Bond Investing in 2017
As growth and inflation expectations have risen over the past several months, stocks and bonds have had very different reactions. Let’s look at some principles of bond investing to shed some light!
Bonds can be offered by many different types of agencies, including federal governments, municipalities, and corporations. These securities have five inherent components:
- Maturity – how much time is left until the bond expires and the principal is returned to the lender. The longer the maturity of a bond, the more sensitive the bond market price is to changes in prevailing interest rates.
- Duration – the maturity of an investment based on weighted cash flows. If the majority of a bond’s cash flows are attributable to the final principal payment, then the duration will be closer to the bond’s maturity.
- Coupon/interest rate – the stated amount that the lender will be compensated on a regular basis for providing the loan to the borrower. The amount is typically paid on an semi-annual basis and is based on a percentage of the par value of the bond. For example, a bond with a coupon rate of 5%, paid on a semiannual basis, and $1,000 par value will receive coupon payments twice a year of $25.
- Yield – the annual return, in percentage terms, the investor will expect to receive by investing in the bond if held to maturity. Yield is inversely related to price; the higher the yield, the lower the price, and vice-versa. Yields can be stated as return within a certain time period such as yield to maturity or yield to call. If a bond’s price is greater than its par value, the bond is stated to be priced at premium and the yield to maturity will be lower than that of the par priced bond. The opposite of a premium is a discount, and occurs when the market price is lower than par price.
- Credit rating – is an assessment of the likelihood that the borrower will repay the borrowed principal and meet scheduled interest payments. The lower the credit rating, the less likely that the borrower will meet these payments. There are two tiers to credit ratings, investment grade and speculative (junk) grade.Weatherly limits its fixed income investing to bonds with investment grade ratings.
Fixed income valuations are derived from the characteristics listed above, but are responsive to universal market risks. Investors are compensated for taking on additional risk through a higher coupon payment or higher yields/lower prices. The following risks are common in bond investing:
- Interest Rate Risk – As interest rates rise, newer issues of bonds will have higher yields that compensate lenders at a higher amount. Now that these “new” bonds with a higher compensation rate and lower priced bonds are available in the market, bond buyers will have less of an appetite for the previously issued bonds with a similar risk profile, but lower interest/coupon rate. Therefore, these “old” bonds will experience a decline in market value and rise in yield until there is an equilibrium in the marketplace.
- Credit/Default Risk – The greater the likelihood that an interest payment or repayment will not be met by the borrower. As with most other risks, the investor will be compensated with a higher coupon rate or higher yield for taking on the higher risk.
- Maturity Risk – In a vacuum, a bond with longer maturity has a greater risk than a bond with a shorter maturity purely because the lender is required to wait a longer period of time to receive the principal repayment amount. This is featured on the upward sloping yield curve, as investors are compensated with a higher yield on their investments, the longer the maturity of the bond.
- Inflation Risk – Traditional bonds will repay principal at the maturity date and pay the stated coupon at the regularly scheduled date. The inherent risk to lenders is that these payments are not indexed for inflation and will therefore not rise in value with the inflation of a given currency, negating the real return of the investment.
If rates do rise, how will that affect fixed income investing for Weatherly clients?
Investments with longer maturities such as 30 year or even 50 year investments experience a more dramatic drop in price compared to similar shorter maturity investments as rates rise. Speculative grade investments with lower credit quality also respond with a larger depreciation in market value in a rising rate environment in juxtaposition to investment grade bonds. Weatherly strategically invests in high-quality (investment grade) and short to medium term (generally <7 years to maturity) investments with values that are marginally less affected by interest rate changes risk to avoid a steep drop in portfolio returns. Duration is generally much lower than average maturity in Weatherly portfolios.
How will the new administration’s policies affect bond values and availability?
The new administration has advocated for widespread tax reform, most notably the decrease of marginal tax rates for individuals and increased infrastructure spending. Municipal bond income is untaxed for individual bondholders and boost after tax yields for high-net worth individuals. Marginal tax rates would be required to drop significantly to equalize the current after-tax yields of municipal bonds with comparable U.S Treasuries and corporate bonds. The current administration has also proposed infrastructure spending in many districts that would boost municipal bond issuances and a potential offering of a Build America Bond replica. Build America Bonds, created under the America Recovery and Reinvestment Act in 2007, are taxable municipal bonds that carry federal subsidies for the bond issuer, who can then pass on the subsidy to bond buyers. Build America Bonds are often attractive for individuals with minimal difference between their pre-tax and after-tax yields, but a desire for high quality credit ratings, low duration, and high yields. Government spending could also be advantageous for TIPS and convertible debt holdings, as the stimulus could drive inflation in the economy, benefiting holders of investments that keep pace with inflation.
As the domestic fixed income investing environment dynamically changes, Weatherly continues to be a stalwart investor for our clients to find securities that boost yields, while maintaining risk/return profiles.
** The information provided should not be interpreted as a recommendation, no aspects of your individual financial situation were considered. Always consult a financial professional before implementing any strategies derived from the information above.