Friday, November 25, 2016

This Week's Message: Bonds' Painful Lesson...

Being that bonds have not been a feature of our clients' portfolios for quite some time, I've not been compelled in quite some time to make them a topic herein. But with the dramatic drubbing they've taken of late (chart), I thought I'd go there this week. Plus, if this keeps up -- which it'll have to for awhile -- we might, after a long hiatus, find ourselves actively pursuing bond market opportunities on behalf of our clients...

The iShares Aggregate Bond ETF (white) and the S&P 500 (green) from June 30 through November 23:  click to enlarge...


Bonds to many are synonymous with safety. In the early days of my career, when I was in total need of the counsel of others (my employers), I was fed steady helpings of what today remains popular thought:
"You have to own bonds if you hope to limit the depths of the inevitable draw downs that come from owning stocks."
There was little, if any, talk of interest rate sensitivity, credit and tax risk, etc. It was basically:
"Put X percent of the client's portfolio -- based on how he/she answered our boilerplate risk questionnaire -- into our corporate and/or government securities bond fund(s). And, of course, divide the equity portion among our equity funds."
Aside from the obvious conflicts of interest ("our") implied above, while the urgings of my superiors didn't necessarily represent unsound (when delivered properly) advice, they desperately lacked scrutiny.

Sure, you buy a high quality bond and hold it till it matures and you'll receive the promised interest rate and get all of your money back. Ah, but a not so funny thing can happen between here and, say, 2026 when, say, General Electric will hand you back your principal: Should interest rates rise your monthly statement will give you a bit of a shock, as the value (the price another is willing to pay for your GE bond due in 2026) plunges. So, in a panic -- or perhaps in bewilderment -- you call your adviser to find out what's what. He/she calms you down by explaining that that plunging price only applies if you were to sell, which you're not going to do. Which is what you might hear from me with regard to your stocks during a correction, but we're talking bonds here -- which are supposed to represent the "safe" part of your portfolio...

Well, yeah, okay, it's true that if you don't sell (and instead hold till maturity) you (forgetting inflation) don't lose. However, I can virtually guarantee that your adviser will leave out the unfortunate part that if rates continue rising and ultimately hang around awhile at some historically sensible rate (they've been historically non-sensible for a long time),  the opportunity cost -- the difference between your historically-low yield and what you would be receiving had you waited and not bought a bond at a historically-low yield -- is a doozy!

And, alas -- if like the majority of advisers I grew up with would still do -- yours sells you a bond mutual fund, it can be even worse than my example above. Per the above, when you buy an individual bond from a high quality borrower, you know you'll eventually get your money back and you know precisely when. With a fund, you won't even enjoy that luxury. Its manager(s) (for a fee that you wouldn't have to bear while owning individual bonds) is forever buying, selling, holding and reinvesting the matured principal of generally the great number bonds that populate the fund. The fund itself has no maturity date and, thus, you can't relish the thought that -- at least if I wait till, say, June 30, 2026, I'll get all of my money back.

Other potential problems:

In the interest of brevity, I focused the above on the risk of owning "high quality" bonds in a rising rate environment. As for credit (or default) risk -- the risk that the issuer can't make the interest payment and/or return your principal -- that's most prevalent with the bonds of lower-rated (aka high yield) issuers, which are subject to economic and business, as well as interest rate, risk. Downgrade risk is felt when a rating agency (like S&P or Moody's) lowers an issuers credit rating, inspiring bondholders to exit, which -- as you might imagine under such circumstances --would see the price lower, perhaps by a bunch.There's also what's called "prepayment risk" which applies to mortgage backed securities that would return principal at perhaps inopportune times when some of the mortgages held are refinanced. It also applies to bonds with a call feature that allows the issuer to redeem the bond prior to maturity. Tax risk applies to municipal bonds and occurs when the prospects for lower tax rates might mitigate their tax-free advantage and, thus, inspire investors to sell (forcing prices down) and look for better opportunities in taxable issues. Liquidity risk becomes an issue when the market for a particular issue lacks willing buyers (think downgrade risk), which could see your bond hugely lower in price as you and/or others try to convert it to cash. And, lastly, there's inflation risk; the risk that inflation rises while you sit there holding the bond you bought in a lower-rate/inflation environment. Sure, you could sell, but that's the problem we just explored in this blog post.

Bottom line: Bonds are a bit more complicated, and potentially more volatile, than I fear a lot of yield-chasing folks are aware of. Could be a painful lesson...

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