIONS
Emergency funds: The best way to keep money to which you want immediate access is in a short-term bond fund. Most major no-load fund families have these funds, which usually give you check-writing privileges like you would get with a money-market fund. The principal in these funds will fluctuate, so you can lose money. But these funds’ higher yield is ample compensation. My favorite short term bond fund is Vanguard’s Short Term Corporate Bond Fund. If you’re especially conservative, choose an ultra-short-term bond fund such as Strong Advantage. It will pay lower interest, but its volatility is lower as well.
Daily and monthly cash flow: The bank checking account is seldom your best deal. Most pay paltry interest – or none at all. Their federal insurance guarantee is a bonus, but the chances that you will ever need it are remote. You’ll get much better interest, and virtually all the same conveniences, with a money-market fund. Many large brokerages and fund companies offer money-market funds without a minimum balance requirement, without a minimum size check you can write and with debit cards to give you instant, widespread access to your money. These accounts are usually available to customers who keep a minimum balance in funds or other securities at the brokerage firm or fund family. Strong Funds, to name one company with which we are familiar, offers such an account as part of its Strong One service, with no maintenance fee for customers with Strong mutual funds balances that total at least $10,000. With an account like this, you probably don’t need a bank.
Monthly income: Our recommended bond portfolio for generating monthly income consists of three Vanguard bond funds: GNMA, High-Yield Corporate and Long- Term Corporate. In mid-November, these funds’ current yields were 6.78 percent, 9.27 percent and 6.97 percent, respectively. Table 1 shows quarterly returns from January 1987 through September 2000 for each of these funds, and for the composite average of the three funds.
Staying as close as possible to the comfort of certificates of deposit: Really risk-averse investors can keep most of the comfort of government-guaranteed CDs, and still get higher returns, by investing in bond funds that own only securities issued by the federal government. My suggestion is to leave half your CD money where it is, invest 25 percent of it in Vanguard GNMA and 25 percent in Vanguard Short-Term Federal.
Stabilizing a stock portfolio: The best way to stabilize a stock portfolio, based on extensive research, is to invest in bonds of one to five years duration. Investors who use longer-term bonds may get a higher return from the bond part of their portfolios, but they will do so only by accepting higher volatility – which is exactly what bonds are trying to reduce. If you want to raise your level of risk a bit in order to raise your overall return, we believe the best way to do so is to increase the percentage of the portfolio that’s in stocks, not move to longer-term bonds.
The Ultimate Bond Alternative
This leads me to propose my very favorite use of bonds: to make up one-half of a total portfolio, the other half of which is equities. Of all our core investment strategies, the most popular with our clients is what we call the Worldwide Balanced Portfolio. It invests one quarter of the money in U.S. stock funds, another quarter in international stock funds and the final half in U.S. bond funds and each part is timed.
Obviously many variations are possible on this theme, but over and over again we have found that this combination of half stocks and half bonds works well for people, especially retirees who need to protect themselves against bear markets while they provide the growth potential of stocks.
We have managed these assets for many years using proprietary market timing systems and a variety of funds. But in Table 1 we show a simplified implementation of this strategy using only three funds and public domain timing systems that anybody can use.
I think the Worldwide Balanced combination is a very strong alternative to the three-fund combination we show in the table. Going from the combo to Worldwide Balanced improves the annualized return from 8.4 percent to 11.5 percent; that’s the difference between having $100,000 grow in 25 years to $750,000 (in the bond combo) or to about $1.5 million (in the Worldwide Balanced) – at a similar level of risk as measured in number of losing quarters, the average of those losses and a lower risk level as measured by the worst four rolling quarters.
Some conservative investors may be intrigued by these figures but still uncomfortable putting half their portfolio in equities. For them, I calculated another variation that’s not shown in the table: a portfolio equally split between the three-bond-fund combination (without timing) and the Worldwide Balanced strategy with timing. This new combination, which keeps 75 percent of a portfolio in bonds, would have produced an annualized return of 10.1 percent over the period covered in the table, with 10 losing quarters averaging only 1.1 percent losses. And the worst-four-quarters measurement was a loss of 2.1 percent.
Compared with the three-bond-fund combination, this 25 percent excursion into equities raised the annual return by 20 percent – from 8.4 to 10.1 – without any significant increase in risk.
Source: http://www.fundadvice.com
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