The Appeal of Bonds

“We must all suffer one of two things: the pain of discipline or the pain of regret or disappointment.”

                   Jim Rhon, entrepreneur/motivational speaker

As fixed-income investments, bonds are all about income. Cash flow will be consistent, based on the bond’s coupon, until the bond matures. Each day that passes, the bondholder is accruing income and shortening the bond’s maturity, even though those changes aren’t reflected in the value of their account.

The risk in bonds is in their price, which fluctuates. Bond prices are affected by many factors, including interest rates and inflation. When interest rates increase, yields increase, too, and bond prices generally move in the opposite direction.

With interest rates rising, many investors are concerned about the impact that will have on the price of their bonds, but the Federal Reserve Board has already said that rates will remain below normal levels for years to come. It’s doubtful, for example, that the yield for a 10-year Treasury will exceed 3% anytime soon.

In addition, inflation will likely remain low for some time. The U.S. inflation rate has dropped from 2.7% in February to just 1.6% in June.

And while changes in price matter, most of a bond’s return comes from its coupon. Recognize that it’s all about cash flow and you’ll understand why bonds are a safer investment than stocks.

Income Isn’t a Loss

During retirement, many investors live off of the income produced by their bonds, so they generally have higher-coupon bonds in their portfolios. Investors who purchase bonds with a 5% coupon in a low-interest rate environment, for example, will pay a large premium, but the majority of that premium is going to come back in the form of cash flow.

If the bond has a 10-year maturity, it will take 10 years for the investor to collect all the coupons and make the portfolio whole again. If the portfolio is a premium portfolio and the investor is receiving the income, the portfolio is going to look as if it is constantly losing money. It’s not, given that the investor is receiving income.

Duration Is Key

Income aside, bond investors can minimize the impact of rising interest rates on their bond portfolio. The key is to be positioned in bonds that will maintain their value even as rates rise. That generally means investing in bonds with a short duration, but other factors should also be considered, such as average maturity, credit quality, sector allocation and your top 10 holdings.

Duration, a measure of a bond’s sensitivity to changes in interest rates, quantifies the change in a bond’s price based on changes in its yield. It takes into consideration all cash flows of a bond’s principal and interest payments, discounting cash flows to their present value.

When interest rates increase by 1%, for example, a bond’s price will decrease by an amount roughly equal to its duration. Conversely, when rates increase by 1%, the bond’s price will increase by its duration.

For example, consider a GE corporate bond with a duration of 10 years and 3% due on Nov. 15, 2027. If interest rates rise by 1%, the bond’s price would decline 10%. If the duration were five years, a 1% increase in interest rates would cause the price to decline by 5%. If interest rates fell by 1%, the price would increase 10%.

The shorter the duration, the less sensitive the bond will be to changes in interest rates. Typically, the larger a bond’s coupon the shorter the duration, because a greater proportion of the cash payments are received earlier.

Selling your bonds with the longest duration will go a long way in protecting your principal in a rising rate environment. By shortening the duration of your bond portfolio you will have an opportunity to reinvest your bonds at higher interest rates as they mature.

Call Features Also Matter

Whether you’re invested in individual bonds or bond funds, it’s important to know the duration of your bonds, but it’s also important to know if they have call features. For example, a Marlborough Mass Go 4.13% bond that matures on June 15, 2025 has a call feature that allows the municipality to call the bond on June 15, 2018 at a price of $100.

The call date acts as a buffer until rates rise above the coupon. If interest rates move higher, the bond’s call feature is no longer an attractive feature and the bond’s price will adjust from pricing at the callable date to its final maturity. This means the bond converted from being a short-duration bond to a longer duration bond, which will have an impact on its price.

Laddering Is Flawed

Some investment managers use a technique called “laddering” to reduce exposure to interest-rate risk, but this method is flawed.

To build a laddered portfolio, you purchase bonds that mature throughout a set investment period. Maturity dates are evenly spaced across several months or several years, so that the bonds mature and the proceeds are reinvested at regular intervals. For example, if you invest in a 10-year bond ladder you may own bonds that mature in two, four, six, eight and 10 years.

As each year passes, you reinvest the proceeds of the bond that matured into new bonds that mature in 10 years, so you are always maintaining the 10-year ladder structure.

By laddering your portfolio, you are spreading your risk over not only different time periods, but different interest rates.

The problem with laddering is that it is based on when the bond becomes due, rather than paying attention to the business cycle. It is a long-term strategy that does not take the current interest-rate environment into account. Using a 10-year ladder, an investor may be forced to continue to have long-term bonds, even though long-term bonds are especially sensitive to interest-rate increases.

Managing Risk

The stock market has been setting records, so why keep any money in bonds? One reason is that the stock market has been setting records.

We’ve previously referenced Shiller’s cyclically adjusted price/earnings ratio (CAPE), which as a mean average for all stocks since 1870 is 16.7. We expressed concern about stock valuations in December, when it hit 27.2, which put it historically in the 95th percentile. Today, as I’m writing this, it’s at 30.05, which is the level it reached on Black Tuesday in 1930.

No one knows what the stock market will do tomorrow, so it’s important to manage risk by diversifying with other investments. John C. Bogle, founder of the Vanguard Group, has been quoted as saying that diversification “is not only the first most important thing investors should think about, but the second and the third, and probably the fourth and fifth, too.”

No one knows what the bond market will do tomorrow, either. Early in July rising yields had a negative impact on equities and CNBC noted, “Bond strategists say if higher yields trigger a bigger sell off in stocks it could slow down the upward movement in interest rates, as investors will seek safety in bonds. Bond prices move opposite yields.”

Chasing Yield

While investors typically realize that there’s a world of difference between penny stocks and the blue-chip stocks of companies like Apple and Microsoft, there is a tendency to think that all bonds are alike.

Yet there almost as many different types of bonds as there are stocks. As investors in Puerto Rico’s bonds are finding, some bonds are very risky. Yet U.S. Treasurys are perhaps the safest investment a person can make.

Some investors, though, underestimate risk for the prospect of higher returns. Those who are too conservative regret not taking more risk if the market surges, while those who take on too much risk regret doing so if the market drops in value.

By following an asset allocation strategy, with a set percentage of investments in stocks, bonds and perhaps other investments, you can minimize both “the pain of discipline” and “the pain of regret or disappointment.”

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