Continued from Part 85 . . .
With all of this, why buy bonds? Proper diversification between asset classes enhances portfolio growth because, as someone once said, “When one asset loses, another gains”. That only happens when there is an imperfect correlation between assets. Bonds are the classic asset used to offset potential losses in stocks. After all, a company has the option of distributing dividends or not. But bonds have contractually obligated interest payments and maturity date. If the issuer doesn’t abide by the terms, the company falls into default. A company doesn’t do that lightly.
The recommended (liquid) portfolio is often quoted at 60% stocks and 40% bonds. The reason for the heavy bond component is obvious: losses hurt more than gains help. For example, if one starts with a single asset portfolio valued at $100 and the asset loses 40% (the investment is now down to $60), it would take a 67% gain ($40) just to get back to the original $100. It takes a big gain to offset a small loss. One object (not the only object, but one of several) of good portfolio management is to minimize losses through a selection of imperfectly correlated assets. Bonds can be an important part of that.
Many investors are entirely satisfied with managing their bonds in a minimalist fashion: buy, put the dividends in the cookie jar, and when the bond matures reinvest the principal and accumulated dividends in more bonds. Simple and reasonably safe.
Even simpler, some investors just buy into a bond fund that automatically reinvests the interest received. Still simple, still reasonably safe, and now even easier.
Not everyone, however, seeks safety or simplicity, or even ease. As we’ll see in a moment, there are adventure seekers who chase total return. Total return is the sum of the interest plus the change in principal. The principal is the amount paid by a buyer in exchange for the bond. The amount paid for a bond is elastic: they can be re-sold after their original purchase for more or less than the last guy paid.
When bought on the primary market (primary market: the market where bonds are originated), bonds are supposed to be fixed return instruments. While the bond is still outstanding the investor expects to receive the contracted interest payments (the return on her money). When the bond matures the investor anticipates getting the entire face amount of the bond (the return of her money) restored to her.
But things can be different in the secondary market.
Adventurous people, the Bond Geeks, focus not on simple, safe, and easy returns but on quick profits. These people are active in the secondary market (secondary market: where existing bonds are bought and sold). When dealing in the secondary market, neither the interest rate received by subsequent buyer(s) nor the purchase price a new buyer pays is restricted by the terms earlier agreed to in the primary market. In the secondary market, magic sometimes happens. A bond with a nominal yield of 2% can offer a higher (or lower) yield. A bond designed to return a fixed amount upon maturity can be tweaked to generate capital gains (or losses).
Fluctuations in the Secular Interest Rate
The wizardry can happen in at least two major ways. One is when interest rates adjust to present market conditions. When interest rates change, the value of the bond also changes.
Example : A one-year bond was purchased on the primary market for $1,000. The bond paid $30 annual interest (3%). At the time the bond was bought on the primary market, this was a marketable rate. Then something happened: the market interest rate changed.
Rates Went Up
If the economy became stronger and the market interest rate went up, to say 4%, the market value of this 3% bond would decrease. Rates go up, prices go down. If there were no change in the price, the bond would still be offering the new buyer a 3% yield and nobody would buy it because identical bonds paying $40 were available for the same price. To sell his bond, the current holder (now getting $30 annually) would have to reduce the price he’s asking for his bond until the $30 annual interest represents a 4% yield on the reduced offering price. A moment with a financial calculator shows that, in this case, the bond would be marketable at $990.38. At that price the bond would yield 4%.
Rates Went Down
Oh,oh! My mistake! The economy didn’t get better, it got worse. In an effort to kick-start the GDP, the Fed reduced interest rates to 2%. What is the new value of that 3% bond when the market is paying 2%? The value goes up, in this case to $1,009.80. Since the new buyer paid above par for the bond, she would be receiving a lower than par yield. Rates go down, prices go up. But the previous buyer, who paid $1,000 for it, would realize a capital gain. He paid $1,000 for something he later sold for $1,009.80.
Arithmetic: The math is dirt simple: divide the new buyer’s total return by what she paid for the asset. That’s all there is to it.
Step 1: In the Rates Went Up example, the new buyer’s gain was the bond’s nominal interest ($30) plus $9.62 (the discount the seller offered). That’s a total return of $39.62.
Step 2: Divide $39.62 (total gain) by the cost to the new purchaser ($990.38). The answer is 4%.
Same-same for a declining interest rate market.
Step 1: Although the new buyer will be getting only $1,000 (the face amount of the bond) at maturity, she paid a $9.80 premium. Her total gain on the investment is therefore $30 minus $9.80, or $20.20.
Step 2: Now divide $20.20 by $1,009.80 to find the new total return: 2%.
The principles are the same whether one is negotiating a single $1,000 transaction or a $1,000,000,000 placement.
- The primary market establishes the interest rate paid by the bond issuer.
- If a bond is sold before maturity, the value of the bond is determined by the then-current market interest rate.
- The yield on a bond is determined by the price paid. If rates go up, the price paid goes down. If rates go down, the price paid goes up.
- These principles are scalable.
Assuming Greater Risk
What follows are additional examples of some of the techniques the Bond Geeks use to goose their returns. For clarity, the examples below will use hypothetical data and do not adjust for taxes, inflation, or other trifles that might obscure the larger point.
Longer Dated Bonds Are Riskier: The bond rating agencies (ex: Standard & Poor’s, Moody’s, and Fitch) use unique letter grades to indicate riskiness. Everything else being equal, as a general guideline, longer dated bonds are associated with higher default rates. After all, a five-year bond has more time to go bad than a 90 day Treasury bill. To offset this risk, in a normal world the longer dated bond would reasonably have a higher (offsetting) yield. If everything goes well, an investor can increase her expected yield by buying longer maturities.
Lower Rated Bonds Are Riskier: A riskier (sub-investment grade) bond would also be expected to pay a higher interest rate than an investment grade bond, even if their maturity dates were the same. If a bond investor requires the higher yield, she will have to accept a greater probability of loss. That’s reflected in the historical data (see chart, below). Graphing the risk structure in this way lets us view the default history on a spectrum of bonds, ranging from investment grade to “high yield” while maintaining the same (in this case, 5 year) maturity date. The default rate is interesting.
Example: Five-Year Avg. Default Rates: Corporate Bonds (Moody’s Ratings)
Presume five-year AAA corporate bonds are being offered at a yield of 1.5% (an annual interest payment of $15 on a $1,000 bond). Being investment grade, the bonds are considered to have low risk levels. The expected yield, in this example, is 1.5% minus <1% (i.e., probably an unmeasurable number above zero but beneath the margin of error) for a net-of-risk yield of approximately 1.5%, or $75 over the five year term.
This particular investor, however, cannot abide $75 in exchange for locking up her money for 5 entire years. She’s a woman-of-the-world: she wears a Burberry keffiyeh with her Michael Kor’s and lunches with the girls twice a week. She requires a higher yield because: expenses.
She is considering buying a “B” rated (sub-investment grade) corporate bond currently paying 3%, and scheduled to mature in five years. The bonds are issued by the XYZ Widget Company. Sadly, “B” rated bonds have an anticipated loss of about 20%, meaning that an investment of $1,000,000 is statistically likely to incur a loss of $200,000. For any particular portfolio it might be more or it might be less, but minus 20% is the line of best fit. How might she compare the expected results of purchasing investment over sub-investment grade, or vice versa, over a five year hold?
Why Total Return is Important: An Example of AAA vs B Rated Bonds
- At a purchase price of $1,000,000, AAA (investment grade) bonds paying 1.5% annual interest will provide $15,000 in interest payments over each of the next 5 years (a total of $75,000 in interest). At the end of those five years the bond matures and the investor receives the return of her principal (the entire $1,000,000 originally invested). Her total return (on her money and of her money), will be $1,075,000.
- If she bought sub-investment grade B rated bonds instead, that $1,000,000 of B rated issues would certainly be paying a higher interest rate (say, 3%), but would also be subject to a default rate equivalent to 20% of principal. That’s a huge loss, and it leaves only $800,000 to earn interest. At 3% annually the interest comes to $24,000 per year, or $120,000 over the five years. Her total return under this scenario would be $800,000 (return of principal upon bond maturity) plus $120,000 interest. She would receive a total return of $920,000 in exchange for a $1,000,000 investment. Compared to what she could have made on the AAA bonds, that’s a disappointing $155,000 loss ($1,075,000 minus $920,000). Yuck.
The Counter-Party: Somebody Always Makes Money
The person who bought those B-rated issues from our keffiyeh-clad investor was an adventurous bond speculator, recognizable by his gold incisor. He’d just read that the Board of Directors had approved the computerization of XYZ Widget’s sales and inventory system. Up to this point, the company closed for three days every quarter to hand count widgets, but with computerized inventory the counting of widgets could be done almost effortlessly: open the computer, click “Sales and Inventory”, click “Update”. That’s it. No more shutting down three working days out of 60 every quarter (i.e., 5% of business days) to hand count stuff. Even better, the company could monitor if red widgets were selling faster and determine whether they should take the paint crew off the blue-widget line and put ‘em on the red. Given these (and other) benefits, the company could reasonably be expected to stop hemorrhaging cash and achieve higher profitability.
Once the Board’s decision becomes generally known, the speculator anticipates that XYZ bonds will be rated more highly and thus sell at a materially lower yield, for a strong net gain to him.
- Know thyself.
- An investor who speculates can lose her keffiyeh.
- On the other hand, a speculator who knows what he’s doing can occasionally do quite well.
This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate Klarise Yahya can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email info@KlariseYahya.com.