Bonds – Professionals – The Big Short

Compared to stocks, bond investments are pretty simple, right? You lend your money to the U.S. government (Treasuries), or to a state or local government (muni bonds) or a company (corporate bonds) for some period of time (called the “maturity”). In return, they pay you interest and then, at the end of the loan, you get your money back. What could be easier?

It might surprise you to learn that many financial planners think bonds are the most complicated investments they deal in–far more complicated than stocks.

Why? First of all, consider the ratings.

You already know that companies like Moody’s Investors Services and Standard & Poors investigate the balance sheets of companies (or municipalities), and assign ratings to their bonds which look a little bit like the grades they give out in high school: AAA, AA, A, BBB, BB, B, CCC and so forth. Shaky companies (or municipalities) get a low rating, which is the rating agency’s way of saying the chances of default (tumbling into Chapter 11 and not paying back the bond investors) are higher than for a company (or municipality) that is on sounder financial footing.

Sometimes the bonds issued by shakier companies are affectionately known in the trade as junk bonds, but you don’t ever hear the companies issuing them refer to them that way. Who wants to buy junk?

A chart included in a Congressional report on the Municipal Bond Fairness Act of 2008 shows the safety difference between differently-rated bonds about as clearly as anything you’ll find. It shows that before 2008, only about half a percent of all corporate bonds rated Aaa (Moody’s) or AAA (S&P) have defaulted during their full maturity. But when you get down into the Ba/BB ratings, the default rate jumps to 19.12% (Moody’s) or 29.93% (S&P). In other words, at those lower rating levels, one or more percent of your bond holdings might default in an average year. Munis experienced lower default rates, and Treasuries have never defaulted–and are considered by most bond experts to be safe from the danger of default.

The bond agencies don’t always get these ratings exactly correct, but in general, the highest-rated bonds are the safest, and therefore pay the lowest interest to borrower/investors. Lower-rated bonds will pay higher rates to compensate you for the added risk of default. In a perfectly efficient market, if you owned a portfolio of lower-rated bonds and experienced some defaults, you’d get paid approximately as much as if you held higher-rated bonds with zero or fewer defaults. The markets are seldom quite that efficient, but that’s the general idea.

The difference in yields between AAA-rated bonds and bonds of various lower ratings (the “spread”) can be graphed over time, and they will move up or down because people get more or less nervous about default, and because default rates do tend to go up or down as the economy weakens or strengthens. A Moody’s study of corporate default rates shows about what you would expect: sharp spikes in defaults in the 1930s and around the 1990 recession; diminishing numbers of defaults during the boom years of the 1990s. Astute bond investors will often evaluate these spreads to determine where the market is offering the best yields per unit of risk.

Of course, these ratings can change. A company that hits a rough patch can be downgraded, which doesn’t change the coupon rate, but does lower the bond’s value–the price that you could sell the bond for on the open market. If somebody were to buy that downgraded bond from you, they would demand a higher coupon rate by offering a lower price.

The other risk in bond investments comes from up or down movements in interest rates. If interest rates go up, the value of your bond goes down, because people can buy bonds paying more attractive (higher) rates. If interest rates go down, your bond is worth more, because you’re getting a better yield than people could buy on the market.

How much do your bonds move up and down? This introduces the most complicated calculation in the bond world: what we call “duration.”

The basic idea is not complicated. If interest rates go up, a bond that matures in 2040 is going to drop in value a lot more than a bond that is due to mature in six months. In the former case, you’re going to have to live with lower yields for the better part of a generation before you can invest at a higher rate. In the latter, you wait just half a year, redeem the bond for its face amount, and then can turn around and buy the higher-yielding bonds.

You can find a fairly complicated discussion of bond duration in Wikipedia, but it is basically a measure of how sensitive a bond is to interest rate movements, measured in years. To calculate a bond’s duration, you look at the present value of all the coupon payments yet to be made plus the payback of the face amount you lent in the first place, and then calculate how that would change if interest rates go up and down by varying degrees. Wikipedia offers a somewhat oversimplified rule of thumb: if a bond has a duration of two years, its price would fall about 2% if interest rates rise one percentage point. If interest rates FALL by one percentage point, then that bond’s price would rise by 2%.

To see how this might work in the real world, suppose you bought a bond with a face amount of $1,000, a maturity of 10 years, and a coupon rate of 5%. (Buying at the face amount is called buying at “par.”) Suppose interest rates rose by 0.6%. Suppose somebody offers you $900 for your bond. If they buy at that price, they would still be getting the $50 payment, but that yearly return would now be equal to 5.56% of the amount paid. ($50/$900 = 5.56%)

However, you also have to factor in the fact that this person paid $900 for an investment that will (assuming no default) pay a face amount of $1,000 when the maturity date arrives. This raises the effective interest rate, but by how much? If the bond is purchased nine years before the maturity date, the $100 difference would amortized over nine years, producing a lower yearly amount than if it was purchased five years before the maturity date, which, in turn, would be lower than if it was purchased just one year before the bond matures.

Unfortunately, this is not a straight line calculation. That extra yield is assumed to compound from the time of purchase to the time when the bondholders get their money back. Add that to the effective coupon yield, and you get a number that people in the trade call “yield to maturity,” which is the number you most often see quoted whenever bonds are traded after issuance.

At this point, you know more about bonds than any layperson you’re likely to meet, and more than a few professionals. But if you want to really impress people at cocktail parties, or want to know the more detailed ins and outs of your bond investments, you’re invited to read a few more paragraphs.

First, look at the bond market through the eyes of a professional. You notice ever-changing yield spreads between high-quality bonds, junk bonds and everything in between. You also, in another dimension, see ever-changing spreads between bonds of different maturities. In general, the longer the maturities (in the lexicon, the “farther you move out on the yield curve”), the higher the yields, because 20-year maturities expose you to two decades of long-term changes in interest rates and possible default, whereas 30-day T-bills expose you to practically none. Sometimes this yield curve is “steep,” meaning there’s a big difference between the yields on 30-year bonds vs. 10-year or 1-year issues, and the curve will be steeper in some areas than others.

Sometimes, albeit rarely, the markets deliver what is called an “inverted yield curve,” where rates are lower for longer maturities than they are for shorter ones. Why? This can happen if investors think that long-term rates are going to come down, and try to lock in current rates on longer-term bonds. Shorter maturities become less attractive because they don’t lock in rates for quite as long.

Professional investors can also watch a third kind of spread: between municipal bonds and Treasuries. As you probably know, munis offer a tax break: their coupon yields are exempt from federal taxes, and if they’re issued in your state, you don’t have to pay state taxes either. Because of this, they normally pay lower rates than Treasuries, whose yields are taxable at the federal level. A financial planner or accountant would look at your tax rate and calculate the “tax-equivalent yield” by subtracting, from the yield, the various taxes you’d pay on Treasuries. Theoretically, the Treasury bond’s tax-equivalent yield would be approximately the same as the the yield on munis of similar quality and maturity. But sometimes concerns about the economy and the possibility of default and downgrades will drive muni yields as high as Treasuries, despite their tax advantages.

There are a few other complexities to consider. One is figuring out how much of a commission the bond trader is taking whenever you buy individual bonds. Unlike stocks, bond prices usually include some built-in compensation (a “markup” or “spread”) for the brokerage company selling you the bond, which is usually not disclosed. Markups can vary widely. Unless you’re really good at these duration calculations, you would never even be able to estimate how much you paid the broker.

Another complicating factor is that corporate or muni bonds (but not Treasuries) usually have “call provisions.” That’s a fancy way of saying that if interest rates go down, the company (or municipality) issuing the bond can pay off the note, give you your money back, and issue new bonds at the lower rate–not unlike when you pay off your car loan or mortgage early.

These call provisions can add a LOT of complexity to your evaluation of a bond investment, since the company can snatch the bond out of your hand right when it has gone up in value (due to that drop in interest rates). Meanwhile, if rates go up, the issuer will have no incentive to call, and you’ll be stuck with the lower yield–heads they win, tails you lose. Bond traders sometimes talk about the “yield to call,” the yield of a bond or note if you were to buy and hold the security until the call date.

Another complexity: with the advent of new derivative and collateralized securities, it has become difficult to evaluate what, exactly, bond-oriented mutual funds are buying on your behalf. The definition of a “bond” has been expanded to include derivative securities that can be highly-volatile, and can lose value faster even than stocks. One often-cited horror story involves certain Morgan Keegan bond funds, including the RMK Select High Income Fund, the RMK High Income Fund, the RMK Strategic Income Fund and the RMK Advantage Income Fund. Recently, Financial Planning magazine has reported multimillion dollar arbitration awards as a result of losses in their bond holdings amounting to between 50% and 67%–in a single year.

Then if you buy or sell bonds on the open market at something other than par, the yield will often be taxed one way, the difference between what you pay and the face amount of the bond (either plus or minus) will be taxed a different way. Meanwhile, zero coupon bonds, which accrue the interest payments to maturity rather than paying them out over time, will trigger taxes on money that you haven’t actually received.

Finally, did you see 60 minutes last week-end (March 14, 2010) and the story they did on Michael Lewis and his book The Big Short. His book shows an even more confusing and scarier side of bonds than anything we have discussed so far. In his book Michael Lewis explains how mortgage bonds were misused and misunderstood over the last 10 years or more. He shows that most brokers were caught up in making money much more than taking care of their customers.

If you want to read something really scary, read this book. It will make for some very interesting cocktail party discussions. If you want to be taken advantage of or just give your money away, don’t read this book.

About the author

Ted Feight, CFP®

I have been an asset, financial, life and wealth manager for 36 years. During that time the profession has been in a state of rapid evolution. What my core clients expect of me today is very different from what they expected 36 years ago When I started, clients were just beginning to invest and had little. Now many are near and or are retired, and have accumulated a great deal.
I believe I have given my clients peace of mind and comfort that occurs when they have had a trusted relationship with someone for many years. What keeps my clients coming back to us is not product, but the confidence that someone is looking out for their best interest, listening to what they are saying and serving as a partner in helping them get where they want to be. Who else has asked the questions about who they are, where do they want to go, and what drives them? I have been my clients' sounding board, confidant, coach, guru and in the end the stronger the relationship we have had, the greater were their successes. We do not always have the "Be your client's best friend" type of relationship but, in the end, I want to be their "go to" guy when they need questions answered or need help.

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