Understanding Bond Investing

McRae Capital Management publishes Commentary as a useful service to help our customers and readers realize the rewards of a consistent, disciplined approach to investment management and long-term financial planning in changing times.

Bonds. Does any word resonate with a more satisfying or solid sound? When financial markets heave and churn, aren’t bonds a harbor of solace and security?

Yes… and no. Bonds were initially designed to possess those qualities, but their halos are not entirely untarnished. In fact, there may be more popularly held misconceptions about bonds than any other financial asset.

Join us, then, as we seek to penetrate the myths and uncover the realities of bonds.

Bonds are perfectly safe: (MYTH)

If by safety you mean getting your money back at maturity, bonds are generally speaking, quite safe. But they are not without risk. In fact, there are two principal risks associated with bonds: a quality risk and a market risk.

The quality risk is related to the credit-worthiness of the issuing agency or company. It’s entirely possible that over the life of a long bond – say, 30 years, – the fortunes of the issuer may decline. In that case, the bonds will not be as attractive to potential buyers if they need to be sold. If the decline in the company’s fortunes is serious enough, the issuer may not be able to make interest payments and, in the worst case, may entirely default on interest and principal.

MCR.05.main.webThe market risk for bonds is associated with both the economic cycle and the longer term secular trends in inflation. Either can cause interest rates to rise… which may cause the value of your bond to fall.

For instance, if interest rates go up, you may have problems. Let’s say you buy a 10-year Treasury bond paying 5 percent interest. After two years, interest rates increase to 9 percent. That means your bond will be worth only $831.50 for every $1,000 of face value. Now you’re in a quandary: if you hold the bond, you’re losing interest; if you sell it, you’re losing money on your original investment.

You can insulate yourself from these market and quality risks: (REALITY)

Good continuous investment management is needed to protect yourself from market risks. No longer can bonds be bought and ignored. At McRae Capital Management, we structure portfolios to be flexible. We choose maturities in anticipation of changes in interest rates, stagger maturity dates and diversify the portfolio among a number of different issues. Quality must be monitored continually.

Bonds are not volatile: (MYTH)

Because interest rates are volatile, bonds are volatile. Both short and long term interest rates are changing all the time – the result of a number of factors, from rational ones like the current demand for money to emotional ones related to economic uncertainties, such as the prospect of higher inflation. Care must be taken to ensure the proper maturity schedule to avoid losses due to rising interest rates.

Bonds are an important part of most portfolios: (REALITY)

Short and medium term bonds are important for investors because they provide stability and income. Along with equities, bonds are one of the ingredients of a balanced portfolio. At times, available returns on bonds are higher than those anticipated for equity investments.

An investment advisory firm like McRae Capital Management concentrates principally on stocks: (MYTH)

Fixed income investments are an essential part of our investment approach. In fact, with few exceptions, the portfolios we manage contain various types of bonds, depending on clients’ needs and our assessment of the relative attractiveness of various types of investments. Our approach to investing is one of balance. McRae seeks growth in the equity portion of the investment portfolios it manages and income and stability in the fixed income portion. As an independent investment firm, McRae Capital Management designs bond portfolios that are right for its clients – a far different situation from that encountered by most individuals who wind up buying from a broker’s limited inventory.

That means everyone should own some bonds: (MYTH)

Examples from McRae-managed portfolios can best illustrate this. A few clients’ portfolios – very few are completely composed of fixed income investments. Yet we also have some that are 100 percent invested in stocks. The point is that it’s never wise to generalize about portfolio composition because every investor is unique.

McRae Capital Management designs bond portfolios that are right for its clients – a far different situation from that encountered by most individuals who wind up buying from a broker’s limited inventory

If you buy “quality,” it’s hard to go wrong buying bonds compared with buying stocks: (MYTH)

In fact, we believe that since World War II more people have been hurt in bonds than in stocks. Over the last 60 years, the average return for long term bonds has been lower than the return on either common stocks or short term cash equivalents. The reason is inflation. People commit to long term bonds and then see their purchasing power eroded. Let’s say someone bought a 30-year bond paying 6 percent interest annually. And then, as it did in the late 1970’s, inflation kicks into high gear with annual increases on the order of 12 – 13 percent. In that instance, the bondholder has less real income every year the Consumer Price Index (CPI) exceeds the coupon rate.

This is an example of the type of market risk discussed earlier. That 6 percent bond cannot be sold for face value when prevailing interest rates are running above 6 percent – it must be sold at a discount to compensate for the fact that its coupon rate is lower.

Junk bonds are just that: junk. (MYTH)

Perhaps this is a matter of semantics. Actually, only 5 percent of American corporations issue what are ranked as “investment grade” (meaning highest safety) bonds. That leaves some fairly well known American corporations today issuing bonds that pay a premium interest rate because there is more risk involved. While these bonds are lower quality, they are not truly junk bonds. The name “junk bond” arose during the last few years when very high coupon bonds were issued by corporations that were being restructured through various types of leveraged buyouts. Several “junk bonds” are now in default, but the big worry is how many will fail during the next recession.

At McRae, we don’t include “junk” bonds in our portfolios. As Mark Twain once said, “I’m more concerned about the return of my money than the return on my money.”

Bonds are hard for most people to understand and follow: (REALITY)

Bonds don’t command the headlines like stocks and are subject to lots of technical jargon. Bond traders don’t talk in terms of price, but rather basis or yield, and prices move inversely to yield. Additionally, there are many types to consider: convertibles, zero coupons, put bonds, variable rate bonds, municipal bonds, etc.

But good bond management – sorting out the myths and realities – is every bit as important as good stock management. Experience and in-depth knowledge to make decisions about what to buy and what to sell, and when, are essential. A consistent philosophy – such as McRae’s balanced approach – helps immeasurably in the search for bonds with true gilt.

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This article can provide only a general understanding of sometimes difficult financial concepts. For for a more thorough explanation, or if you have questions about your own portfolio, please feel free to reach out to us here at McRae at (973) 387-1080.