Chapter 13: Bonds and Bond Funds

Most individual investors include bonds as part of their investment portfolios. Typically, bonds are the “safer” (or less risky) part of the portfolio. Essentially, bonds are loans to the government or a corporation, which are then paid back to the lender or bondholder over time. To simplify, a buyer of a bond has a contractual right to interest payments on a regular basis, and then the return of the principal. An exception would be a zero coupon bond (zeros), which has no coupon. Zeros are purchased at a discount to the par or face value. Upon maturity, the bonds are worth par or 100. The difference between 100 and the purchase price is your return. By purchasing bonds from highly-reliable issuers, a bondholder can have a very safe stream of income in the future.

Bondholders are protected. Usually, if a corporation goes bankrupt, bank debt is paid first, then secured bondholders, then unsecured bondholders. Only after those obligations are paid will excess funds be distributed to the holders of preferred and finally common stock.

One aspect of bonds that is not intuitive is the relationship between the “yield” of the bond (the return) and the “price” of the bond (what it costs to buy the bond). The yield and the price have an inverse relationship:

• When bond prices rise, bond yields fall.
• When bond prices fall, bond yields rise.

Just picture a see-saw with price on one end and yield on the other.
Other factors also influence the price of a bond. Generally, the longer the “maturity” of the bond, the more the bond’s value is exposed to rising and falling interest rates, and the general stability of the government or company that is repaying the bond. So, longer-term bonds pay higher rates of interest to compensate for those risks.

Financial advisors can use either individual bonds or bond funds for their clients. A portfolio of individual bonds provides certainty of the return of principal on specific dates, which offers major advantages:

• Individual bonds with stated final maturities can enhance financial planning opportunities. A “laddered” portfolio can be constructed with maturities coming due each year for a 10-year period, for instance. If interest rates fall, the longer-maturity bonds are providing a higher rate of interest and preserving income. If interest rates rise, the investor is not stuck with too many bonds at the old, low interest rates. Instead, when the short-duration bonds come due, you can reinvest the money to purchase higher-yielding bonds.

• Individual bonds eliminate many of the expenses associated with bond funds. Conversely, bond funds have the same disadvantages as equity mutual funds—high fees—and they do not guarantee the return of principal.

• Managers of bond funds may assume more interest rate risk or credit risk by purchasing bonds with longer maturities or lower credit quality to increase returns in an effort to compensate for their high fees.

• “Tax-free” bond funds may contain bonds that are subject to the alternative minimum tax (AMT), which is a federal income tax that affects millions of taxpayers each year. Bonds subject to AMT are taxable to certain purchasers. The higher yield makes the bond fund appear more attractive than it may be. Consider this example: If you are subject to the alternative minimum tax—as millions of Americans are—you would experience the following reduction in after-tax yield with regard to municipal bond funds with holdings that are subject to AMT.

Assumptions:
4.0 percent yield
26 percent alternative minimum tax rate
30 percent of the bonds in the portfolio are subject to AMT

Your effective rate of return would be approximately 3.69 percent, as opposed to the 4.0 percent yield advertised by the bond fund.

• The maturities of bonds held in a bond fund are constantly changing, but bond funds typically report their holdings monthly or quarterly. It can be difficult for shareholders to know the amount of interest rate risk or maturity risk that they face at any given time. An end-date or target date bond ETF, or a personalized portfolio of individual bonds, are more transparent and address this problem.

To be fair, bond funds do offer greater diversification than buying a few bonds directly. For smaller purchase amounts—$1,000–$10,000 for instance—index funds may make more sense, as many allow for investments of $1,000 or less. There is typically no transaction charge to purchase directly from the fund, as opposed to using a broker to purchase ETFs. Again, ETFs trade like individual stocks, so you may have to pay a commission for each transaction if purchased through a broker. ETFs that invest in bonds can be a cost-effective route to obtaining exposure to many fixed-income markets, such as Treasuries, corporate bonds, and high-yield bonds. Some bond ETFs are available with target end-dates as well, which addresses the uncertainty inherent in bond funds; however, if you need tax-free income that is free of both federal as well as state income tax, there are not many ETFs available. A portfolio of individual bonds issued in your state of residence may be the easiest way to avoid state income tax, as well as federal income tax. Many states levy state income tax on out-of-state municipal bond income.

Just like equity ETFs, fixed income ETFs experience tracking error—
failing to generate the performance of the index they seek to mimic. Also, certain segments of the bond market lack liquidity. This can make it difficult to obtain exposure to some of the individual bond issues represented in the index and, consequently, to track the index.

Most ETFs use a market-cap weighting approach. This means that the issuers with the most debt outstanding receive higher weightings in the index than less-indebted issuers. You and your advisor should be comfortable with the individual underlying holdings in any ETF, as well as the weightings applied to each holding.

To help avoid tracking error in ETFs, a good rule of thumb is to avoid an ETF until it has a track record of at least three years.
Does Your Advisor Have Bond Market Experience?
A financial advisor who understands credit analysis and how to trade bonds, and who can readily determine a bond’s value can add a great deal of value; however, most financial advisors have been trained to sell packaged financial products in which the actual investment is done by a third party. The advisor simply gathers money and hands it to someone else to manage. As noted several times previously, this approach adds a great deal of unnecessary expense. In the fixed-income arena, fees matter even more, because investing in bonds does not provide the potential growth that is provided by the equity markets.

Whether you purchase bonds directly from one or more brokers, and manage your own bond portfolio or elect to utilize a professional fixed-income manager, you are responsible for knowing what you own, and monitoring it for changes. At a minimum, bond investors should establish parameters with respect to:

• Credit risk
• Interest rate risk
• Position size
• Sector exposure
• Geographic exposure
• Liquidity

The following list is an example of allocation exposure to various areas of the municipal bond market:

1. No bond should have an “underlying rating” lower than A by S&P, Moodyor Fitch. Some bonds are insured and consequently carry a higher rating than they would without the benefit of such credit enhancement. If a bond does not meet your credit criteria without the insurance, or does not have an underlying rating, be careful. Investors who relied on insured bonds got a rude awakening when many of the bond insurers experienced huge losses in 2008-2009, and no longer offer much comfort to bondholders. Non-rated bonds can offer great value, but require professional management.

2. No more than 50 percent of the portfolio should be “revenue bonds” (for instance, bonds whose debt service is derived from revenues such as water or sewer revenue bonds, as opposed to tax collections).

3. At least 50 percent of the bonds in the portfolio should be “general obligation” bonds—bonds whose debt service is dependent upon some form of tax collections versus revenue. These so-called general obligation bonds may be issued by a state, municipality or local school district.

4. No position should represent over 10 percent of the portfolio for general obligation bonds, and no more than 5.0 percent for revenue bonds.

5. Essential service revenue bonds should have a debt service coverage ratio of at least 1.20:1.00. In other words, there is sufficient cash flow dedicated to the bond issue to sustain the debt service and provide a cushion should revenues fall. Other bonds whose revenues are not as stable should have much higher debt service coverage. For example, a small town with only one major employer is vulnerable. So are its water and sewer bonds.

6. Liquidity. This will vary depending upon whether you are investing in corporate bonds or municipal bonds, many of which have relatively small issue sizes. Ten million dollars or less for some municipal issues, versus $500 million for certain corporate bond issues.

7. No improvement district bonds. An improvement district that must sell lots in order to generate enough user fees to cash flow its sewer bonds is dicey. Yields may appear generous, but they are high for a reason—greater risk This is just a sample of the beginnings of an IPS for municipal bonds. An IPS for corporate bonds or U.S. government agency bonds would differ somewhat.

Remember, do not rely solely on the rating agencies. The rating agencies have a less-than-stellar record in identifying problems before it is too late.

For municipal bonds, the following questions should be part of the credit analysis performed by your financial advisor. The advisor should not blindly rely on the rating agencies, bond insurance or their firm’s trading desk:

1.What changes have occurred in the issuer’s financial statements?

2.How will economic adversity, such as a manufacturing plant closing, affect the creditworthiness of a bond?

3.What are the sources of repayment of the bond? Are there dedicated sources of revenue or general tax receipts?

4.Is the population in the issuer’s area growing or shrinking, and how will this affect repayment?

5.What’s the personal income per capita in the area?

6.What is the issuer’s debt-service reserve? Is it fully funded? In cash and/or securities, or through an insurance policy?

7.What is the debt service coverage for a revenue bond, such as a water revenue bond or sewer revenue bond?

8.What are the call features?

9. What is the size of the bond issue?

Individual bonds are much more transparent than bond funds; however, you as well as your financial advisor must be diligent about monitoring the issuers of the bonds you own. Certain transactions—such as interest rate swaps—have backfired on some municipalities, causing the value of their bonds to fall precipitously.

The following resources will help you track certain developments and activity. The web address for the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access (EMMA) is www.emma.msrb.org. On this site, you will find:

-Recent trade activity of individual municipal bonds (Just enter the bond’s cusip or bond identification number).

– Recent official statements describing the issue.

– Continuing disclosure documents.

The SEC requires issuers to disclose certain material events (ME) to every nationally-recognized repository for municipal securities should they occur.

These events include:

1. Rating changes.

2. Failure to pay timely interest and principal.

3. Modification of bondholders’ rights.

4. Sale, substitution or release of any assets securing the debt service for the bonds.

5. Any event affecting the tax treatment of the bonds.

6. Any unscheduled drawdown of debt service reserves or credit enhancement.

7. Calls.

8. Defaults.

9. Debt defeasance.

Always check your trade confirmations and monthly statements closely. If you notice “ME” beside a particular bond(s), call your financial advisor to find out why. You should always do your own due diligence. Do not strictly rely on your financial advisor. The aforementioned EMMA website will provide this information. All you need is the bond’s cusip number, which should be identified on your trade confirmations and statements. Another source for checking recent trade activity is www.investinginbonds.com. Look for the Trade Reporting and Compliance Engine (TRACE). Use this free resource to verify what others are paying for the same bond in which you and/or your financial advisor are interested.

The financial advisor’s employer will control which bonds are offered, and at what price. If you limit yourself to only one firm’s inventory, you severely restrict your opportunities. ClientFirst maintains relationships with many broker-dealers. Clients benefit from many firms’ underwritings and inventory. Prices are negotiated on the client’s behalf.

Call Features

Regardless of whether the bond is a municipal, corporate or government agency bond, you should always ascertain the “yield-to-worst” call. The bond may have more than one call feature. You should know what your lowest yield will be in the worst case scenario—the yield you will have if the most disadvantageous call feature is realized. This information should be identified on your trade confirmation (Purchase price/yield to maturity).

Most bonds—excluding U.S. treasury bonds—are callable by the issuer at certain dates and at certain prices prior to maturity. The call price may be higher or lower than the price you paid for the bonds. Consider this example:

Issuer: Bugtussle Water Revenue Bonds
Coupon: 5.0 percent
Maturity: 12/1/2039
Callable: At par 12/1/2024, to yield 2.39% to the call
Purchase price: 106.382
Purchase date: 112.246 / 11/22/2019

If this bond is called on 12/1/2024 at 100—the yield-to-worst call—your yield will amount to 2.39 percent. If the bond is not called on 12/1/2024, your yield will rise slightly the longer the bond remains uncalled. If the bond was never called (and simply matured), you would enjoy a yield-to-maturity of approximately 4.09 percent, because you got to hang on to the attractive 5.0 coupon all the way to maturity.

Do not be too impressed by the coupon or the “current yield” (coupon/purchase price). The yields that matter most are the yield-to-worst call and the yield-to-maturity. In the example above, the price was 112.246. Any price above par or 100 is referred to as a premium, and any price under par is known as a discount. This does not necessarily mean that one is a better value than the other as you might expect, it is just bond terminology.

Your financial advisor should not only be able to analyze the creditworthiness of a particular bond, but should also be able to recognize opportunities to avoid taxes. For instance, advising you to sell very short-term taxable bonds with long-term capital gains. This way, you are taxed on the gain at the much lower long-term capital gains rates versus waiting for the bond to mature at face value and paying ordinary income tax) on the remaining coupon interest payments.

Moreover, do not assume that your financial advisor has done a great deal of research regarding a bond fund recommendation. Ask them to share with you the amount of research they did to arrive at the recommendation. Some bond funds hold nasty surprises. They may use certain derivative securities (securities that derive their value from other securities) to enhance yield —derivatives that have counter-party risk to whomever is on the other side of the trade. As many Wall Street firms learned the hard way during the 2008-2009 financial crisis, certain counter-party risk can be devastating.

Checking Prices of Individual Bonds

Broker dealers charge mark-ups, as opposed to commissions, where individual bonds are concerned. If a broker dealer pays 98.0 for a particular bond, the bond might be reoffered at 100 to retail customers, for instance. Mark-ups are not required to be disclosed. Broker dealers acting as “principal” actually own the bonds. They are not required to, and typically do not, disclose their mark-ups, even if they just owned the bonds for one minute. If the broker dealer is acting as “agent,” commissions—such as commissions charged for a purchase or sale of common stock—must be disclosed on the trade confirmation.

If you buy bonds from a broker, you should check the prices paid by others for the same or substantially similar bonds. Otherwise, you might overpay. I do not believe that broker dealers should have to disclose their mark-ups any more than your grocer should have to disclose his mark-ups on produce. Sometimes, broker dealers take losses when they own or inventory bonds.

The amount of the mark-up is not as important as the price at which the bonds are offered. This doesn’t mean you should not try to negotiate.

Again, two websites that provide valuable information about bonds are www.investinginbonds.com and www.bondview.com. At investinginbonds.com, you can verify the prices at which various bonds have recently traded.

You can use this resource to compare the price you are being asked to pay against recent trades in the same or similar bonds.

TIPS

One particular type of bond fund that can be difficult to research is a fund that invests in Treasury inflation-protected securities (TIPS). The problem here is yield inflation. Morningstar tracks over 170 of these funds, and even though they all invest in TIPS, their yields vary wildly. According to a May 2011 Wall Street Journal article entitled How Inflation-Protected Funds Getto Inflate Their Yields by Jason Zweig:

“Among the 173 TIPS mutual funds tracked by Morningstar, the reported ‘SEC yields’ as of March 31, (2011) ranged from minus -0.77% to 5.58%, with twelve funds yielding at least 5.0%. Four of the seven exchange-traded funds that specialize in TIPS displayed yields greater than 5.0%.

Yet no TIPS (the bonds that these funds purchase) yield more than 1.75%. How could anyone but an alchemist generate 5.0% or more out of 1.75% or less? The answer lies hidden in the term ‘SEC yield.’ In 1998, the Securities and Exchange Commission (SEC) forced funds to include only dividends and interest income in the yield that they must show investors.

In months that capture a small inflation change, SEC yields on TIPS funds will be low. In months when the rise in the Treasury’s inflation value was 0.5%, SEC yield can brush 6.0%.

The return on TIPS, however, comes not just from interest income, but also from any adjustment in value as inflation rises. The SEC hasn’t issued any guidance to fund companies on how to handle this peculiarity when they show standardized yields.”

This situation allows mutual funds a great deal of flexibility in how they choose to identify their respective yields for TIPS funds.
This can be very confusing, whether you are a layperson or a financial advisor. The performance of TIPS funds may appear superior to the returns of traditional bond funds; however, this can be an expensive illusion, as investors flock into what they mistakenly believe is a higher-yielding security. If a true apples-to-apples comparison to traditional bond funds was available—in other words, if the required yield calculations for TIPS funds were the same as the yield calculation requirements for traditional bond funds, this confusion would not exist.

Stress Tests

At bondview.com, you can “stress test” your bond portfolio to see how prices may fluctuate under various interest rate scenarios. For example, how will your bond portfolio be affected if interest rates increased or decreased by 1.0 percent (100 “basis points”)? The stress test is a very valuable tool. Many bond investors have no idea just how far and how fast bonds can lose value when interest rates rise. “Duration” is a measure of interest rate risk. For instance, a 7-year duration implies that if rates rise one percentage point, the bond’s price will drop by 7.0 percent.

Given a low interest rate environment, if rates rise by just 2.0 percent, you could expect a five-year maturity non-callable government bond to fall in value by approximately 8.0 percent. Conversely, a 10-year maturity bond could be expected to fall in value by approximately 14 percent and a 30-year maturity bond by approximately 23 percent. Obviously, the longer the maturity, the greater the interest rate risk. Although your principal would be returned at maturity, newly-issued bonds would be paying much higher interest rates. Thus your “opportunity cost” (the difference in the yields on the bonds you already own versus the higher yields you could obtain if you had cash on hand) would be high. Your financial advisor should be able to run stress tests on your portfolio on a regular basis.

Investing in a Time of Low Interest Rates

At the time I wrote this (late-2011), low interest rates had forced individual investors to stretch for higher yields to meet their income needs by purchasing long-term bonds. The problem is that if interest rates rise—or rather, when they rise—those investors will be stuck with bonds paying very little interest.

Their income will be locked-in at poor rates of return, and they will suffer opportunity costs. They have foregone the opportunity to invest at higher rates in the future, unless they want to sell their bonds at a loss. The same is true of investors locking in annuity rates.

As of this writing, U.S. interest rates are at 60-year lows. This is due to several factors—most prominently U.S. government policy to keep interest rates low, and investors’ desire for safe havens for their money. Millions of baby boomers who were burned by the dot-com bubble, and again by the financial crisis of 2008, flocked to bonds. Unfortunately, this has created a bond bubble. Whenever the bubble bursts (and it will!), there will be a mad rush for the exits. Be sure that you and your financial advisor discuss what-if scenarios, such as:

• What if interest rates spike substantially higher?

• What if interest rates rise gradually over time?

• What if credit problems materialize in the bond market, and there is a rush for the exits?

• How can I maximize income without taking on significant interest-rate risk or credit risk?

• What is the plan of action in each of these scenarios?

As always, you should know what you own and how it may perform under various scenarios. With respect to the bond market, you need not stand at the exit trembling with fear, but you and your advisor had better know where the exit is.

Whether you choose to work with a professional fixed-income manager, or you are buying bonds from brokers on your own, you should have a basic understanding of the bond market.

Exit Strategy

Those who rely too heavily on bond-rating agencies may be surprised when the rating agencies make mistakes. This is what happened in 2008 to holders of many bond issues, including Lehman Brothers bonds, which maintained an investment-grade rating right to the end. Investors had ample opportunity to exit Lehman Brothers bond holdings. True, the sale might have been for 90, 80, 70 or even 50 cents on the dollar, but any of those bids were much better than nothing. The financial advisor who did not have his clients exit Lehman Brothers before it was too late, either lacked an exit strategy or was afraid to use it. An exit strategy is critical—especially for corporate bonds—as companies have fewer options in rough times than do governments, which can raise taxes or user fees to pay their bondholders.

The rating agencies got it wrong again with sub-prime mortgage bonds, as well as with the bonds of M.F. Global Holdings, Ltd., which were still rated BBB- by S&P a week before the company filed for bankruptcy in October 2011. Don’t take ratings as gospel. They are only one indication of value.

Your advisor should provide a robust, detailed analysis of your bond
portfolio, featuring:

• Weighted average coupon (WAC)
• Weighted average maturity (WAM)
• Modified duration (a measure of price volatility when interest rates change)
• Effective maturity (the date to which a bond is priced, considering
embedded options such as call features)
• Number of positions
• Average price
• Face amount
• Market value
• Yield-to-worst call
• Yield-to-maturity
• Accrued interest
• Cash flow spreadsheet
• Geographic dispersion
• Credit quality dispersion

In the next several chapters, I will discuss some costly products developed and sold by Wall Street. Enter the gauntlet.

Have a question? Contact Ed Mahaffy.

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