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Bonds, Debt Securities, and Lending Investments

If interest rates rise, what will typically happen to bond prices?
  1. Rise
  2. Fall
  3. Stay the Same
  4. No Relationship
  5. Don't Know

     The term “bond” has many definitions, but from an investment perspective it typically refers to a legal agreement between two parties (for instance, a lender and a borrower). One of many definitions is "a sealed instrument under which a person, corporation, or government guarantees to pay a stated sum of money on or before a specified day." Bonds differ from ownership assets like stocks and real estate in that you don't share in ownership, but you do have a commitment to get payed by the organization. That commitment is considered senior, or higher priority, than the owners’ claim in the event of a bankruptcy. In other words, if a company goes bankrupt, the bond holders get payed from any available assets before the stockholders receive any remaining value.

     The major benefit of investing in most bonds is that they usually provide current income and some degree of stability of capital. Bonds tend to be safer than ownership assets, especially in the short-term, but they tend to underperform stocks and some other investments over the long term.

     Historically stocks have provided substantially greater returns than bonds, however there are good arguments for investing in bonds for the long term. According to James Paulsen, from 1870 to 1940 bonds had returns almost equal to stocks, but with less volatility.1 He claimed most of stocks outperformance occurred from 1942-1962 during abnormally strong real economic growth. During the first decade of this century, bonds in fact outperformed U.S. stocks. Edward McQuarrie also argued in a recent paper that stocks did not out-perform bonds in the first few decades of the nineteenth century.2 Regardless of the period, many believe bonds should be considered as a major component of a diversified efficient portfolio.

     In general, the shorter your investment horizon and the lower your risk tolerance, the higher percentage of bonds you'll seek. If you hold a bond until it matures, your primary risk is default risk, meaning that the organization doesn't pay you back in part, or in full. U.S. Government treasury bills and bonds are considered "risk-free" because it is assumed the government will not default. Whether U.S. Government debt is actually "risk-free" can be debated on several fronts, and my opinion is that of course it's not risk free, for several reasons. But it's still useful to use the term "risk-free" (keeping in mind that it may not be a strict definition) for discussion purposes and because other U.S. bonds are priced relative to U.S. guaranteed debt.

     Valuation of bonds is based on the concept of the time value of money, which is effectively the present discount rate. Current values are worth more than future values (except when you have deflation) provided it can be invested with a positive return. So in general, the sooner the cash flow the better. For instance, if you can invest safely at 2%, a sure payment of $102 one year from now is worth $100 today.

     Credit ratings agencies provide ratings for securities that help market participants determine bond prices. One of the reasons U.S. bonds may not be as "risk-free" as they were considered prior to the global financial crisis is because Standard & Poor's (S&P) reduced the United States rating from AAA (outstanding) to AA+ (excellent) on August 5, 2011. Most believe (in the short to mid-term) that the U.S. Government will not default, but given the history of many other nations defaulting, it is reasonable to at least ask the question of whether any scenarios could result in default. Sovereign defaults that have occurred in the past include Spain in the 1500s, several Latin American countries in the 1800s, and more recently Russia defaulted on its domestic as well as foreign obligations in the 1990s, in addition to Greece which defaulted on a $1.7 billion payment to the IMF in 2015.

     AAA is the highest rating followed by AA, A, and BBB. Those categories are generally considered "investment grade." Ratings of BB or lower are generally considered "non-investment grade" and are frequently referred to as "junk bonds" although they are usually marketed by the psychologically more optimistic term "high-yield" bonds.

     Junk bonds are a good example of the principal that the higher the risk, the higher the expected return. Investors will pay more for higher rated bonds, thus the interest rate or expected return is lower. Lower rated bonds have more risk which translates into lower valuations for the same scheduled payments since there is a greater chance of a default. Similarly, a bank or lender offering mortgages to homeowners will charge a higher interest rate to a home owner with a lower credit rating, as opposed to a borrower with a high credit rating.

     There are multiple credit rating agencies for bonds and other debt securities and they may have some differences in their ratings scales, but the market of buyers and sellers will ultimately determine actual interest rates and prices at any given time. Similarly, there can be some grey area in mortgages given that there is no universally agreed definition of some terms, like "subprime." Prime mortgages are those issued to high rated borrowers (similar to investment grade bonds), while subprime mortgages are issued to borrowers with lower credit ratings and higher default risk (similar to junk bonds). A subprime borrower may have to pay several percentage points more in interest, while junk bonds' interest payments will typically be several percentage points higher than investment grade and "risk-free" bonds with the same payment terms and maturity.

     Investors attempting to increase their yield or return often choose to invest in lower quality securities. But higher yield does not always translate into higher returns. In general and over the long-term, investors should get higher returns for taking more risk, but that's certainly not guaranteed. It's very common for investments with higher interest rates to underperform otherwise equivalent lower interest rate investments and there can be several reasons. The premium for the extra yield fluctuates and can move against an investor during the holding period, the actual default rate can be higher than expected (wiping out more than the extra yield), and the ratings for the underlying organizations or securities can change. Additionally, more complex and lower rated securities tend to have higher associated costs, which can also reduce or wipe out any expected additional yield. In fact, some researchers have found evidence that investors reach for higher yield and take on extra risk when interest rates are low.3

     As mentioned in Chapter 13, bonds and debt securities make up a large percentage of the world's investable universe. The variety and number of options available to investors is extremely diverse and broad. The fact that there are so many options can be viewed as an additional complication that can be overwhelming to some, but can also be viewed as a great opportunity for well informed investors to find investments that are best suited for meeting their needs and goals.

     There are also types of hybrid securities that can be viewed as part debt, part ownership. Some classes of investors are limited to the types and ratings of securities they can hold (for instance insurance companies and many foreign funds have mandates to only invest in bonds with a certain rating) and there can be tax differences that advantage some investors over others. All those factors should be kept in mind when evaluating various fixed income investments.

     It’s important to keep in mind that this chapter is only intended as a brief and general introduction of important elements for evaluating bonds and other fixed income investments. The relatively short length of this chapter does not correlate with the complexity that may be involved in analyzing bonds. So I am limiting the number of terms and formulas, yet there are some terms that most investors should familiarize themselves with.

     The term "maturity" usually refers to the date the principal of the bond is payable and the term "duration" can be particularly helpful. There are various duration terms (like modified, Macaulay, and effective duration) that may have different definitions, but duration is intended to simplify a kind of weighted average time until repayment. The big advantage of duration is it allows for a simple estimate of price sensitivity of bonds or funds to changes in interest rates. For instance, if a bond has a duration of five years, its price is will tend to rise about five percent if the interest rate drops by one percent, or drop by five percent if the yield rises by one percent.

     There are many excellent resources for getting better educated on bonds, both online and in print. for example provides yield and duration, as well as performance information and expense ratios on funds.

     The following list of types of bonds and fixed income investments is not a comprehensive list, but summarizes many of the primary options. Investors can consider buying bonds either individually, or (as recommended in most cases) in funds that provide diversification. Investors should always evaluate the costs associated with the various options, the various risks, and the tax implications.

Government Bonds

     Government bonds can have varied maturities and payment features. For instance, zero-coupon bonds don't pay interest, but mature at a higher value than the purchase price. Most government bonds pay regular interest and mature on a specific date. U.S. Treasury bills mature within a year, U.S. Treasury notes mature in one to ten years, and U.S. Treasury bonds mature in more than 10 years.

     There are some bonds that are effectively guaranteed by the government, for instance Government National Mortgage Association (GNMA, known as Ginnie Mae) bonds. GNMA bond funds are made up mortgages on homes that were sold by banks and repackaged into funds that investors and funds buy. There is an interesting side note relating to government bonds and global financial crisis around 2008. The U.S. Government stopped selling 30-year bonds on August 9, 2001. They were reinstituted in August of 2005, but some have pointed out that many investors seeking longer term debt investments used Government guaranteed longer term mortgage backed securities (which still had longer terms than the then available government notes) as alternatives and that demand may have reduced rates and increased mortgage lending, which could have contributed to the run up in prices that led to the crisis. As mentioned earlier, the U.S. Government's own credit rating was later compromised following the crisis. The primary causes and appropriate prescriptions for preventing future crisis are complex and I'll discuss that topic further in chapter 27, but some understanding of how bonds and mortgages impacted the crisis and knowing how respective bond types performed during the crisis is certainly useful knowledge.

     Treasury Inflation-Protected Securities, or TIPS, are marketable Treasury securities whose principal amount is adjusted for inflation. They were first auctioned in January 1997 in a response to strong demand for an inflation-indexed asset class. The principal for TIPS increases with inflation (as measured by the Consumer Price Index). Upon maturity the owner is paid the adjusted principal or original principal, whichever is greater. In October of 2010 TIPS yields went negative for the first time. The inflation adjustment was so attractive, or investors were so concerned about inflation, that they were willing to pay the government every year to buy insurance against it. TIPS are priced relative to other government bonds, which frequently also have a negative real return (meaning your return net of inflation is negative). If you buy a bond yielding 2% and inflation is 2.5% your real return is -0.5%. Arguably, the TIPS just make the net yield more transparent.

     Investors can also buy bonds guaranteed by other governments (including several that have undisputed AAA ratings). This can introduce currency risk although some funds intentionally hedge that currency risk using various securities, so investors can diversify into other countries without making a bet on whether the U.S. dollar or another currency will move one way or the other.

Municipal Bonds

State and local government bonds (often called munis) typically pay interest that is federal and state tax free in the issuing state. This can be attractive to investors in high tax brackets in taxable (non-retirement) accounts. They tend to pay low interest rates because of the tax benefit, but their after tax yield can be higher than comparable bonds that have taxable income. The combination of tax benefits and diversification make munis an attractive option for many investors, in fact many investors sleep well knowing they have a set amount of tax free income from municipals every month.

     Muni bonds are generally considered as second only to Government bonds in terms of safety. But as with other bonds, there are highly rated muni bonds and there are poorly rated bonds, so be aware of ratings and carefully investigate their risks. In 2013, Detroit became the largest U.S. city to ever file for bankruptcy, although bond insurance covered some losses (the first such default by an American state or commonwealth since the Great Depression). In 2016, Puerto Rico defaulted on constitutionally guaranteed general obligation bonds, but those are extreme examples and according to Moody's Investor Services, between 1970 and 2015, the annual default rate on muni bonds in the US was less than a tenth of a percent.4

Corporate Bonds

Individual Government and Municipal bonds are typically accessible for interested sophisticated investors with fairly large portfolios, but a large percentage of investors get exposure to them through funds. Corporate bonds are somewhat more complicated and likely to be accessed through a fund since they are not as accessible individually through discount brokers. Corporations also have a wide range of ratings and quality. In 2016, Standard & Poor’s downgraded the debt of Exxon Mobil Corp. leaving just two U.S. non-financial companies with the AAA rating (Microsoft and Johnson & Johnson).

     There are many types of bond funds. Some index funds own the entire universe of bonds including government bonds, which tend to dominate many of the total bond funds. But there are also many style pure funds. A good default for investment grade corporate bonds is the iShares ETF LQD, which is a diversified fund with over a thousand bonds. LQD is one of the largest ETFs at over $34 billion (late in 2019) and has an annual expense ratio of 0.15%.

     Barclays High Yield Bond ETF (ticker JNK) has a higher yield than LQD but has underperformed LQD over some periods. It has a 0.40% expense ratio (which can explain part of any underperformance) and it’s not an apples to apples comparison between the two since more than just ratings differentiate the funds, but it as an example of the point that you can't always assume a higher yield will translate into outperformance.

     Vanguard offers bond mutual funds and ETFs with a range of maturity and durations. For instance VCSH is a short-term corporate fund and tends to have around a 3 year maturity, VCIT is a mid-term corporate fund with roughly 7 year maturities, and VCLT is a long term corporate fund with maturity usually over 20 years, but duration usually below 15 years (all three ETFs have expense rations of only 0.07%). SPSB is an even shorter term ETF from S&P with average maturities around 2 years (and also a 0.07% expense ratio).


One example of a hybrid between bonds and stocks is convertible bonds. They generally provide regular income and investors have the option to convert the bond into the stock of the issuing company. So they appear to offer the best of both worlds since they have regular income like a bond, plus upside if the stock appreciates. But convertibles tend to provide less income than not-convertible bonds. Some convertibles also have call features (allowing the issuer to call the bonds when it’s advantageous for them), plus they can be complex (which can favor institutional investors’ research ability relative to individuals), and investors should carefully track how the valuation of the convertibles may be impacting their asset allocation.

     Despite those concerns, I think convertibles can make sense for some investors, both practically and psychologically. For conservative investors, they can be viewed as mostly an allocation to fixed income, yet providing some upside from the equity exposure of the convertibility feature. Those interested in investigating converts can research the ETF CWB which has a 0.40% annual expense ratio.

Preferred Stocks

Preferred stocks are somewhat of a hybrid and are technically equity investments, but in general behave like some higher yield long term bonds. They provide a dividend before common shareholders can get dividends, but in the case of a bankruptcy, all debts are senior to preferred stocks. They tend to have a fixed yield, like a bond, but generally without a fixed maturity date. In periods of high inflation, the fixed payments will become less attractive over time. They also sometimes have call features, which like convertibles are more likely to occur when it is advantageous for the company, not the investor. Preferred stocks tend to have weaker ratings from the ratings agencies (relative to bond issuers) so they tend to have fairly high yields, which is one of their main attractions to investors.

     Another unusual characteristic to be aware of with preferred stocks is that U.S. corporations get favorable tax treatment on preferred stocks (of other companies). They can exclude up to 70% of the dividend from their taxable income (as long as they are held at least 45 days and own less than 20% of the other company). Individual investors don't get that advantage. The tax advantage corporations get causes more demand for preferred stocks and pushes their price higher, effectively lowering the yield for individual investors. Those interested in the asset class can familiarize themselves with the ETF PFF (which has a 0.46% expense ratio) and check its current yield relative to bond categories.

     Bonds markets are considered very efficient and fees should be examined carefully, and ideally avoided entirely if possible. Worth magazine ran an article in November 1996 titled "Losers out the gate" which began "Let's be blunt: government securities mutual funds don't deserve to exist." The point was that in "this part of the fixed-income market, coughing up management fees for active management almost never pays off." David Goldman expressed similar thoughts in an October 21, 1996 Forbes article titled "When bond fund managers get bored" which discussed how little active management can increase returns when the yield spread between 30 year corporates and 30 year treasury securities is under 1%. "The lesson here for mutual fund investors is this: There's little point owning a mutual fund that invests in high-grade corporates right now because there is little the manager can do to earn his keep."

     It’s important to note that bond ratings can and do change and the spreads between ratings move accordingly. Over an investment horizon, returns are determined by the initial spread, changes in the spread, and transitions in credit quality (changing ratings). The value of bonds can also fluctuate dramatically as interest rates rise and fall.

     Annuities are another option often marketed by insurance companies that are intended to provide fixed payments in exchange for an initial investment. The issuing company typically guarantees the income, but annuities tend to have fairly high expenses and investors can usually purchase the underlying investments directly without paying the annuity sponsor to package the portfolio (at a cost).

     The question at the start of the chapter was part of the Financial Literacy Quiz. Only 28% of the 2015 participants correctly responded that when interest rates rise, bond prices fall. 33% chose wrong answers and 38% responded they did not know.5 The explanation according to the National Financial Capability Study is as follows.6 “When interest rates rise, bond prices fall. And when interest rates fall, bond prices rise. This is because as interest rates go up, newer bonds come to market paying higher interest yields than older bonds already in the hands of investors, making the older bonds worth less.”

1. Source: "Are Bonds A Better Bet Than Stocks?" Pensions & Investments, June 24, 1996
2. Edward McQuarrie, The First Eighty Years of the US Bond Market: Investor Total Return from 1793, Combining Federal, Municipal, and Corporate Bonds, October 4, 2018
3. See Chen Lian, Yueran Ma, Carmen Wang, Low Interest Rates and Risk Taking: Evidence from Individual Investment Decisions, Review of Financial Studies, August 22, 2018
4. Moody's Investor Service, US Municipal Bond Defaults and Recoveries, 1970-2015, May 31st, 2016

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