With the stock market grabbing all the exciting headlines, you could conclude that the bond market is simple and inconsequential. At first glance, bond investing seems easy: you buy a bond, receive periodic interest payments, and get your money back at maturity. Piece of cake, right? Not really. The bond market is far more complex than that.
When you own a stock, you actually own a piece of that company. It may be an extremely small piece, but it’s ownership nonetheless. A bond, on the other hand, represents debt. So when you own a bond, you are essentially lending money to the issuer of the bond. And all sorts of entities issue bonds:
• Corporations need money to run their businesses
• Sovereign governments need money to run their countries
• U.S. municipalities (cities, states, and counties) need money to build bridges, sewers, schools, etc.
In general, the interest you earn on bonds is taxable, but if you own municipal bonds, you earn interest that is not federally taxable. This is enticing, but not necessarily a better deal. For example, is it better to own a taxable bond that pays 5% interest or a tax-free bond that pays 3% interest? The answer: It depends! If you pay taxes at a high rate, then you are more likely to benefit from avoiding the tax. Simple math can tell you which is best for you.
Additionally, bond interest payments can vary widely:
• Fixed-rate bonds pay the same amount every year until maturity.
• Payouts for floating-rate bond change depending on the prevailing market interest rate. When rates go up, the bond pays more, and vice versa.
• Some bonds do not make cash interest payments at all, they just accrue interest over time and pay at maturity.
• Payments from mortgage-backed securities (MBS) depend on cash flows from homeowners. Standard mortgage payments are part interest and part principal. Therefore, when you own an MBS, you receive a monthly payment that is part interest and part principal (as opposed to getting all the principal back at maturity). MBS’s can get much more exotic when cash flows are sliced, diced, and repackaged for sale to investors, so it is important to do your research.
Many bonds have features that completely change their risk profile.
• Some provide protection. For example, you may become concerned that a company mismanaging its finances would not be able to pay you back at maturity. If the bond were “putable,” you could force the company to pay you back early.
• Another feature can hurt your return. If the bond is “callable,” the company can force you to sell it back to them prior to maturity, potentially at a lower price than you paid for it.
• Convertible bonds can be exchanged for shares of stock in a company. You get upside potential, like a stock, but still earn interest on the bond if that upside does not pan out.
The most obvious risk when you lend someone money is that they will not pay you back. If they are trustworthy, you may offer better terms. Similarly, if you buy a bond issued by a reputable company, you would be willing to accept a lower interest rate. In the bond world, credit-rating agencies help investors sort out the dependable from the deadbeat. Credit ratings fall into two broad categories — investment grade (less risky) and non-investment grade (more risky) — but relying heavily on these agencies and their ratings is dangerous. After all, they did play a big part in causing the 2008 Financial Crisis. At BCWM, we dig into the financial reports and perform our own credit analysis when crafting bond portfolios.
Buying a stock is easy. Most stocks trade by the millisecond on an electronic exchange and the current price is always known. But buying a bond is a far murkier process. Here, bond dealers act as middlemen between buyers and sellers, and the price is more of a negotiation. The dealers then take a cut as compensation for arranging the trade. The size of your trade really matters, too. Bond dealers don’t earn much on a small trade, so they’ll take a bigger cut, and that hurts your investment return! Our team’s ability to trade bonds in bulk results in favorable prices for our clients.
This peek into the bond market offers some sense of its complexity. By thoroughly understanding the intricacies of bonds (and other securities), the BCWM Portfolio Management team is able to craft portfolios for clients with the goal of delivering the return they need with as little risk as possible.
This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.