Bonds are an investment vehicle which many investors, from individuals to institutions, find attractive and desirable as a part of their investment package. Bonds are obligations of the issuer to the purchaser and are usually issued for a set period of time with regular payments of interest to the purchaser from the issuer occurring during that term. Generally speaking, bonds are seen as less risky than stocks and other investments and are also valued in terms of providing income to the investor.
Before you get too excited about owning bonds, though, it is important to remember that like any other investment bonds carry risks and uncertainty. Bonds also are affected by the markets, the central banks, political events and much more. Here are several things you might want to know about bonds that would help you understand how and when you might use them. Of course, consulting with your financial advisor and learning what you can from other resources are also very helpful with bonds as with most other investments.
Should you own individual bonds or own bonds within a mutual fund or ETF? An investment vehicle that owns a variety of bonds, such as a mutual fund or ETF, is generally very diverse and typically has a low expense ratio. Though individual bonds can be purchased to obtain a level of diversity, it is unlikely that it will approach that offered through a mutual fund. Further, individual bonds can be expensive to purchase. When a client requires liquidity, that provided by a mutual fund or ETF is generally much better than a portfolio of individual bonds. As we will see below, this is only one factor in the selection of a bond investment.
What is the attraction of Treasury bonds? Treasury bonds issued by the US government are in a class by themselves. Sometimes referred to as inexpensive insurance against the risks inherent in stocks and other securities, these bonds are seen as a safe haven for investors. Most in the financial industry view treasuries as a form of guaranteed investment backed by the government and at the same time paying interest. These bonds are often a cornerstone in many investment portfolios and may be obtained individually or as a mutual fund or ETF.
What are callable bonds? Many bonds carry with them a provision allowing the issuer to call the bonds – that is, to redeem them – prior to the end of the term. The purchaser would receive the value of the bond but interest payments would cease at that point. The call option allows an issuer flexibility in a time of changing interest rates so that the issuer might be able to replace a higher interest rate bond with a new issue at a lower interest rate, for example. In the current financial environment, the volume of bonds being called in by the issuers is higher than normal. The fact that a particular bond is callable will have little or no effect on an investor in a bond mutual fund or ETF.
How might a default affect a bond investment? When the issuer – a corporation, foreign government, local or state government – runs into financial difficulties it may be unable to pay the interest due on bonds it has issued (think of Greece, Puerto Rico, Detroit and the like). Such a default often leads to negotiation between the issuer and its creditors (the purchasers of the bonds) or perhaps even a failure to pay with or without any negotiations. Such agreements may provide for what is termed a haircut to the purchaser’s interests, saving the issuer some of the cost on its obligation. Do not be misled by the use of that term haircut because it usually is more akin to major surgery and painful to the investor. However, remember that the interests of bond holders stand higher than the rights of shareholders in a business and so they will be paid first, before shareholders. This suggests that owning stock in a business is riskier than owning bonds issued by that same business – but remember that the bond holders will not participate in any gains in value the business experiences.
Should you be worried about zero or negative interest rates? The central banks of some countries have moved to negative interest rates on some types of transactions, and according to Fitch Ratings, “government bonds with negative yields have grown to $11.4 trillion”.[i] This suggests that there is opportunity for investors to own such bonds, although it is unlikely that you will be interested in bonds that carry negative yield. After all, a major factor for most bond investors is to be paid for providing the issuer funding it needs for its purposes and not to simply preserve most of one’s invested capital. However, fears that economies and markets may do badly encourage some investors to accept a little loss so as to avoid a potential larger risk.
The flip side is, of course, that attempts to maintain the desired yield will result in investors taking on more risk such as by exposure to bonds from emerging markets or less creditworthy issuers.
In the context of bonds with no yield or negative yield, note that a zero coupon bond – another type of bond product – does not in fact pay interest to its purchaser during the term of the bond. However, at maturity such bonds generally pay more than the face value of the bond, in effect deferring the interest until the end. Such bonds tend to vary significantly in value during the term and may not be appealing to investors seeking certainty.
What are convertible bonds? Some bond issuers offer convertible bonds which, under certain specified circumstances, may be converted into stock of the issuing company. These bonds typically pay interest – the coupon – during the term until maturity or conversion. When the bond is converted, instead of a return of investment, the purchaser will receive stock in the issuer. When the issuer does well, the holder of a convertible bond may choose to receive stock and participate in that positive performance. While holding the bond, where the issuer performs poorly, the purchaser has better downside protection with the bond than the shareholders in the issuing company.
What is the attraction of municipal bonds for my portfolio? Municipal bonds are intended to raise money for a variety of government activities and are made more attractive by offering tax advantages to their purchasers. Income from most municipal bonds is free of taxation at the federal level and, if offered by a state or subdivision thereof will be free of the issuing state’s income tax as well. This can be a strong incentive for many higher income investors who desire the tax break.
What form of municipal bonds might I consider for my portfolio? A common form of municipal bonds is that of general obligation bonds of the municipality which bonds are paid out of the municipality’s tax revenues and backed by the “full faith and credit” of the municipality. However, recent trends for revenue and expenses in some areas have left municipalities considering non-payment of their general obligation bonds or at least a “haircut” in what is owed to the bond holders. This risk should not be ignored when choosing or retaining bonds.
The largest subset of muni bonds is the category of revenue bonds which are associated with activities which generate a stream of revenue that is dedicated and used to service the bonds. This includes activities such as hospitals, sewer or wastewater, municipal power, airports, toll roads and a variety of other similar services. These bonds tend to exhibit less volatility than the general obligation bonds which are affected directly by the health of the municipality and local economy.
Finally, there is a more limited category of high yield municipal bonds based on more non-traditional activities such as the tobacco settlement proceeds. These bonds can provide greater returns but may carry more risk.
Where do corporate bonds fit in all of this? A corporation may issue bonds in order to obtain funds for the business, whether for expansion, capital investment, or simply to provide current liquidity for operations. Those bonds are rated based on the perceived creditworthiness of the corporate issuer. Oftentimes, the more robust and healthy the business of the issuer, the lower the interest rate necessary for it to offer prospective buyers of their bonds. At the outside, companies with fewer resources or weaker management pay high yields in order to secure the financing. As in many arenas, this investment carries with it more risk for a chance at more return.
These are just a few of the questions you might ask about bonds and there is plenty more to know about these investments and the many forms they take. Your adviser should be able to point you in the right direction for your needs as well as answer any questions you may have regarding specific bond investments.
[i] “Bond Funds Turn Up Risk”, by Carolyn Cui and Mike Bird, the Wall Street Journal, August 15, 2016.
George Chamberlin & Mentor RIA Consulting ©2016