Investing Magazine

One reason stocks are more popular than bonds is that the latter are more complicated. Ironic, considering their risk and returns bonds are easier to judge and predict with confidence.

Adding to the complexity are the differing tax issues affecting bond returns.

Federal, state and municipal governments issue bonds to borrow money beyond what taxes bring in. Unlike corporations, they can make those (usually) lower yielding bonds more attractive by coupling them with tax incentives. State and local bonds, for example, are generally free of U.S. Federal taxes and are often offered tax-free by those states or municipalities.

A higher yield bond may actually return less after-tax income depending on the investor’s tax rate, depending on whether the bond is subject to state or Federal taxes and other factors.

For example, assume $10,000 is invested in two different bonds: one Municipal tax-free yielding 4%, another a taxable bond with a yield of 5.5%. $10,000 x .04 = $400, in the first case. $10,000 x .055 = $550 in the second case. The second appears to be a better return. But now assume a 28% tax rate. $550 x .28 = $154 lost to taxes, leaving only $396 ($550 – $154). The higher stated yield actually returns less actual yield. A higher tax rate makes the situation even worse. For example, at 33% only $368 of interest is retained after tax.

Remember to factor in all taxes, since a bond can be free of Federal tax but subject to state taxes or vice-versa.

Any calculation of yield on a bond (the actual return over time) is complicated, usually requiring computer help to carry out. Adding tax considerations increases the difficulty, but fortunately utilities are readily available on the Internet to help. A simple search will locate one that allows inputting income tax rate, Federal tax burden, state, coupon rate, etc.

To provide the simplest equation for those interested:
R(te)  = R(tf) / (1 – t)
where:
R(tf) = the rate paid on a tax-free municipal bond
t     = the investor’s marginal tax rate
R(te) = the taxable equivalent yield for the investor with a marginal tax rate of "t"

Now let’s add yet another wrinkle. Some government bonds are issued as ‘zero coupon’. These pay no interest, but sell at a discount to their face value. Profit (one hopes) is realized at maturity when the full, non-discounted principal is repaid.

But, the government is not to be denied its cut. Even though the bond holder doesn’t receive any interest, in the US the IRS (Internal Revenue Service) requires "imputing" an annual interest income and reporting it as income each year. However, when bought for a tax-deferred account, such as an IRA (Individual Retirement Account), the imputed interest doesn’t have to be reported as income.

‘Zeroes’ tend to be more sensitve to prevailing interest rates, and some investors buy them, seeking capital gains when interest rates drop.

Now let’s add one final twist to drive ourselves completely insane. Coupon rates are not always fixed these days, as they have been historically.

There are floating rate coupon bonds and inverse ‘floaters’ as well. With an inverse floater, as interest rates rise, the coupon rate falls. When short-term interest rates fall, two things happen: (1) The bond price rises, and (2) the yield increases. And that, too, of course has tax consequences…

Not to panic! Before moving that mouse to buy another 100 shares of XYZ, search for a bond calculator. Profits go to the fearless.

Measuring Risk

Few investments offer as objective an estimate of risk as bonds.

Because of some fixed characteristics – par (face value, repaid at maturity), coupon (interest rate, percentage paid in semi-annual payments on the par) and maturity (date principal is repaid) – predicting bond values and risk with some confidence is as much science as art.

First, a bit about bond prices and yields. Bond prices are quoted as a percentage of the bond’s face value. For example, a bond trading at 102 is trading at a price 2% above it’s par. For a $1000 bond, the quoted price would be 102, and the purchase price $1020. (For bonds in increments of $1000, simply add a zero at the end of the quote. Otherwise multiply the face value by the quote. E.g. $3,000 x .99 = $2970 on a bond selling ‘at a discount’ of 99.)

Next, observe that bond prices and yields move in opposite directions. When yields rise, prices fall. Common sense reveals the reason. A 5-year, 5% bond purchased today at $1000 will be worth less in a year if interest rates have generally risen to 6%, because new bonds can be purchased that pay higher interest payments.

Now, onto measuring risk.

Every bond carries some risk that the issuer will default on repayment of the principal, or suspend interest payments.

A bond’s maturity period plays a large factor in determining that risk. The future 10 years on is less clearly predictable than that only a year hence. Interest rates, to which bonds are highly sensitive for reasons seen above, are less likely to change much over a year than over 10 years, and in much more predictable directions. They may be exactly the same 10 years from now, but almost certainly will have changed up and down in the interim. But how much and in what direction is harder to know, the longer the time frame.

On the other side of the ledger, issuers tend to compensate for that extra risk by offering higher rates on longer-term bonds, in order to attract investors.

One way to measure that risk is to calculate what a bond price is likely to be at some point in the future. Remarkably, this is done every day with a high degree of precision and probability.

To estimate the degree of a specific bond’s price change should interest rates change, the bond market uses a measure known as duration. Duration is a weighted average of the present value of a bond’s payments – semi-annual interest payments, as well as a large repayment at maturity.

‘Present value’ is a measure of the value today of expected money to be paid in the future. Think, for example, of the worth of loaning money to a neighbor. That money is a value today, but the expectation of re-payment plus interest tomorrow has a value too.

If you’re tempted to believe that value is ‘purely psychological’, loan a large sum – say in the form of buying bonds – to a AAA company then go to the bank to borrow money. Those future interest payments are regarded as an asset by the bank. You could potentially borrow more for having the right to those coupon payments.

Calculating duration is a more technical affair than can be taken up here, but sample computations (as well as calculators to do it for you) are readily found on the Internet.

Duration calculations are unique to each bond but they allow comparisons between bonds with different maturities, coupons, and face values. Knowing it makes possible predictions of a bond’s approximate price change in the event of, say, a 100 basis point (1/100 of a percent) change in interest rates.

For example, if general interest rates fall by one percent, yields on every bond in the market will fall by the same amount. Thus, the price of a bond with a duration of two years will rise two percent and the price of a five-year duration bond will rise five percent.

Despite the appearance of numerology, measuring risk quantitatively is carried out by analysts every day. Take advantage of their knowledge by using it to judge investment risk for your own portfolio.

Every bond carries some risk that the issuer will default on repayment of the principal or suspend interest payments. Once that risk is measured (see ‘Measuring Risk’ elsewhere in this series), then what?

First, a review.

Duration: Duration measures a bond’s interest rate risk, expressed in years. The longer the duration, the more sensitive the bond’s price is to changes in interest rates.

When interest rates change, a bond’s price will change by an amount related to its duration. For example, if a bond’s duration is 5 years and interest rates fall 1%, a bond’s price will rise by approximately 5%. Therefore, if interest rates are expected to rise, invest in bonds with lower durations. Low duration means less volatility or price risk.

In general, the shorter a bond’s maturity, the less its duration. Bonds with higher yields also have lower durations. (‘Duration’ is not the same as ‘maturity’, which is the date the principal repays. Duration is a technical approximation. See your favorite search engine for details and a ‘Duration Calculator’.)

[Convexity also measures interest rate risk, but more accurately in an environment where yield change is greater or within shorter time frames. The concept is more technical and we'll save it for elsewhere.]

So, what to do with this information?

Managing risk is essentially an exercise in comparing how much capital you have against what you can afford to lose should an investment go sour, and what your goals are.

Investors with a low psychological or financial tolerance for risk would be well advised to accept the inevitability of lower yields. Tax-free muni’s (municipalities) or AAA corporates are suitable for such investors. Investors with the time, temperament and funds to endure greater risk can lean toward lower ratings with higher yields.

Managing risk involves comparing instruments (prices and yields) available today with a prediction of what will be available tomorrow, then including inflation and tax considerations. Is a 5% bond selling at 102 better than a 4% tax-free selling at 100, when you add the effect of a 28% tax rate? Let’s see:

Assume a $1000 bond. At 102 (2% above par, i.e. face value) that’s $1020. 5% annual interest payment amount is $1000 x .05 = $50. At 28% tax, the after tax amount = $35.28 The after-tax yield = 35.28/1020 = 3.46%. For the 4% bond: $1000 x .04 = $40. Since the muni is tax-free, the yield is 40/1000 = 4.0%.

Part of the effect is due to taxable vs tax-free, another part from the discount or premium as a result of the coupon compared to prevailing rates. Include both factors when making calculations.

Other forms of risk than interest rate and credit risk exist. (Credit risk is the possibility of default on principal or suspension of interest payments. Interest rate risk is that incurred by the chance that rates will change over the lifetime of the bond.) Liquidity is also a factor.

Unlike most stocks, bonds – though the market as a whole is much larger – often do not attract buyers and sellers as readily. It may be – and happens often enough – that a buyer is harder to find unless the seller is willing to sell at a considerable discount.

Consider your goals. Are you seeking predictable cash flows and willing to retain the bond to maturity? Or, are you seeking the highest yields and willing to endure not only the credit risk, but the liquidity risk involved in selling a bond others may rate as ‘junk’?

The choices can only be made wisely by the investor willing to do the extra research entailed in bond trading.

‘Junk’ bonds – more politely known as high-yield bonds – acquired the name as a consequence of their low rating by the major agencies and their high rate of default. ‘Default’ is the failure to repay principal and/or suspension of interest payments.

But a curious thing happened in the 1980s. Michael Milken examined the market carefully and determined that the default rate was unlikely to be as high on certain bond issues than was previously thought. The ‘high-yield’ market was born.

Of course, high yield bonds existed long before. Milken and others developed techniques for predicting with greater confidence which were and were not truly ‘junk’. And, Milken’s group encouraged the issuance of those bonds then profited from them – illegitimately so, some argued, which led to later legal entanglements.

The result has been: millions made millions by taking calculated risks on high-yield bonds.

That’s the key to prudent investing in high-yield bonds – calculated risks. Throwing darts blindfolded works less well in the bond market than in the stock market – where it already works badly.

Fortunately for those with the time and temperament to make the effort, research on bonds is available by the carload.

Step one is to get a rating from one of the major agencies, such as Standard & Poor’s, Moody’s or other. ‘Junk’ is distinguished from ‘investment grade’ (AAA/Aaa, AA/Aa, A/A, BBB/Baa) and carries a designation of BB or below.

But there are many steps after step one, including carrying out independent research on a company’s current financial status and likely prospects, just as one would when buying stock. All the usual potential concerns exist: changes in prevailing interest rates, recession or high unemployment, technological changes obsoleting a company’s product or service, limited liquidity, and so on.

Carrying out that research takes practice and guidance, but that too is available in abundance via simple Internet search. The diligent will quickly find advisors with a good track record, who make objective, moderately cautious statements about a potential buy.

And there are success (and failure) stories to learn from. In 1991, those who risked investing in lower rated bonds reaped the highest total returns: an average 34.5%. One year later, in a less outstanding year for bonds, junk debt took second place in the race for high returns, 18.2% compared to 22.4% return on convertible debt. ‘Convertible debt’ has more than one definition, but one example is the purchase of bonds which can be converted to common stock at the holder’s option.

The example remains relevant today. In some categories, high-yield bonds constitute almost a third of the total issues. And, even at the lower figure, the returns challenge the average return on shares. Of course, nothing can beat those high flying stocks that some are lucky – or skilled – enough to pick.

What constitutes a high yield is relative to general rates of return, of course. But historically, anything above 8% or so would be considered very healthy and 15% exceptional. By comparison, the S&P 500 has an average return of about 12%, if the investor stays in for several years or even decades.

As with any high risk investment, the total portion in a portfolio shouldn’t be more than 10-20% depending on the research backing the choice and an individual’s tolerance for risk and potential loss of capital.

First, a confession: Interest rates are unpredictable. But then, you knew that already. Fortunately, they’re not entirely unpredictable. Good bets are possible.

But before discussing some of the factors influencing them, a few words about why you should care: Price-Yield correlation. Which means what, now? As interest rates rise, bond prices fall. When rates fall, prices rise. Common sense reveals the reason.

Suppose a $1000 bond carries a 5% interest rate, and therefore pays two $25 semi-annual interest payments. If interest rates rise to 7%, several things can happen.

Anyone holding that bond seeking to sell will be forced to offload at a discount. Current potential buyers can get 7% ($70 per year) elsewhere. (Assuming similar credit risk and maturity.) Second, the holder can experience pressure to sell, since they’re losing the opportunity to make an extra 2% per year.

If interest rates fall, bond prices for existing or new issues rise. Run the same argument, just reverse the arithmetic.

So, predicting interest rate movements – both when considering a new bond purchase and when debating when or whether to sell – has consequences for determining real yields. (Current Yield = Annual Interest Amount/Current Price. For more accurate estimates, see the ‘Calculating Bond Yields’ article.)

Now, what causes them to move? Naturally, the answer is: many things, any one of which has its own set of complex causes. Let’s simplify.

For good or ill, U.S. Treasury securities have a significant impact on general bond rates. Their rates in turn are influenced by (and made somewhat predicatble by) GDP (in Europe, GNI), CPI, PPI and a variety of other economic indicators.

GDP is the Gross Domestic Product, the total output of goods and services produced in the U.S. (In Europe, they have the good sense to calculate it per capita, in order to adjust for differences in population, where it’s known as GNI, Gross National Income.)

Large unexpected changes motivate the Fed (the U.S. Federal Reserve Bank) to adjust short-term rates up or down. That change influences short-term bond rates, since bonds compete with other possible investments.

CPI (Consumer Price Index) is a measure of the average change over time in prices of a select group of goods and one of the major measures of inflation. (Unfortunately, it doesn’t include the cost of food or energy, which is fine for those who don’t need to eat, heat their homes or travel anywhere.)

Since (most) bonds are issued with fixed interest rates, actual returns over time have to be calculated by subtracting the influence of inflation. 8% sounds like a healthy return until 4% inflation is subtracted, reducing the annual net return to 4%.

A higher than expected CPI influences bond prices to fall and interest rates to rise.

PPI: The Producer Price Index, which measures the average change over time in the prices recieved by domestic producers of goods and services. Somewhat the flip side of CPI, this measures price change from the seller’s perspective.

When higher than expected, PPI rises signal inflation, again causing bond prices to fall as interest rates rise.

Other factors influence rates, such as unemployment rates, housing starts (new housing construction begun) and others. How much any one (or all together) influence rates is an ongoing academic debate with more than academic consequences.

Nevertheless, certain trends stand out.

Interest rates on domestic bonds tend to move with Treasuries, and the 30-year mortgage rate on home loans historically runs about 1-2% above the yield on 30-year Treasury bonds.

When the Fed increases the Fed Funds rate, it does so by supplying short-term securities in the open-market. This tends to decrease the money supply, which increases short-term rates. Bonds with short maturities will therefore tend to have higher yields.

When the U.S. government borrows it does so by issuing longer-term Treasury bonds to institutional lenders. This tends to drive rates up on corporates, since higher risk instruments have to compete with the more low-risk Treasuries. (One available alternative is Eurobonds, since the European Central Bank tends to peg its rate a percent or more above the Fed. Competition is beneficial.)

How much any of these factors influences rates is best researched by studying the charts available via simple Internet searches. They don’t provide certainty, nothing in investing does, but bets based on sound data are as good as it gets.