Special Bond Market Investment Opportunities
- Feb 8, 2008
In the previous chapter, we discussed investment-grade bonds, which represent most of the U.S. bond market. You also learned a technique to identify when interest rates trends are favorable for holding investment-grade bonds, and when they are unfavorable. The biggest problem with investment-grade bonds as of mid-2007 is that the interest rates they are paying are relatively low by the standards of the past 25 years. There are two negative implications of historically low interest rates:
- Even the most carefully selected portfolio of investment-grade bonds is unlikely to return more than 6%/year over the long term, because that is the level of current interest rates.
- Because interest rates have far more room to rise than to fall, interest rate risk is as great as ever.
As a result, investment-grade bonds are very unlikely to return as much in the next 25 years as they did in the previous 25.1
In order to get potentially higher returns from your bond investments, you can turn to some special types of bonds that are less visible to the investing public than investment-grade bonds. This chapter will introduce four such bond niches: high yield bond funds, floating rate bank-loan bond funds, inflation-proof bonds, and tax-exempt bonds.
Higher Interest Payouts... But Greater Risk
Up until now, the only risks regarding bonds that we have discussed resulted from the possibility that interest rates might move against you. However, there is another potential risk from bonds: the possibility that the borrower will not pay you the interest or principal that had been promised. That risk is called default risk. As you might expect, if you know at the time you buy a bond that the borrower has a significant risk of defaulting, you would demand a higher interest rate than if you were buying a bond from a financially secure company that has very little chance of failing to meet its obligations to its bondholders.
Bonds Have Credit Scores Too
If you watch TV or log onto financial websites online, you have likely heard advertisements asking you to pay to learn what your credit score is. The higher your credit score, the easier it should be for you to get a loan. It turns out that corporations that have issued bonds (or that plan to) also pay to receive a sort of credit score, called a credit rating. A credit rating is an assessment of the level of confidence that a company will be able to honor its obligations to pay interest and principal to bondholders when due. If financial conditions at a company change, the credit ratings on its outstanding bonds may change. There are three major firms in the U.S. that assign credit ratings to bonds: Standard and Poor's, Moody's, and Fitch.
The top credit rating applies to bonds guaranteed by the U.S. Treasury because the Treasury can literally print money if it needs to in order to pay the interest and principal it owes. Treasury debt amounts to approximately 30% of outstanding bonds in the United States. Below the risk-free credit rating of Treasuries, there a number of possible grades. (Personal credit scores are numbers, usually in the 600–800 range, but bond credit ratings are lettered.)
However, there is only one distinction of crucial importance for individual investors: investment grade versus below investment grade. Issuers of investment-grade bonds have rarely failed to make interest or principal payments on schedule. For example, from 1981–2000, the odds of the lowest-rated level of investment-grade bonds (a rating of BBB) defaulting were 0.22%.2 That means that for every $400 in investment-grade bond holdings, less than $1 worth defaulted in an average year. Bonds that are below investment grade, in contrast, have a significant chance of defaulting. The long-term average default rate for bonds that are rated below investment grade has been 5%, although the default rate in 2006 was well below that, at only 0.8%.3 Bonds that rated below investment grade are called high yield bonds or junk bonds.
Bottom line: We have already seen that changes in interest rates are one source of risk to your bond investments. Credit risk is another.
Not all defaults are equally harmful to investors. Some high yield bonds are backed by specific company assets (such as equipment). If specific company assets are pledged as collateral for a loan, the lender knows he will be able to recover something in the event of default. In contrast, most high yield bonds are backed only by a general obligation on the company to repay its loans. In the absence of specific pledged collateral, there is no guarantee that a borrower will have any resources available to satisfy its creditors in the event of a default. For this reason, asset-backed high yield bonds have historically lost less after a default than have high yield bonds without asset backing.
It is not necessary for a bond to default in order for bondholders to be hurt by credit risk. If a bond is downgraded, meaning that the risk of default appears to have increased, then the price of the bonds will likely fall. Conversely, if a bond's credit rating is upgraded, existing bonds will rise in value.
Just because a bond is rated below investment grade does not mean that it is a bad investment. High yield bonds are more likely to default than investment-grade bonds, so they must pay higher rates of interest in order to attract investors. Usually (but not always) the level of interest they pay makes high yields more attractive than investment-grade bonds. The trick to investing in high yield bonds is to be in the sector during stable market conditions (which is most of the time), but out of the sector during the steep declines that have periodically hit high yield bonds. You will learn how to do this in Chapter 8, "Treasure in the Junkyard—How to Tame High Yield Bonds."
In Chapter 6, "Bonds—An Investment for All Seasons; we state that only a relatively small number of open-end mutual funds have been attractive investment-grade bond investments, mainly because the expenses of most funds has outweighed the benefits that the portfolio management has provided. The high yield bond world is different: As a general rule, traditional open-end mutual funds are the best vehicles with which to access the high-yield area. Although we will see in Chapter 8 that there are some high yield bond funds that have excelled, even the average high yield fund has provided important benefits in terms of diversification and lower transaction costs that have more than made up for the funds' expenses.