The Name’s Bond, Fixed Income That Is
Don’t Listen To Me, But Please, Hear Me Out: # 22
Shaheeda Abdul Kader, October 22 2020
“But everyone wanted to be a Big Swinging Dick, even the women. Big Swinging Dickettes.”Michael Lewis, Liar’s Poker
I learned about Bonds and Bond Traders from reading Michael Lewis’s “Liar’s Poker”. It is a hilarious, naked and worrying tale about Bond Traders at the now defunct Solomon Brothers. Bond Traders were the “Big Swinging Dicks”.
And I’ve stayed away from Bonds ever since.
However, interest rates are so low today that Corporations are issuing Bonds as if they are giving away candy on Halloween. So should we reconsider Bonds? For example, Apple raised $8 and $5.5 Billion in Bonds in May and August of 2020. These Bonds have a coupon of a paltry 0.55% for a 5 year Bond to hardly-worth-mentioning 2.55% for a 40-year Bond.
What are Bonds and Why Should You Care?
If you’re like most of us, you have taken some sort of a loan. A student loan, car loan, a mortgage or a personal loan. Do you remember the process you went through? You had to prove your credit worthiness and convince the banker that you had the ability to pay back the interest and principle on time. Bankers need to see that you have a steady income from a job, a business or other investments. Sometimes, they may even ask you to pledge property or other assets as collateral.
Have you wondered why Banks are giving you 0.2% on your savings, but when you want a loan, you have ti pay them 10 to 20 times of that rate? If you have a stellar credit history, then today in the USA you could get a 30-year mortgage rate of 2.25%. in the UAE, you could get a rate of 2.75% with certain conditions.
Just as you can get financing through a bank loan, Corporations can also get financing by issuing what is known as Bonds to the Public. You may borrow to build a home or buy a car, while Corporations borrow to invest in infrastructure like warehouses or machinery, R&D or even pay back more expensive debt. Just as your credit score dictates the interest rates banks would charge as well as how many banks are willing to finance you, the credit ratings of corporations determine how low of an interest rate they can pay before the public will purchase their Bonds.
What Is A Bond?
A Bond is a loan that investors extend to corporation or governments. A coupon is the interest that the corporation or government pays for that loan to the investor. Bonds are called Fixed Income Instruments or Investments because if you buy Bonds, you get a fixed income in the form of interest/coupon payments usually every 6 months as per the terms of the Bond. However, these days there maybe variable or floating interest rates so that the income you get may vary each period.
How are Bonds Valued?
2 Criteria determine the Bond Value:
1. Credit Risk of the Corporation or the Country (if its a Sovereign Debt, example, US Treasuries)
2. Time Till Maturity
The better the Credit Rating, the lower the Coupon that Bonds have to pay to investors.
The longer the term of the Bond, the greater the inherent risk of meeting the Bond obligation and therefore the higher the Coupon the Bond must pay.
How Are Bonds Traded?
Bonds are securitized assets that are traded in the financial markets. At the end of the term of the Bond, the issuing corporation must return your Principal to you. Bonds are not risk free as there is a chance that the corporation may default on both interest and principal payments.
When corporations issue Bonds, the price per unit of the Bond is called Face Value and it is usually $100 or $1,000 for USD denominated Bonds.
Investment Grade Bonds
In May 2020, Apple issued a $2.25 billion Bond for five years, maturing in May 2025 with a coupon of 1.125% and a Face Value of $100 per unit sold. Apple has the second highest rating for Bonds at AA+.
Bonds rated BBB (triple B) or above are considered investment grade bonds or low-risk Bonds. AAA, AA, A, BBB are all investment grade bonds.
Whenever interest rates are low as is the norm these days, Bond Prices go up. Generally, Corporate Bonds pay a higher interest than Government Treasuries. Today, banks like Emirates NBD is paying 0.2% on your savings account in AED. An investment grade Bond that pays 1.125% is therefore attractive.
Are Bonds Liquid?
You do not have to hold your Bond till maturity as you can trade them in the financial markets. Be careful however, because Bonds are not as liquid as stocks. Since investors buy Bonds to get the Fixed Income, naturally they won’t trade it as often. Also, you may still lose money in your Bonds if the NAV (Net Asset Value) of the Bond is trading lower than your purchase price.
When interest rates go down, Bond prices go up because demand from investors to get a higher return will increase. Apple issued Bonds at $100 per bond on May 11 2020. Today it is trading at a premium of $102.44. You do not have to hold the Bond until it matures in 2025. You can trade it now. In this case you could get a small profit by selling at a premium, but you should consider where you would invest your gains before selling.
Note that the coupon is always calculated and paid out on the Face Value and not on the price of the Bond. Imagine an investor had 10 units of the Apple Bond. This investor would earn 1.125% * 10 *$100 = $11.25 in interest per year. If he holds the Bond till maturity, then by May 11, 2025, he would earn a total of $56.25 in interest and Apple would pay back the original Principal of $1,000.
If interest rates were to increase and let’s say your bank starts giving you 1.5% on your saving, then naturally Bond prices will fall below par or Face Value. Since the coupon is always paid on the Face Value, i.e, $100, there will be buyers willing to buy bonds below face value of let’s say $98, because he will earn interest on the $100 and not $98.
Types of Bonds
There are many types of Bonds like a Callable Bonds, Puttable Bonds etc. I won’t go into details here but suffice it to say that Callable Bonds favor the Issuer and Puttable Bonds are better for the investors. Junk Bonds may have puttable features to entice investors to buy.
Who Should Invest in Bonds?
Since Bonds are usually for conservative investors or older investors looking for a fixed income to subsidize their living expenses, it does not make sense to invest just $1000 in a Bond. Moreover, usually the minimum initial investment for Bonds can be quite hefty and can be $50,000 or $250,000 or higher.
A $250,000 investment in the aforementioned Apple Bond would yield, $2,813 per year in interest income, hardly sufficient to live on.
Yield To Maturity
When you want to invest in Bonds, please look for the Yield To Maturity (YTM) and NOT the coupon rate on Bonds. The YTM takes into account the NAV or price of the Bond, the Coupon and time remaining till maturity and calculates the actual expected Yield for the Bond should you hold till maturity.
What are Junk Bonds or High-Yield Bonds?
High Yield Bonds or Junk Bonds are Bonds with credit rating like BB, B, CCC etc. In other words, these are high risk and low credit quality bonds.
Suppose an individual wants a bank loan. Unfortunately, he has a history of history of not paying his bills on time. Perhaps he is unemployed or has not been at his only for a short period.
Banks would take these factors to determine that he is of high credit-risk. Therefore, the bank would charge him a higher rate of interest if they decide to finance him.
Similarly, corporations that have lower probability of paying back the loan, have shorter or no credit history, or have declining revenues or are in a declining industry etc., would have to pay higher interest rates to entice the public to purchase their Bonds.
Example of A Junk Bond
China Evergrande Group is a residential property developer with a credit rating of B+ by S&P and Fitch rating agencies. They issued a US denominated High-Yield Corporate Bond for $2.025 Billion at a coupon rate of 8.25%. The face value was $100 per unit. Minimum investment was $200,000.
It is now trading below par at $84 per unit and the YTM is almost 22%. Maturity date is March 23 2022. Even though interest rates are low, the Bond price for this Junk Bond is NOT rising because it carries high risk. Investors would therefore demand significantly higher yields to risk purchasing this Bond.
Can You Plan Your Retirement Solely With Investments In Bonds?
If you really want to cover living expense and earn income from Bond investments, you need to put aside at least $10 Million in investments. At $1.125% in an investment grade Bond like Apple, a $10 Million investment would get you $112,500 per year which could be sufficient.
To increase your returns from Bonds, you may choose to diversify across investment grade and HYB or Junk Bonds, but you would still need $5 – $10 Million in investments to make a meaningful income from Bonds. Remember that HYB could default on payments and you could lose your principal as well as interest payments. (If you are in the UAE, you may remember Abraj defaulting on its loans.)
Therefore, Bonds alone are not great investment options for the average person. Also, picking and choosing the right number of Bonds to balance risk and return may not be feasible for the average investor. You need a lot of cash to do this well. Moreover, Brokers could charge between 1-5% of the price of the Bond as commission.
Advantages of Investing in Investment Grade Bonds:
- Steady income
- High probability of capital preservation (for Investment Grade Bonds)
- Lower risk than investing in stocks
Disadvantage of Bonds:
- Lack of transparency of underlying assets
- Not as liquid as stocks
- High Broker fees: 1%-5%
- High Initial investment amount: $50,000 – $250,000 or more
- Need a substantially large sum of cash to make a decent income: $5 Million to $10 Million
- If interest rate rises, you could lose money
Could Bond Funds Be a Solution?
Bond Funds are Mutual funds made up of corporate bonds, government bonds, mortgage backed securities (MBS) or other debt instruments. One big draw back is that, if many investors decide to cash out at the same time, the Fund Provider can restrict or temporarily freeze redemption. This happened with certain mutual funds earlier in March 2020 during the crash.
Bond ETF’s however maybe traded just like stocks. They track an index of Bonds and tries to mimic the performance of the Bonds within the ETF. They have 2 interesting characteristics because they are:
- More liquid than individual Bonds.
- Pay out monthly interest / dividends as opposed to every 6 months.
Practical Example of a Bond ETF
One of the most traded Bond ETF’s is Blackrock’s, iShares 7-10 Year Treasury Bond ETF.
If you go to the Bond Fund Sheet today (October 22, 2020), you will see that the Price of the Bond is about $120.
Reviewing the Performance, you will see a chart that looks like this.
You may get excited seeing the 11.32% YTD returns or the 50.31% 10-year cumulative returns. You should be cautious and instead look at the YTM figure. This is the true expected Yield to Maturity or YTM if you buy the Bond today.
You can find the YTM data under “Key Characteristics” of the fund sheet. YTM is 0.70% as of Oct 21 2020. This makes sense as this Bond ETF tracks the investment results of an index composed of U.S. Treasury bonds with remaining maturities between seven and ten years. Currently, the US 7-year Bond rate is 0.57% and the 10-year Treasury Bond rate is 0.81%.
The YTD 11.32% return is calculated based on the change in price of the Bond ETF at the beginning of the year and now. It also assumes dividends are re-invested. You could only realize those gains IF you had traded the Bonds. If you go back to the Fund Sheet, you will notice that under the NAV of $120.61, it shows in smaller print, a 52 week range which is between $110.12 and $122.95.
YTD (as on Oct 21) returns in NAV = ($122.951 – 110.12)/110.12 = 11.65%. Magic!
“In the land of the blind the one-eyed man is king”Michael Lewis, Liar’s Poker
Bonds or Fixed Income assets are good if you wish to preserve capital and want income to pay off living expenses. For older individuals or retirees, a portfolio weighted towards Bonds could be good.
However, to get meaningful returns from investing in a diverse set of Bonds, you need to be already wealthy and have at least $5 – $10 Million to invest.
Bond ETF’s are more accessible for the average retail investor but be careful and investigate the fund; learn as much as you can about the fund, how liquid it is; can you easily trade it; is there sufficient volume of trade; what are the tax implications of coupon or dividend income?
Moreover, as investment grade Bonds have yields close to zero or less than zero if you’re in Europe, holding investment grade Bonds is as good as holding cash and you’re essentially losing value of your capital. So, the way to make money in Bonds is to trade the volatility or price of the Bonds. Today, Bond prices can fluctuate more than 1-2% in a day where’s the interest you get is about 1% or less per year.
I recently listened to Barry Ritholtz’ Masters In Business podcast with the billionaire investor Ray Dalio. Please listen to it from minute 50 onwards where Ray talks about where to invest (Cash, Stocks, Bonds etc). He essentially advises you to stay out of Bonds (investment grade). It’s best to have a balanced portfolio of stocks or other investments that manage country risk, category risk and currency risk.
You could start by checking this post or this post. Happy Investing!
You can find a list of articles and resources I referred to here.
If you would like help on how to budget, save or invest more, please feel free to reach me, on Twitter @saq3 or LinkedIn @Shaheeda Abdul Kader, or leave a message at email@example.com. I’d be happy to offer you my services. Please do check my other blogs here.
I am NOT a certified broker or financial advisor. Please DO NOT make investment decisions based solely on my blogs. My intention is to show you how to research stocks or funds for yourself so you can feel empowered and knowledgeable to do your own investigations and invest with confidence. It is best to consult with your broker or advisor if you have questions. You can also reach me and I’ll do my best to help you with your queries.