A Guide to Bonds: Risky, Arcane, but Essential
By ROBERT D. HERSHEY Jr. -- January 3, 1999
Jay Gatsby was a bond guy in F. Scott Fitzgerald's
yarn of the Roaring Twenties. The bond market was
also the playground for John Meriwether's 1990s band of
Nobel laureate-speculators who made eight-figure
fortunes for Long-Term Capital Management before its
recent meteoric fall.
Traditionally, though, bonds have been seen as boring,
arcane investments suitable only for the aged, the
already rich, the unimaginative and the hopelessly
conservative. Not all that long ago, bond yields were
lower than those on stocks on the grounds that it was
stocks -- can you believe it? -- that people thought
might carry some risk.
The truth about bonds is that they can be arcane, and
they can be risky -- but that they have a place in
almost every portfolio. And that is the case despite
four consecutive years of supercharged gains in stocks,
and despite the fact that the interest being paid on
quality bonds, once collar-sized and then hat-sized, is
as slender these days as a woman's ring size.
A generation has grown up believing that there is no
growth in just lending money to a company or
government. No, the smart thing is to become an owner,
to get a piece of the action -- in other words, to be
in stocks.
But life is more complex than that. Markets change --
consider the gyrations of the last year alone. People
budget for college, face job losses, approach
retirement or just plain get nervous when some stocks
sell at multiples of revenue that at one time would
have been thought ridiculous multiples of profit.
Investors may know that through history, stocks have
outperformed bonds by handsome margins -- but they
worry nonetheless that form won't hold indefinitely. In
fact, not only did bonds beat stocks during the first
nine months of 1998 -- long-term Treasuries returned 20
percent, three times as much as the Standard & Poor's
500-stock index -- there have been periods as long as
two decades when bonds were the better investment.
So investment astuteness is not properly gauged by how
thoroughly one shuns the bond market.
"Relatively few people should be 100 percent in
stocks," said Scott Lummer, chief investment officer at
401(k) Forum, an advisory firm in San Francisco.
"Savviness does not mean, 'I take all the risks I
want."'
Perhaps the best way for most people to think about
bonds is as ballast for their portfolios.
Higher-quality bonds can usually be counted on to do
well when the economy stumbles; their promised flow of
interest payments gets even more attractive as interest
rates decline, pushing the price of existing bonds
higher. That stability also gives investors
psychological "staying power" when confronted with the
inevitable swoons in the stock market.
Held for the long haul, bonds are also good for
anticipating large specific expenses, such as college.
With good fortune, some can even use bonds to make
capital gains.
Investors are often advised to shift into bonds as they
age, the very rough rule of thumb being 1 percentage
point of a portfolio for each birthday. (The rule is
usually expressed in terms of stocks -- subtract your
age from 100 to figure the equity portion of your
portfolio, assigning the rest mostly to bonds.)
Tolerance for risk is another crucial factor, though
investors don't really know in the abstract how much
they can stand. Here, the rule in tough markets is to
sell until you can sleep again.
Still, the bond market is a huge place, forbidding to
most amateurs and sometimes impenetrable even to
professionals. There are many traps for the unwary --
even in bond mutual funds, by far the most popular
vehicle for individuals.
In fact, belying their staid reputation, bonds are far
from the haven many assume them to be, as anybody with
a stake in Far East debt learned last year. Financial
planners report a dismaying number of clients who
assume that nothing can go wrong with a bond purchase
-- especially if the bond receives a coveted triple-A
rating.
But interest rates can rise, depressing the value of
all previously issued bonds. Or the issuer's fortunes
could reverse, jeopardizing its ability to pay you
back. Prices for bonds are often hard to obtain, and
you may not find much of a market if you decide to sell
before a bond comes due. You can wind up owing taxes on
interest you have not yet collected. And if your bond
is paid off early, your choices for reinvesting the
money may be unappealing.
And those are just the dangers of individual bonds. As
for bond funds, their names are sometimes misleading,
fees are often high and investors are at the mercy of a
manager who may have little concern about the tax
implications, for the fund's holders, of all his
trading.
Following are some of the considerations that can help
bond investors size up these markets, instead of just
assuming that one bond is pretty much like another.
Bonds, or Bond Funds?
The typical do-it-yourself bond buyer -- someone with,
say, less than $100,000 to invest -- is decidedly
handicapped in two respects.
One hurdle is getting enough diversification in a bond
portfolio, given that the smallest municipal bond you
can buy generally costs $5,000, and corporate and
Treasury bonds are rarely bought in smaller units.
The other hurdle is the transactions themselves. It is
a challenge to get timely quotations on bond prices. In
the municipal market alone, there are 1.4 million
issues outstanding, counting each annual maturity
separately. And while there are more corporate bonds
than stocks listed on the New York Stock Exchange,
virtually all the trading takes place off the exchange,
in the over-the-counter market.
So your broker must either shop for you or deal with
you from his own firm's inventory, leaving investors
somewhat in the dark about prices, markups and
commissions. And if you need to sell before a bond
comes due, most issues are so thinly traded that you
may take a beating.
All this explains why individual investors increasingly
are buying bonds through mutual funds or brokerage
firms' investment trusts. Besides the benefits of
diversification and professional management -- arguably
even more important for bonds than for stocks -- bond
funds are inexpensive to get into and make it easy to
reinvest interest payments, reducing the chance that an
investor will fritter away that income.
Yet bond funds can also be hazardous to your financial
health. Portfolios can harbor bonds that investors
would never expect -- and sometimes even contain
stocks.
"I would not make any assumption that the name tells
you anything," advised Jack Burks, a bond specialist at
Offitbank, a money management firm in New York.
And because annual fees take a greater proportion of
the return than for many stock funds, it is especially
important to shop around. For example, the Scudder
Income fund has an expense ratio of 1.18 percent, while
fees for the Dodge & Cox Income fund, similar in size
but with a better five-year record, run less than half
as much -- 0.49 percent.
Moreover, bond fund managers labor under the assumption
that investors want them to husband principal above
all. If portfolio managers then find themselves
underperforming peers, they may be tempted to take more
risk than is prudent -- perhaps by buying bonds with
more distant maturities -- to try to catch up.
Such sensitivity is aggravated by the daily publication
of bond funds' net asset value, which exposes the
bond-market volatility that is so well cloaked for
individual bonds.
Investors in bond funds also need to bury the
widespread assumption that a high return makes a fund a
good buy. They need to be especially wary of a common
bond-fund gambit of inflating current yield -- at the
expense of total return -- by paying premium prices for
high-coupon bonds that are likely to be paid off early
or will certainly depreciate back to face value as they
approach maturity.
"You can't look at top performance and assume it's
going to continue," cautioned David F. Hill, president
of Safeco Mutual Funds. "Timing the bond market can be
at least as hard as timing the stock market" -- which
to most professionals means impossible.
Measuring Risk
One hazard for bond investors is a general rise in
interest rates, which raises market yields on new bonds
while depressing the value of existing, lower-yielding
ones. This market risk does not matter if you hold
until maturity. But if you need to sell before then,
you face a hefty loss of capital.
Credit risk, sometimes called event risk, is more
specific: Will the issuer be solvent when the time
comes to pay back your principal? If this begins to
look doubtful -- a development that probably would be
reflected in a downgrading by rating agencies -- the
price of the bonds will sink, independent of the
general trend in interest rates.
There can always be surprises, but the rating agencies
are quite good at categorizing bonds. Default rates run
highest on the worst-rated bonds, lowest on the
best-rated. Moody's Investors Service, one of the
prominent rating services, ranks bonds from Aaa (prime)
down to C (for those in default). Standard & Poor's and
Fitch IBCA have similar systems, ranging from AAA to D.
In the last few months, as corporate mergers boomed
again, specialists pointed to the danger that the
company whose bonds you bought may combine with a
weaker company, jeopardizing its ability to service
their joint debt.
"There are some potholes out there" for bond buyers in
such situations, said Gregory Lobo, senior fixed-income
portfolio manager at HGK Asset Management in Jersey
City, N.J.
Gauging Price Volatility
In general, the longer until a bond comes due, the more
it will fluctuate in value -- and thus the greater the
risk of it being significantly depressed when you need
to sell. The unwary, however, will typically fail to
take account of a crucial distinction between a bond's
maturity date and what is known as its duration, which
is a far better gauge of price volatility.
A bond's duration reflects the weighted stream of
payments, usually semiannual, through the life of the
bond, while maturity merely considers when the
principal is to be repaid. So bonds with the same
maturity can have different durations -- and thus
different levels of exposure to market risk.
Consider the differences between two 30-year bonds. The
Treasury's 5 1/4 percent bond due in November 2028 has
a duration of about 15 years, meaning that its price
will move up or down about 15 percent for each
percentage-point move in interest rates. But a Treasury
zero-coupon strip maturing at the same time -- a bond
that pays no interest over its life but is bought at a
steep discount to its face value -- has a duration of
29 years, which means that a percentage-point change in
rates will move its price by 25 percent.
Factoring in Prepayment
A persistent worry with bonds, including even some of
the Treasury's, is that the issuers can pay them off
ahead of schedule if rates fall. In other words, they
can refinance, as homeowners do with their mortgages,
and borrow anew from somebody else at a lower rate.
Indeed, bonds backed by mortgages are particularly
susceptible to early redemption. So their yields, which
tend to be seductively higher than on other debt, may
prove fleeting.
"Mortgages I've always viewed as toxic waste," said
Lincoln Anderson, a bond strategist in Boston who
formerly was chief economist at Fidelity Investments.
While there is often the solace of getting somewhat
more than face value when a bond is called -- typically
an extra year's worth of interest -- this premium may
well be already reflected in the price of the bond.
That means investors must know the yield to call date
of a bond, as well as the yield to maturity.
Some bonds have sinking-fund provisions, under which
the borrower intends to redeem a specified part of an
issue each year. The bondholders to be affected are
chosen by lottery.
However it happens, early repayment almost by
definition means an investor will find it hard to buy
another bond promptly on equally favorable terms -- a
situation called reinvestment risk. Where, for example,
will holders of Amoco bonds due in 2016, which the
company recently called at face value, match their 8
5/8 percent yield without accepting a lower-quality
issue?
Making Room for Junk
Infamous for their aggressive use in corporate
takeovers during the 1980s, junk bonds can be
respectably employed, even in conservative portfolios.
Only the hardiest small investor will buy individual
junk, or high-yield bonds, since by definition they are
less than investment grade.
For wealthier investors, however, some strategists
contend that a combination of essentially risk-free
Treasuries and carefully selected junk will often
produce superior risk-adjusted returns than a portfolio
of average-quality bonds. That is particularly true in
good economic times like these, when default rates on
junk bonds stand far below their peaks.
For most investors, junk-bond funds are an appealing
choice; even the most venturesome is less risky than
the most conservative stock fund. In one sense, the
typical high-yield bond fund actually poses less risk
than funds composed of high-grade corporate bonds -- or
Treasuries themselves -- because it is less vulnerable
to a rise in interest rates.
Watch out, however, for closed-end bond funds whose
quoted yields may be exaggerated because -- unlike the
more common open-end funds -- they are not required to
use a government-approved calculation method.
Coming Up With Zeros
"Zeros," issued by the Treasury, by corporations and by
municipalities, are ideal for many small investors.
They let the purchaser determine exactly how much a
modest amount of money invested today will grow to by a
specified date -- perhaps the month that Junior is due
to start college.
The entire return is paid at maturity; the zero
represents the amount of interest paid over the life of
the bond. Investors lock in a rate at the outset and
avoid the risk of having to reinvest periodic interest
payments at lower rates.
But with the payout coming at maturity, appraising the
risk of default is crucial. And with the long durations
of zeros, the price fluctuations can be up to three
times as great as on an interest-paying bond.
There is a further caveat: Except with tax-exempt
municipal zeros, income tax is due each year on the
accrued interest, even though the interest is not
actually paid until the bond comes due.
A cousin of the zero is a bond indexed to inflation,
like those now issued from time to time by the
Treasury. These provide guaranteed purchasing power at
maturity, rather than a guaranteed sum, by adjusting
the principal in line with the inflation rate.
A Place for Hybrids
Convertibles -- corporate securities that can be
exchanged, under specified conditions, for stock -- are
in theory a way to combine bond-like income with
stock-like growth. The interest income, now averaging
about 5 1/2 percent, cushions the impact if the company
fails to thrive and the stock declines.
As recently as a decade ago, most convertibles were
issued for 15 or 20 years. Now they are more
investor-friendly, with five-year maturities, according
to John P. Calamos, president of Calamos Asset
Management in Chicago.
But they are still tricky to analyze, involving both
bond-market math and the ability to pick stocks.
Although blue-chip companies like IBM and, more
recently, Monsanto, have sold these hybrids, many
issuers are fledgling companies whose survival is
uncertain.
"It's a complex security," said Calamos, who
specializes in convertibles, noting that institutions
remain the chief buyers. "The ordinary investor needs
to be careful."
Now, the Hard Part
If you conclude that it is time to add bonds to your
portfolio, remember that bonds can be as different as
chalk and cheese and that disinterested professional
advice is hard to find. Most brokers tend to shun
bonds, both because commissions are relatively low and
because the investment is usually locked up for years.
"That's not were the money is," said Richard Ganz,
president of Fixed Income Management Group, a Garden
City, N.Y., bond specialist. So read up to avoid the
pitfalls and be sure to shop around.
But while bonds remain what Ganz calls an "information
deprived" subject, technology is starting to pierce the
curtain long drawn over prices. The Bond Market
Association, for example, recently added preceding-day
transactions in the most active municipals to its Web
site and hopes to start a similar listing for corporate
bonds in the spring. And bonds are beginning to be sold
on the Internet.
Perhaps the most important advice, professionals say,
is to avoid the crowd's fixation on high rates to the
exclusion of other considerations -- especially risk.
"There's a tremendous hunger for yield -- and Wall
Street is so good at feeding that hunger," said Mark
Lapman, executive vice president of Independence
Investment Associates, a money manager in Boston. "That
worries me."
[Community College Distance Learning Network]
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Copyright 1999 The New York Times Company
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