Cooking is the science - and art - of combining different ingredients together to create something that nourishes our body and also pleases our palete. Some might say that cooking is more art than science and that investing is more science than art. One of the ingredients in our investing recipe is bonds. Like the food pyramid, they can be thought of as the layer just above the base (cash) that tends to keep our financial world from toppling over.
What Is A Bond?
A bond - or fixed income instrument - is essentially an IOU. It is inevitable for some embarrassed student to forget their lunch money on the first day of school. Those of us who had enough spare change might loan money to our new classmate and request that they give us a cryptic note documenting their name, the date, and the amount owed back to us. A bond is a similar "contract" where the borrower (that poor kid) agrees to pay back the principal (the amount borrowed) plus some interest. The interest rate charged may be minimal - if that kid seems trustworthy - or large when we think there is a good chance that they will not pay us back. The image shown below represents a $1,000 bond initiated May 1, 1895. The loan is for a 30-year term to help build the Western Pacific Rail Road. After the 30 years, the bearer of the certificate had the right to reclaim their $1,000 principal.
Why Invest In Bonds?
One of the reasons people wanted to (and still do) invest in bonds is that they often provide a steady stream of income. The small images at the bottom of the Western Pacific Rail Road certificate are called coupons. Beginning in May and November, the certificate holder would literally clip the next coupon in line and deliver the piece of paper to the bond issuer - in this case the City & County of San Francisco. The beautiful fine print indicates that this particular bond paid a 7% annual interest rate. Each of the semi-annual coupons was worth $35 (7% * $1,000 / 2) which was paid in gold! The coupons shown above lost some of their detail when we zoom in, so another example is presented in the below image. This is for another railroad company and the semi-annual coupon pays the holder $21.25. This looks like the 93rd coupon in a series of 100 payments that completes on April 1, 1981. If my math is correct, the initial bond was made around April 1, 1931. 50 years is a long time to be collecting these coupon payments and my guess is that much of this income was paid in cash or check to the investor holding the certificate.
Another reason for investing in bonds is that their return patterns are often very different from those of stocks. This has the effect of smoothing the "ride" for an investor who hedges their bets by using these two parts of the capital structure to help them grow their portfolio over a long period of time.
A final reason to consider investing in bonds - especially these types of bonds - is to provide capital for the growth of an entity or project. We might be hard pressed to find any budding entrepreneur who would not be giddy about the idea of funding the construction of a railroad back in the late 1800s.
What Are The Returns?
Professor Roger Ibbotson of Yale University and Ibbotson Associates fame has compiled very useful data from 1926 to the present. This data is published once a month in the Morningstar Stocks, Bonds, Bills, and Inflation (SBBI) database. The table below shows the total annualized returns for a handful of major asset classes over the last 95+ years. This data is sorted from highest risk asset class (small US stocks) to the least risky asset class (30 day Treasury Bills). We can see that over that time, the three classes of bonds have returned between 5.12% per year and 6.14% per year. The LT acronym tells us that these were 20+ year maturity bonds while the IT designation is for 5 year bonds (often referred to as notes). The bottom line is that - although the bond investors did not become as wealthy as the stock investors - their $1 investment would have still turned into between $114 and $287 over that 95+ year period. I guess that good things really did come to those who waited!
What Are The Risks?
You may find the growth of a $1 table too good to be true, but it was Albert Einstein who said the miracle of compounding was the 8th wonder of the world. These impressive long term results, however, did not come without their risks. The returns for each of the three bond categories described in the preceding table often dipped below zero - meaning that investors who sold in a panic did lose money. Once bonds are issued in the "primary" market, they can either be held to maturity and the investor can recover their principal after waiting for the typical 5 to 50 year bond term or they can be sold in the "secondary" market at the then current market price. The equation that defines the current market price of a bond includes four inputs: (1) the principal amount invested, (2) the length of the term to maturity, (3) the amount of the periodic coupon payments, and (4) the current interest rate. The three primary risks we will mention today are interest rate risk, call back risk, and credit risk.1 Interest rate risk occurs when the secondary market interest rates rise and the price of our bond falls. Another risk comes from certain types of bonds when they can be "called" or bought back by the issuer. This is most common when interest rates fall - and investors are "forced" to sell their bond at a higher price (a good thing).
- Interest rate risk
- Call back risk
- Credit risk
Credit risk is what keeps most professional bond analysts up at night. These analysts try to quantify the creditworthiness of the bond issuer and how it might change over time. In boom times, the bond issuer (with whom we invested our money) may be doing great and paying our coupons on time. When the economy hits the skids (like the last year), that same borrower may have a harder time repaying the loan we gave them many years ago to help them grow their business. The table below shows the qualitative range of ratings from the three primary bond rating agencies. These ratings are very much like a personal credit score our bank might "pull" before we are granted a loan for a car or home.
The higher our personal credit score, the lower our perceived risk (from the lender perspective) and the lower our borrowing costs in the form of interest rate payments. The table above also shows two main portions of the bond market as described by the credit spectrum - investment grade and high yield (junk). Prime credits never miss their coupon payments and are very unlikely to discontinue their business operations. Companies in default, however, have already missed coupon payments and may be at risk of dissolving or restructuring their business operations. As investors, we are in the seat of the lender and our main goal is to accurately translate a corporate credit rating into a quantitative input to place an objective value on our bonds. Analysts spend every waking hour trying to accurately model credit risk - so it is worthy of our attention in a subsequent blog post.
What Are The Costs?
We might think that bonds seem like a really good idea. They offer a counterweight to the returns of stocks that helps smooth our portfolio "ride" and they often provide periodic income to help pay our recurring living expenses. While the race to zero commissions in the brokerage world has reduced the cost of trading stocks and exchange traded funds (ETFs), that same dynamic has not cascaded into the bond markets. Standard & Poor's recently estimated that the average markup for an investment grade corporate bond was 0.85% of the principal value and the same markup for an investment grade municipal bond was 1.21% of the face value.2 Another challenge with investing in individual bonds is the face value increment. Creating a diversified portion of a portfolio from bonds is very difficult when the increment for most bonds is now $5,000. That is one of the reasons that ETFs are a more convenient and cost-effective way for many investors to access the benefits of the bond markets.