Investment Guy

As investors, we have a variety of opportunities to determine where to place our money and ‘bet’ on the markets. For an aggressive investor, the stock market has been the venue of choice. For conservative investors, bonds have had the upper hand.

The famous cowboy/philosopher Will Rogers always said “I’d rather have a return of my money than a return on my money”  Hopefully this quick guide to bond risks will help you invest in bonds and receive not only a return on your investment, but more importantly, a return of your investment.

Over time, the markets have expanded their offerings from traditional holdings of stocks and bonds to more creative opportunities and higher risk assets. Still, bonds have not changed their stripes over the years. These have traditionally been stable, secure investments that have offered a predictable stream of supplemental income.  This is because a bond is issued with a fixed payment rate of return over a specified period of time- typically until the bond matures.

 However, there are still risks to consider. Let me name a few:

• Inflation Risk: Because of their relative safety, bonds tend not to offer extraordinarily high returns. That makes them particularly vulnerable when inflation rises.
• Interest rate risk: Bond prices have an inverse relationship to interest rates. When one rises, the other falls.
• Default Risk: A bond is nothing more than a promise to repay the debt holder. And promises are made to be broken. Corporations go bankrupt. Cities and states default on muni bonds. Things happen…and default is the worst thing that can happen to a bondholder.
• Downgrade Risk: Sometimes you buy a bond with a high rating, only to find that Wall Street later sours on the issue. That’s downgrade risk.If a credit rating agency such as Standard & Poor’s and Moody’s lowers their ratings on a bond, the price of those bonds may fall.
• Liquidity risk: The market for bonds is considerably thinner than for stock. The simple truth is that when a bond is sold on the secondary market, there’s not always a buyer. Liquidity risk describes the danger that when you need to sell a bond, you won’t be able to.
• Reinvestment Risk: Many corporate bonds are callable. What that means is that the bond issuer reserves the right to “call” the bond before maturity and pay off the debt. That can lead to reinvestment risk.

If you want some more information about how individual bonds are priced in your account, check out Bonds and Your Brokerage Statement.

2010 Interest Rates on 10 Year Bonds

1.      In 2010, bond yields have moved 1.7% from peak (4.0%)  to trough (2.3%)

2.      In 2010 the Fed has changed rates ZERO times.

Interest rates move up and down in small increments all day, every day.  Over time these small movements can have tremendous effects on your investments.  

It is imperative to understand that rate movements are determined by the market, not the Fed.  This is contrary to the way most people think of interest rates.  Rates can start moving up without any decision from the Fed, and that should negatively effect your portfolio. 

We’re coming out of a declining interest rate environment that lasted for 30 years!  This has been a friendly climate for fixed income investments.  What will the next 30 years be? 

How susceptible is your portfolio?  If you would like to review your investments, please don’t hesitate to call.

Remember: The purchase of bonds is subject to availability and market conditions. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income.

Interest Rates 1970-2010, as of 12/17/2010

When interest rates go up, the price of bonds goes down.  

Take a look at this graph of interest rates going back to 1970.  Rates are at 40 year lows, aside from a short lived blip during the 1^st quarter of 2009 when the economy nearly halted.

In the short term, it is possible that rates stay here or go down more.  But in the long run an increase in rates is inevitable, with the enormous deficit and the amount of money being printed.  Once the economy starts to pick up steam, we will see a reversal in rates and UP will be the new long term trend.

If you hold fixed income investments such as bonds, you need to take a look at the duration in your portfolio.  Duration is different than maturity– this is an important distinction.  Duration can be used to calculate the effect each 1% increase in interest rates will have on your investment.

The economy is still soft, and the fed intends to keep rates low.. for now.  Once the economy picks up however we may see a vicious cycle of rate increases and the subsequent decrease in the price of bonds.

Duration matters.  Now is a good time to evaluate your investments and prepare for the future.  There are steps you can take to reduce the interest rate risk in your portfolio.  Call us today to discuss appropriate strategies.

As if the tax-free income isn’t enough of a reason, here are 2 more reasons that Tax-Free municipal bonds may become even more attractive in the future.

 1.                 Tax rates are going up [probably]

Tax-free muni bonds have always been an attractive investment for their combination of high quality, low default rates, and Taxable Equivalent Yields (TEY). The TEY represents the amount of yield you need before taxes to realize the equivalent income of a tax-free.  The TEY goes up as your tax bracket increases making tax free income more powerful if you are in a high tax bracket.  The greater your tax bracket is, the more interest you keep when compared to a taxable investment. 

 Therefore if tax rates go up, after tax yields shown above will be going down Read more…

There are stocks and then there are bonds.  The bond market is infinitely larger than the stock market and much more influential on the economy as a whole, but it is far less understood by the masses.  The last year and a half has rattled all investment markets across the board, including the historically stable bond market.  The effect that bonds have on brokerage statements and account values is often misunderstood.

First let’s talk about what a bond is and then I will explain how the market effects the value of an investment in bonds.

A bond is debt, issued by an entity that wants to borrow money.  It is a loan, plain and simple.  In principle, it is identical to you, an individual, going to a bank to borrow money.  You borrow money, pay the bank interest, and eventually you will have to pay back the full amount of the loan. 

In lieu of obtaining a loan from a bank, when a company wants to borrow a large sum of money, they will often issue a bond.  Individual investors play the role of the bank, and ‘buy’ the bonds increments of $1000.  Each bond will have a stated interest rate and specific date at which the bond will mature and pay back the loan.

What does all this mean to an investor?  Let’s use the fictitious company the Clam Shack as an example.  Business has been great and management decides that the time is right to expand.  The Clam Shack wants to open 5 more shacks, and determine the need to raise $10 million.  After having their finances evaluated they have been rated AAA and learn that it will cost them 5% to borrow annually for 10 years.

Now, assume that you buy 10 of the 5% Clam Shack bonds.  You have invested $10,000 and will receive $500 in interest payments annually for the next 10 years, and after 10 years you will receive your $10,000 back.

The Secondary Market
Once you own this bond it will show up on your monthly brokerage statement.  However, there are some important things to be aware of.  The bond market is constantly moving and will change from day to day.  The bond market moves much like the stock market, reacting to news, statistics and other indicators.  Your bond will usually be priced on your statement above or below the par value of $1000.  This is an indication of the current state of the bond market, and your bonds relative value.

You have likely heard the statement “the Fed just cut interest rates”.  Let’s assume the fed just cut rates 1%.  The 5% bond that your previously bought will go up in value.  Interest rates goes down, bond prices go up.  And vice versa; it is an inverse relationship. 

 We can easily illustrate this with our previous example.  When we purchased our Clam Shack bonds we were in a 5% interest rate environment.  Now that interest rates have been cut, if you want to buy $10,000 AAA bond you will only get 4% for a 10 year investment.

If you have $10,000 to invest, would you prefer a 4% or 5% rate of return?

This only matters if you want to sell your bond before the bond’s maturity date.  There is a secondary market for bonds that will adjust all prices so that there is a level playing field.  and the 5% Clam Shack bond that you own will be more desirable for anyone seeking income.  By paying $10,800 for annual  income of $500 you will receive an equal investment of $10,000 for $400 interest annually. (approx)

So your brokerage statements will always show the amount of money you will get for your bond if you sold it on that day.  If your statement says you have a $10,000 bond investment worth $9,000 you will still receive $10,000 at maturity.

This is an explanation of how bonds are priced on your brokerage statement.  There is a lot of information to consider when investing in bonds including default risk, reinvestment risk, liquidity risk, and inflation risk to name a few.