The benefits and risks of bond investing

by Jan 31, 2013Investment Consulting

All bonds are safe, low-risk investments, right?

Not exactly. Bonds are issued and traded in a large, complex marketplace. In fact, in terms of total dollars outstanding, the bond market is considerably larger than the stock market. Bonds also differ significantly from one another in terms of their structure and characteristics. These differences can lead one security (such as a three-month treasury obligation) to be considered riskless, while another (such as toxic sub-prime mortgage debt) is extremely risky.

In order to better understand the risks associated with bonds, it will be helpful to first define a bond and then discuss some differences among them.

What is a bond?

In its most basic form, a bond is a loan and the holder (an individual investor, institutional investor, pension fund, etc.) of that bond is the lender. There are two components to a bond: principal and interest. Principal is the amount borrowed, or the amount still owed, on the loan. Interest is the reward the bondholder receives, and the lender pays, for the use of the funds. Beyond these basic components, bonds differ in many ways, including the issuer, term to maturity, existence and quality of any collateral, and the currency used to make principal and interest payments.

Issuer.

The issuer of a bond (the government, corporation, organization, or group that is borrowing the money) is one of the most crucial factors to consider when analyzing a bond. In most cases, it is the financial condition of the issuer that will determine whether the interest and principal payments are made. For example, the U.S. government is far more secure than the Greek government. As such, the default risk (the chance an investor will not receive his or her interest and principal payments) of a U.S. government bond is much lower than a Greek government bond.

Term.

The term to maturity is also a very important factor to consider when investing in a bond. The term of a bond, or length of the loan, can range from a few weeks to upward of 100 years. It is much easier to estimate the financial condition of the issuer (or the collateral if any is present) one year from now than it would be several years from now. As such, the longer the term to maturity, the more uncertainty there is surrounding the payments of interest or principal and the riskier a bond is perceived to be. For example, a bond issued by a corporation with a promise to pay back the principal (the amount borrowed) one year from now is less risky than a bond issued by that same corporation with a promise to pay back the principal 30 years from now.

Collateral.

If a bond is secured, the issuer has pledged specific assets (known as collateral) that can be sold to pay bondholders if it becomes necessary. The quality of collateral, however, can vary significantly from one bond to another. Types of collateral could include physical assets such as property and equipment of a corporation, financial assets such as stocks and bonds, real estate, or automobiles. For example, a bond that is secured by gold valued at twice the amount borrowed would be much less risky than a bond secured by vacant real estate property that has fallen into disrepair and is worth less than the outstanding balance owed.

Currency.

Not all bonds are denominated in U.S. Dollars. A bond whose principal and interest payments are denominated in a foreign currency will have added risks that need to be considered. Over time, currency markets can have significant fluctuations that will affect the amount of principal and interest an investor receives when converted back into U.S. dollars. For example, a corporate bond issued in U.S. dollars would have no currency risk for a U.S. investor, but a corporate bond issued in Mexican pesos would have currency risk for a U.S. investor.

Our approach to bonds.

As outlined above, there can be significant differences among bonds. When constructing client portfolios, we at Sanderson Wealth Management segregate bonds into two broad categories based on their risk characteristics. In addition, we avoid individual securities and diversify across many issuers, as well as types of bonds using mutual funds and other investment vehicles.

The first category, core bonds, consists of safer bonds with a low probability of default and lower expected returns. These investments provide stability, liquidity, and income generation for your portfolio. In times of panic, these investments have historically retained their value and provided comfort to investors when they need it the most. Examples would include investment grade bonds issued by corporations (e.g., AT&T), government agencies (e.g., Fannie Mae), the federal government (e.g., U.S. Treasury), and municipalities (e.g., New York State).

The second category, non-core bonds, consists of riskier bonds that tend to fluctuate more than core bonds. These investments are characterized by increased credit risk, increased volatility, and the potential to fall in value during times of panic or large sell offs in the stock market. To compensate for the increased risk, non-core bonds tend to pay higher interest rates and have higher total return potential than core bonds. Examples of non-core bonds include high-yield corporate bonds, foreign bonds (including emerging market debt), and multi-sector bond strategies.

Monitoring bonds.

Once purchased, however, bond investments need to be monitored on a continuous basis. In a world of ever changing financial and economic conditions, our analysis leads us to recommend changes when we deem it necessary. A current example would be our treatment of foreign bonds. Over the past several quarters, the risks associated with foreign bonds have become elevated. This is most evident in the rising debt levels of European nations, the slowing rates of growth these countries are experiencing, and the extraordinary measures their governments and central banks are taking in an attempt to alleviate the situation. Therefore, we now believe that foreign bonds no longer belong in the core bond category but should be considered non-core bonds.

The increased risks associated with foreign bonds, conversely, can also provide opportunity. We believe that skilled managers can take advantage of mispriced bonds and undervalued currencies throughout the world to the benefit of investors. While these investments have different risk and return characteristics than they did only a few short years ago, they, along with other types of non-core bonds, continue to have a place in portfolios.

In closing, I hope you now have a better understanding of bond investments, some of the ways bonds differ from one another, and how we use them in client portfolios.