The Basics of Owning Bonds

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.

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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.