INVESTING BASICS: STOCKS AND BONDS
Part #1: Bonds
By Mary Lynne Dahl, CFP®
April 13, 2013
In this article, I will begin by explaining how bonds work.
Bonds are “debt instruments”; they represent loans that you make as the buyer, to the seller of the bonds. Bonds are sold by governments and by corporations, usually in increments of $1,000.
Bonds pay interest, like a bank or credit union account. They do not ordinarily grow in value, however; they have a set value, called “par”, usually in denominations of $100 or $1,000. When you buy a bond, it promises to pay a rate of interest for a period of time. At the end of that period of time, called the maturity date, you are supposed to get your principal back at “par value” ($100 or $1,000 per bond).
Some government bonds are guaranteed but corporate bonds are not. None are federally insured, like credit union or bank deposits, but some municipal bonds are insured by private insurance policies, for payment of the promised interest and return of principal at the maturity date. US Treasury bonds are backed by the full faith and credit (and taxing power) of the federal government, so they are considered the least risky type of bonds to purchase.
The interest rate paid to you as the investor in a bond is called the “coupon rate” and it depends on several important factors to consider. First, bonds will pay interest close to the market rate in effect at the time, and generally will “fix” that rate (not change it) for the duration of the bond period. For example, a 3% bond issued today that matures in 5 years means that the rate will not change for that 5-year term; it is “fixed”. Some bonds pay variable rates of interest, but most bonds are fixed. Historically, going back from around 1900 to 2012, 10-30 year bonds have paid average interest rates of around 3% - 4% (with highs of as much as 21% and lows of as low as 1%), depending on a lot of variables, such as the term of the bond (years to maturity date), the quality of the bond and the type of bond.
There are risks associated with investing in bonds that investors sometimes overlook or do not adequately understand. One risk that is not hard to understand is “default of the bond”. This means that the seller of the bond cannot pay the interest promised or return the principal to the investor, so it defaults. It is like defaulting on a mortgage, but there is no real estate involved, just a piece of paper, a promise to pay, that has failed. Corporate bonds have higher default rates than governments, but governments have defaulted on bonds in the past, so it is not unheard-of.
Another very important risk with bonds is “interest rate risk”. This is harder to comprehend, but investors should be very aware of it anyway. This is the risk that the bond that you buy today will decline in price because interest rates on new bonds are paying a higher interest rate than your bond. For example, if you buy a 5-year bond for $1,000 today, and it is paying 2% in interest, but in 3 years newly issued bonds are paying 4%, you cannot sell your 2% bond for the $1,000 that you paid for it. Why? Because it only pays 2%, compared to other bonds selling for the same $1,000 that are paying 4%. Who would pay $1,000 for a 2% bond when they can get a 4% bond for the same price? Your bond will sell for less than you paid for it, and in the meantime, you will receive only half as much interest as other bond owners. When you only invest $1,000 it doesn’t add up to a lot of money, but if you have a whole retirement account that is heavily invested in bonds, as many people do, it does, indeed, amount to a lot of money. Your choice is to continue to hold the bonds paying the lower rate of interest, or sell them in the market at a price loss. Not a good investment strategy.
Bonds are priced to reflect the current, prevailing interest rate. Bond prices decline when rates rise. When interest rates are very low, as they are today, the only real direction that those interest rates can go is up, sooner or later, so bonds purchased in a low interest-rate cycle do carry more risk than if interest rates were high and headed downward. The Financial Regulatory Authority, Inc. (FINRA), a government agency that enforces investment regulations designed to protect the public, sent out an alert on 21 Feb 2013 that if interest rates do rise, “outstanding bonds, particularly those with a low interest rate and a high (long term) duration (maturity date), may experience significant price drops (loss of value).” (Itlalics mine) A 10-year bond paying 3% will fall in value by 10% if interest rates rise to 4%, for example. In a retirement portfolio that owns $100,000 worth of bonds, the value of those bonds would fall to $90,000. This is a serious risk to investors who bought bonds because they were looking for safety and stability. The government regulators who are tasked with protecting the investing public are now warning the public of this risk, because these regulators realize that interest rates are heading higher.
Another risk to be aware of is the degree of risk that bonds carry. Independent rating companies do rate this risk and publish their ratings, but these companies have gotten into trouble recently for failure to do their job adequately; several are currently being sued by the government for their alleged failures to rate bonds accurately. A lot of bad mortgages were rated ok, then packaged into bonds and sold to the investing public as “conservative”, implying that they were “safe” when they were not. Many of these bond packages defaulted because the real estate market experienced the bubble that burst. The reputations and profitability of the ratings companies have been seriously damaged by this, and rightly so. Investors should be prepared to do their own investigations of any bonds that they are considering as investments, and not rely entirely on the ratings of these companies. Even so, ratings on bonds range from “investment grade” being the best quality down to “junk”, meaning exactly what that implies.
Investment grade bonds pay lower interest rates than junk bonds, for good reason. They pay lower rates because they are less risky than junk bonds. Junk bonds have to offer higher rates of interest to offset the higher risks that they carry. So, if interest rates in the general economy are low but you find a bond paying higher interest by comparison to the general rate, know that your bond will be more risky than higher quality bonds. In general, it is not advisable for ordinary, middle-income people to invest in junk bonds; that is for the very wealthy and more aggressive investors, people who can afford losses better than average people.
Another reason why some bonds pay higher rates of interest is because they are for a longer term, maturing farther out into the future than shorter term bonds. For example, if an investor can get 3% on a 10 year bond, a 30 year bond will not attract many buyers if it also only pays 3.5 %. Who would want to wait for 30 years to get their principal back at almost the same rate of interest that they can get by only waiting 10 years? The longer the term, the higher the interest rate. Sometimes, it is not high enough to warrant the wait, though, and investors stick with the shorter term bonds mostly. That seems to be the situation today, and it is understandable.
Today, investors are flocking by the droves into junk bonds. This is a dangerous and unwise choice for most of them. CNBC.com has written an article dated 27 Feb 2013, called “Drunk on Junk: Why We’re Rushing to Risk” in which the writer says “While the central bank’s (the Federal Reserve) bond-buying has helped boost stock market prices it also has driven down fixed income (bond) yields, especially hitting investors holding bonds for coupon (interest) returns as well as savers in plain-vanilla money market and savings accounts. (Italics mine.)
Bill Gross, the founder of Pimco Funds and a manager of the Pimco Total Return Fund, the largest bond mutual fund in the world at more than $285 billion, has recently warned investors of a bond bubble forming, that investors should be aware of, saying that “investors should realize that risks are rising while returns could start falling” in bonds . (CNBC.com “Drunk on Junk” article 27 Feb 2013). Pimco Funds manages over $2 trillion for investors in their funds.
Bonds are not considered a good hedge against inflation, as they do not normally appreciate in value and have not historically paid much more than the rate of inflation. In addition, most bonds are taxable, as well, so after paying the tax owed, the investor may not net much of a return, especially when interest rates are low and consumer prices are on the rise.
The interest paid to investors on bonds is mostly taxable, but there is one kind of bond interest that is not taxable; those bonds are tax-free municipal bonds. They are bonds sold by cities, town, government agencies and municipalities, usually to finance local, state or federal projects. Municipalities pay the interest on the bonds that they sell to investors, from taxes collected by the government, so they are considered lower risk than other types of bonds, because governments can tax and tax and tax, and do so, making the possibility of not being able to pay that interest less likely than a corporation or non-municipal government agency.
This article is only a brief review of the basics of bonds. An interested investor can read entire books on the subject and still not learn everything. The basics, however, are key; bonds are “debt investments”, they pay interest, they have risks, the risks are greater when interest rates are low and economies or governments are unstable, bonds do not generally grow in value very much and bonds can decrease in value when interest rates are rising.
Next article will be on stocks, and then we will cover the basics of mutual funds. Stay tuned in and see how much you can learn!
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©2013 Mary Lynne Dahl, CFP® is a Certified Financial Planner ™ and partner in Otter Creek Partners, a fee-only registered investment advisor firm in Ketchikan, Alaska. These articles are generic in nature, are accepted general guidelines for investment or financial planning and are for educational purposes only.
Mary Lynne Dahl©2013