Bonds 201

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Investing in bonds can be boring and not all that sexy. But when the economic storms are hitting, you will be glad to have a calm harbor to duck into.

I remember times when every asset I owned declined in value with one exception – bonds. My bonds not only didn’t go down, but they also went up during 2000 and 2008 when stocks were plummeting.

Knowledge is power. It is important to understand some of the basics of investing in bonds. Let’s start with the fundamentals.

Bonds are Not Risk-Free

Bonds are generally thought to be safer than stocks. They are “safer” since they are less volatile. The value remains steadier. Depending on the bond, the stock, and the time-frame that isn’t universally true. All investing involves risk. Bond investing is relatively safe, but it is wise to enter knowing the nature of their risk.

Measuring Risk

There are a lot of complicated ways of looking at risk. Many involve variances, standard deviations, Shape ratios, or beta calculations. I like the simpler method recommended by Dr. Marvin Appel of Signalert Asset Management. He talks about the concept of a “drawdown.”

A drawdown represents the psychological pain you will feel in the event of a loss. The response is visceral. The calculation is simple and can be used for any asset class. Just look at the peak asset value and then find the subsequent lowest value. How much did it go down?

If the top-to-bottom change was 5% that may be an acceptable risk. If it was 45%, that is quite disruptive (ask any investors who survived 2008).

Many Risks of Bonds

1. Interest Rate Risk

As interest rates increase, bond prices decrease. Long bonds are more sensitive to this change. Short bonds pay less interest but are less sensitive to interest rate changes. If you buy an individual bond and cannot keep it until maturity you will lose money on your bond in the event of increased interest rates. Intermediate-duration bonds offer a trade-off between return and interest rate sensitivity.

2. Default Risk

Government securities like T-bills and T-bonds are backed by the U.S. government and do not have default risk. Corporate bonds, high-yield bonds, and municipal bonds do have some default risk. If the issuer becomes bankrupt or cannot pay the par value at maturity there is a default risk. This risk is minimal with “investment grade” bonds but significant with “junk bonds.”

3. Credit Risk

Using S&P ratings we know that AAA, AA, and A rated bonds have default rates less than 2%. At the BBB level, the default risk goes up to the 3-5% range. Once you get into the junk range of BB or below the default rates can easily be well into the double-digit range.

4. Inflation Risk

If your coupon rate is 5% and inflation rate is 2% your real return is 3% (5% – 2%). If the inflation rate goes up to 8% then your return is eroded rapidly, and you will lose financial ground every year. Only inflation-indexed bonds such as I-bonds and TIPS specifically compensate for this risk.

5. Liquidity Risk

The best way to have a predictable return on investment from an individual bond is to hold it until maturity. At that time, you capture the entire “yield to maturity.” If you need cash prior to the time of maturity, you incur some risk of selling the bond “under par” (for example if interest rates have risen). This potential for loss has the effect of locking up your investment for a period and thus reducing your liquidity (available free cash).

Bond Ladders

One excellent way to produce a steady income is by using a “bond ladder.” This involves buying individual bonds or target maturity bond funds that have maturity dates spread over time.

How to Build a Ladder

You might choose some bonds that reach maturity in two years. Your other bonds mature in four years, six years, eight years, or ten years. That way every two years some reach maturity. This “laddering” allows you to reinvest at the new interest rate. Over time your average return will be that of the 10-year bond, but your interest rate risk will be less than the average. The interest rate risk is lower since the overall average duration is shorter. Also, your earnings will be 100% predictable since you are holding all bonds until maturity.

Where to Build a Ladder

Bond laddering works with investment-grade corporate bonds, treasury debt, TIPS, or municipal bonds. It can also be used with target-date bond mutual funds in which every bond matures in the same year (e.g. American Century Investments BTTRX Zero Coupon 2025 Fund).

Building a bond ladder is a great way to develop predictable, safe streams of income in a volatile financial environment.

What About Inflation?

Another risk that threatens returns from bonds is inflation. If your short-term bond fund returns 2% but inflation is running 3.5%, every year you are falling behind financially.

I-bonds are an investment option that we never hear about. The financial media and advisors don’t benefit by recommending such no-commission options. You can buy I-bonds directly from the US Treasury at no charge. There is no load, no management fee, no redemption charge, etc.

I-bonds are bonds which are ‘inflation-protected.’ It is a no-cost investment that is as safe as can be. It is guaranteed to not fall behind the inflation rate. Unfortunately, the amount allowed for individual purchase was lowered from 30k to 10k, which makes them a smaller part of retirement planning. Still, they should not be overlooked.

Long-Term Interest

I-Bonds are meant to be long-term investments. They can be purchased in any amount from $25 to $10,000. They continue to earn interest for up to 30 years. You can cash them in after one year. Cash them in prior to five years causes forfeiture of three months of interest.

How to Buy an I-Bond

You can buy an I Bond through your TreasuryDirect account.
You can arrange to buy electronic bonds through payroll direct deposit.

TIPS

Treasury Inflation-Protected Securities (TIPS) eliminate inflation risk from your investing. These are also known as inflation-indexed treasury notes (or bonds).

TIPS start out with a value of $1,000, but their value increases with inflation as measured by the Consumer Price Index (CPI). So, if consumer prices rise 5%, then at maturity you would receive $1,050 instead of the original $1,000. If prices decline rather than increase you are still guaranteed your original $1,000.

In addition to keeping up with inflation, TIPS offer an interest rate just like other bonds. The interest rate is fixed as a percentage.  The payment can increase since it is based on the current inflation-adjusted principal.

Uncle Sam Giveth and Taketh

These investments can create tax problems. When the bond principal is adjusted for inflation that counts as interest income.  This “income” is taxable even though you did not actually receive this cash. It is like being taxed on “phantom income.” These investments are best placed in tax-deferred accounts.

These bonds can be purchased directly from The Treasury.

Inflation-Proof Fund Investing

There are also exchange-traded funds and mutual funds available, such as Vanguard Inflation-Protected Securities Fund (VIPSX). Just realize that if you invest with a mutual fund you lose the inflation-beating guarantee. If prices fall you may incur losses. Some advisors recommend buying TIPS directly and holding them until maturity.

Holding individual securities within a Roth IRA may be the best way to reduce risk and guarantee that you stay ahead of inflation.

Individual Bonds

It is fine to buy individual bonds. It can be a little bit overwhelming since there are thousands of available options. Buying bonds through mutual funds have almost as many choices.

If you focus on diversity and low cost, a few good options will pop up to the top. Although there are always exceptions, investing in low-cost bond index funds will usually outperform most individual bond investors. You benefit from professional management and broad diversification.

Bond Funds

Mutual funds allow individual investors to pool resources and participate in professional management and investment returns that otherwise would be inaccessible.

Individual bonds are generally priced at $1,000 each and are more cost-effective when purchased in a bundle of $10,000 or more at a time. Mutual funds often allow small dollar amounts on a frequent basis allowing you to take advantage of dollar cost averaging (DCA).

If I put $100,000 into individual bonds issued by a corporation I have a significant risk of capital loss in the event of bankruptcy. Investing in a bond mutual fund allows broad diversification.

Review the expense ratio of the mutual fund you are considering. Since bonds have very slim margins, the mutual fund expense ratio is critical. Look for an expense ratio of 1% or less.

Using a company like Vanguard and investing in index funds will typically reduce that expense by 75%. Some mutual funds charge a sales charge known as a “load.” Avoid those unnecessary sales fees by choosing a no-load fund company or a discount broker. Know that some mutual funds also have redemption fees.

Many Flavors of Bonds

Just as individual bonds come in different varieties such as municipal bonds, intermediate corporate bonds, junk bonds, treasury bills, etc. so do bond mutual funds. Most of us should invest primarily in short-term and intermediate-term investment-grade corporate bonds and/or US treasury bonds.

Taxable Investing

Since bond mutual funds produce interest income, you may choose to put your bonds in your tax-deferred or tax-free accounts. If you invest your bonds in a taxable account, consider low-cost index municipal bond funds such as the Vanguard intermediate-term tax-exempt bond fund (VWITX).

Tax-Advantaged Investing

A good choice for investing inside retirement funds would be the Vanguard total bond market Index fund (VBMFX). There are also corresponding Exchange-Traded Funds (ETF). ETF’s trade frequently on the stock market introducing excess volatility and unnecessary uncompensated risk.

If you are not holding all your bonds to maturity there is reinvestment risk when interest rates rise. The most reliable number to assess the yield of a bond mutual fund is called the SEC yield. The SEC yield is a standardized way of reporting yield-to-maturity less the fund’s expenses.

When to Buy

Buy now. And later. Despite the complexity and limitations, a bond fund investing is rewarding. Start now.  Don’t try to time the market. Pick one or two funds. Invest regularly over time (dollar cost averaging). Your assets will grow consistently. You will enjoy much less volatility than with stocks.

What about you? Are bonds or bond funds a part of your portfolio? Are concerned about inflation, duration, taxation, or defaults? How do you manage those risks?

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