The basics of owning bonds
By Barry Ritholtz,
Washington Post, July 20

 

 

I need some yield!

This is the battle cry of investors who have become frustrated with the low yields that the Fed’s zero interest rate policy has created.

Indeed, last week saw the 10-year Treasury bond yields fall to near-record lows. This holding, the backbone U.S. bonds for most fixed-income investors, fell below a yield of 1.5 percent. And Federal Reserve chief Ben S. Bernanke gave rather dour testimony to Congress about his expectations for a weak economy in the near future.

The impact also was felt in equities, where, perversely, the bad news led to a stock rally. The traders’ assumptions — Yeah! The economy is getting worse! — was that more weakness will beget another round of quantitative easing. That excess liquidity has a tendency to goose stocks higher.

But it is in the bond market where some very odd things are occurring. Buyers of the 10-year Treasury are agreeing to lend Uncle Sam money for a decade and receive a piddling interest payment of 1.5 percent. That is barely above inflation in the depressed environment, where price rises have been modest. It is reasonable to expect higher inflation in the future, but when that will finally hit is anyone’s guess.

Given these low, low yields, perhaps it is time to revisit some of the basics about owning bonds, bond funds and ETFs (exchange-traded funds). We can also explore what alternatives exist regarding yield and generating income.

The most important thing you need to know about bonds is that they are essentially loans to some entity. As such, there are three main elements to any bond:

Quality: The credit worthiness of the borrower.

Duration: The length of the loan.

Yield: What the loan pays you in interest.

As is always the case in investing, there is no free lunch. If you want higher yield, you are either buying riskier bonds or lending money for a longer period of time (you can also use leverage, making a riskier investment even riskier).

There is something terribly disconcerting about so many people “discovering” bonds AFTER a 30-year bull run in fixed-income instruments.

My point of view on bonds as investments or income sources is simple. Here are five points to know:

1 Ladder: Owning individual bonds in a ladder — meaning a series of bonds that mature in successive years — is the correct way to own fixed income. By laddering bonds (2014-15-16-17, etc.), you are not tying up money for too long. If and when rates go up, you get to reinvest the specific holdings as they mature with higher yielding issues (note that if this happens, inflation is probably higher).

At present low rates, I prefer to keep my bond ladders to no longer than seven years. (This is much preferred to bond funds.)

2 Independent credit risk analysis: I work only with bond managers who do their own due diligence and have a deep research division. Do not employ any bond manager who relies on Moody’s or S&P for credit ratings. These firms proved worthless to bond buyers in the last crisis. Indeed, their business models have radically changed. You and I as bond buyers are not their clients, but rather, the investment banks that underwrite complex products are the ones who pay their bills. Hence, their ratings are not objective, but rather are bought by and written for investment banks. Thus, we must learn from the last crisis when investors who followed the ratings agencies’ “opinions” lost immense amounts of money. As investors, I am advising you to ignore everything they say and do: Your best hope is that the SEC figures this out and puts them down like a rabid dog.

3 Bond ETFs/Indexes: If you cannot afford a ladder, consider bond index ETFs. I like shorter-term Treasurys, high-quality corporate bonds and (non-bank) emerging-markets bonds. Note that the best of these are passive holdings that reflect a broad bond index.

What makes these superior to bond funds is that there is no risk of managers selling holdings for a variety of bad reasons. Sometimes redemptions cause managers to sell. Even the best of them, such as Bill Gross of PIMCO, simply made a bad call last year by betting against Treasurys. Sometimes the market causes them to panic. Index bond ETFs avoid all of that fund stupidity.

4 Bond funds have different risks from bonds: If you buy a quality bond and hold it to maturity, you will get your money back. Sure, a Treasury can move up and down, but held until maturity it will pay back its investment. Not so with all bond funds. If markets go topsy-turvy and a bond fund faces redemptions, they sell what they can, sometimes at a loss. Hence, it is another risk factor that you simply do not have in bonds themselves or bond index ETFs.

5 Income/Yield: Remember the first law of economics: There is no free lunch. You must be careful in chasing higher yield. Fixed income is supposed to be your safe money — what you must get back and what will cushion the ups and downs of the equity markets. Your first concern should be return of your money, and, second, the return on your money.

In other words, bonds are supposed to be your safety first investment.

You can create a higher yielding portfolio — one that generates more income than risk-free treasuries do. This means you are assuming more risk. If you are willing to accept that, including a possible loss of principal, then there are ways to build a portfolio that generates more income.

My caveat: I treat these holdings like stocks, not bonds, which means that when they begin to misbehave, I kick them out of the portfolio. I always prefer selling for a small loss now vs. a big loss later.

If you respect those caveats, and can exercise some discipline in managing risky positions, here are a few places where you can look for yield:

Mortgage-backed securities: These were a disaster during the 2007-09 crisis. The working assumptions of buyers today is that the worst is over, and these mortgages are trading at a discount. Hence, that moderates the risk levels somewhat. Much of the subprime junk has already defaulted, so risk is out of them. Most people who were going to default on their mortgages have already. There is some truth to this, but there remains a healthy amount of risk in the space.

Corporate bonds: The safest of the non-Treasury bonds. Quality (non-junk) corporates yield between 1 to 7 percent. Corporate bond ETFs often hold hundreds of bonds, have low-expense ratios and yield more than 4 percent. Given that U.S. corporate balance sheets are as strong as they have been in a very long time, this is an attractive risk-reward relationship.

Junk bonds: Even higher yielding and, therefore, much higher risk. Some of these funds yield more than 7 or even 9 percent. They are much more vulnerable to specific failures of any company. Junk bond funds often see defaults that eat into principal. This should never be a large portion of any portfolio.

Master Limited Partnerships: Typically involved in extracting, shipping or storing a natural resource. They pass through 90 percent of their net income. Often, MLPs yield 5 to 8 percent. The problem investors have with these is they require a K1 tax filing, which most accountants hate. The solution is that there are now at least two ETFs that bundle 20 to 30 MLPs — no K1 filing needed. A risk is that eventually these resources are exhausted.

REITs: Are a type of fund that owns commercial real estate such as apartment buildings, office buildings and shopping malls. They get a special tax treatment that requires them (like MLPs) to pass through 90 percent of their net revenue. Yield can range from 3 to 8 percent. The downside is they are economically sensitive — meaning they don’t hold up well in a recession.

Sovereign debt: Owning the bonds of sovereign nations comes with various levels of risk. If we ignore Greece and Spain and instead focus on nations such as Vietnam and Brazil, we can find higher yielding paper for modestly higher risk. Some closed end funds that do this use various levels of leverage. This magnifies the yield but also can magnify losses. If you own any of these funds that use leverage, stick with ones that use modest amounts.

Owning a yield portfolio is a way to obtain higher income but with appreciably more risk. Proceed with caution.

 

~~~

Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. On Twitter: @Ritholtz. For previous columns, go to washingtonpost.com/business.

Category: Fixed Income/Interest Rates, Investing

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

17 Responses to “The Basics of Owning Bonds”

  1. machinehead says:

    ‘Duration: The length of the loan.’

    Actually, that would be ‘Maturity.’

    Duration is the weighted-average period over which cash flows are received … always less than the maturity except in the special case of zero-coupon bonds.

    But duration might be difficult to explain to a general audience.

  2. ConscienceofaConservative says:

    Well , if we’re being precise duration is generally the change in price in response to a change in interest rates although there are other duration measures(spread duration, index duration, prepayment duration…)

  3. wcvarones says:

    Equities are the new bonds.

    When you can get 3-4% dividend yields on companies with solid balance sheets and good long-term prospects, you’d be crazy to buy Treasuries at 0-2%. And even corporate bonds don’t give you that much more yield for the inflation risk you’re taking.

    Check out the Silicon T-bill.

  4. MayorQuimby says:

    “It is reasonable to expect higher inflation in the future”

    Actually it is reasonable to expect massive deflation in the future. Fed induced inflation destroys demand once you have too much excess debt in the system which we do right now. For inflation to persist, people need to be able to:

    A: borrow ever increasing amounts yoy and
    B: pay their bills which means their wages rise and make those prior obligations affordable

    This cannot be achieved by money printing since 90 pct of all new money or counterfeit fed $$$ goes to the top. The Fed would have to literally print 5 – 10x as much money as they have been and naturally that would destroy demand. The only thing the Fed can do is delever via deflation and all of these QE’s will end on a dime when they push too far and one of them actually does more harm then good. When that happens it is game over for the games.

    Whow knows…it might even be QE3…

  5. jake10 says:

    Hey Barry-

    I won’t get into our different points of view as it comes to ETFs, laddering a portfolio, or why REITs / MLPs shouldn’t (in my opinion) be lumped in with bonds, but I think there are some things worth pointing out for readers

    Duration vs. Maturity: As Machinehead already pointed out, there is a big difference between maturity and duration (a mortgage with a duration of 4 years and 30 years to maturity acts a whole lot different than a Treasury bond with 30 years to maturity).

    Yield: yes, yield is interest, but yield to maturity also include the capital appreciation / depreciation as the bond approaches maturity, which is a much better reflection of what to expect in terms of returns for an investor

    Mutual funds vs. ETFs: while there is a bid/ask spread you point out that managers have to take within bond funds when there are redemptions, ETFs are not immune. When baskets of securities are created for bond ETFs that hold illliquid securities, that creates wider bid/ask spreads for the ETF purchase which impacts an investor (likely more than within a bond unless there is a run on the bond by investors

    Mortgage-Bonds: the bulk of mortgage bonds are the safest securities (in terms of credit) as they are backed by the government. It is extraordinarily important when talking about mortgage bonds to distinguish non-agency mortgage bonds (what you are talking about and make up a small part of the universe) from agency mortgage bonds

    Corporate bond ETF yields: corporate bond ETFs with duration risk (LQD) are yielding 3%, while short-term corporate ETF (CJU) are yielding just over 1%. I would love 7% from investment grade corporates, but unless I am missing something, they don’t exist (unless they are high yield incorrectly rated as investment grade)

    Close-end funds: there are plenty of global bond mutual funds that have no leverage and don’t trade away from their NAV (two huge risks within close-end funds). Close-end funds should be avoided by the average investor, but for those that can keep an eye on them they do present very interesting opportunities at times when trading below NAV.

    ~~~

    BR: Hence, the title “The Basics of Owning Bonds”

  6. MayorQuimby says:

    Wc- bond holders get paid when divvies get cut.

  7. MayorQuimby says:

    Yeah…I will back the truck up in aa rated corporates that yield 7 pct! And to think just a few years back.l.

  8. louis says:

    Bonds or Bust!

    “Now if I take a bond and I make a square and I square it again Blah blah blah.”

    “Your a genius , here’s a trillion gazillion dollars, now go rape your citizens.”

    http://www.youtube.com/watch?v=crk_S44RxaQ

  9. wcvarones says:

    MayorQuimby,

    Wc- bond holders get paid when divvies get cut.

    Indeed. But I see continued dollar debasement as far more likely than dividend cuts on companies with strong balance sheets, modest payout ratios, and ongoing businesses.

    This cannot be achieved by money printing since 90 pct of all new money or counterfeit fed $$$ goes to the top.

    Absolutely. But what happens if a deflationary depression scenario starts? The US govt is running trillion+ dollar deficits, which would get much worse in a deflationary depression. Revenues would plummet and social welfare needs would increase. Neither Obama nor Romney (nor their successors) would gut entitlement spending in that scenario. Therefore, there is still only one way out: money printing.

    I said long ago that ZIRP and QE to give free money to the banks wouldn’t fix the economy. I proposed a printing-funded tax rebate for the masses, which I still think is a better idea than anything Zimbabwe Ben and Barack “Government Motors” Obama have tried.

  10. James Cameron says:

    Nice little summary. As always, however, one of the key issues is when to buy . . . and when to sell. In the search for yield some of these sectors have become very crowded. In addition, some of them, like MLPs, can get clobbered. EPD, which has had a sterling run over the last three years, lost over 45 percent of its value during the 2008/2009 financial crisis.

    MayorQuimby brings up an interesting point re:deflation . . . with the immense sums being pumped into the system, and now talk of QE3 and the ECB “doing whatever it takes,” he raises the specter of deflation, others of hyperinflation. Two extremes . . .

  11. louiswi says:

    Kudos to you Barry for a concise basics of investing in bonds. If more folks understood the basics, there would be less consternation all around.

  12. MayorQuimby says:

    “Therefore, there is still only one way out: money printing.”

    Printing is not working. You can see it right now if you look carefully. And technically they are not printing but what they are doing is similar.

    Look – when increasing portions of your gdp are comprised of Fed QE it is already game over – there simply isn’t enough demand for credit to keep the ponzi going for another 20 years. At some point it will break Madoff-style and we will have to endure the ensuing shit-storm. It is the only way for us to ultimately move forward.

    And move forward we will but not until we delever…for REAL!

  13. ToNYC says:

    Video killed the radio star, and ZIRP killed the USTs. The fear of interest rates spiking will continue to require savers be shut out of earning on their savings to the exclusive benefit of the banking system earning interest on free COGS FRN paper. This sort of thinking leads to ignoring the math on the payroll tax “holiday” (yes indeed on Donkey Island) and not noticing the precise opposite of mandatory over-funding of the US postal system. The special purpose New US bonds will earn useful interest and they will be issued at par vs a profound discount decline from a 134 handle on the US 10 yr. They’ll be DTM bonds: Do The Math bonds.

  14. ConscienceofaConservative says:

    With bonds it seems diversification is way over-rated. On the downside spreads or spread duration is more correlated than one might have thought ten years ago. It’s basically risk on risk off. So no point in going after difersification. Basically when it comes to bonds forget OAS, forget yield, and focus on total return and scenario analysis. And of course always look at the underlying credit first. Structure cannot negate that.

  15. philipat says:

    Barry, sorry to nit pick, but your definition of “Duration” ( The length of the loan) appears actually to define “Maturity” not duration?

  16. dead hobo says:

    This is probably one of the best posts you have ever written. I didn’t analyze every word so I assume there are a few nits to pick, but an expanded version should be considered and left as a permanent post for reference purposes.

    Everyone can argue about crooks, thieves, scammers, economists, pundits, fantasy ECB promises and the cattle who believes them, and the like, but bonds are fairly cut and dried. There’s just a lot to remember and organize. Being able to understand the economics of bonds provides a lot of insight into the nature of stocks. Somebody wise once said that the stock market is the idiot half wit cousin of the bond market.

  17. Tyler K says:

    “As is always the case in investing, there is no free lunch. If you want higher yield, you are either buying riskier bonds or lending money for a longer period of time”

    Jebus Barry, you wrote a whole book about free lunches !!! (Bailout Nation … ring any bells anyone? … Bueller?… Bueller?… Bueller? )