Risks and Rewards of Corporate Bonds

A bond is a loan made to a company (or government entity).  Just as with a house loan, the
loan is made for a specified period of time,  Unlike a house loan,
the loan is not repaid over time.  Instead, the company will pay a
fixed amount of interest on the loan during the period and then repay
the loan all at once at the end of the period. For example, a bond
with a par value (loan value) of 1000 and a coupon of 5% would
pay $50 per year, or $25 every six months.  When the bonds mature,
the person holding the bonds would be paid $1000 plus the final $25
interest payment.

During the life of the bond, it will be freely traded on the market and the price will
fluctuate.  An advantage is that one can make both interest and a
capital gain from bonds.  For example, if an investor bought the bond
listed above when it was trading for $500 and then held it to
maturity, he would receive both the interest payments , at an
effective rate of 10% for him, and $1000 when the bond matured.  He
would therefore make a $1000 capital gain.

While it varies by company and term, bonds are generally safer than bonds.  The reasons
are that the bond pays a fixed interest amount, meaning that a return
is generated even if stock prices are going nowhere, and no matter
what the price does, one can regain one’s investment by holding the
bonds until maturity.  As with anything, however, there are risks.
Here are the main risks of corporate bonds:

Default:  Obviously the primary risk with a bond is that the company that issues the bond
will be unable to pay and default on the bond.  When this occurs,
sometimes the company will issue shares fo stock to repay part of the
loan, sometimes the company will repay the loan but at a later date,
and sometimes the company will just default and not pay.  In general
when a company defaults on a bond the investor should expect to get
little or nothing back.

Interest Rate Rises:  Because bonds are primarily bought for the interest they pay they are
very sensitive to changes in interest rates.  For example, if banks
start paying higher interest rates, because a bank account is less
risky than a bond, many investors will sell their bonds and invest
their money in the bank.  Because of this, the price of bonds will
decrease, causing their interest rates they pay to increase (remember
that bond interest rates go in the opposite direction as the price of
the bond).  b]Buying bonds at periods like the present time, where
interest rates are rock bottom and only likely to go up, therefore is
especially risky.  On-the-other hand, buying bonds when interest
rates are very high and most likely to go down is a sound strategy.
As interest rates decrease the price of the bond will go up.  This
will provide income in addition to the relative high interest rate
that will be locked in when buying the bond.

Early Call:  If interest rates are sufficiently low many bonds will trade
above their par value. This is because investors will go to bonds in
order to increase the amount of interest they make when bank accounts
are paying nothing.  Many companies have call provisions that allow
then to repay the bonds early.  If interest rates are very low they
may well call the bonds, paying the par value, and then issue new
bonds at a lower rate.  this is much like a person refinancing their
home.  When this happens, if you’ve bought at above par value you
will lose the difference.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.comor leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

What Will Happen to Bonds if the Debt Ceiling Isn’t Raised?

Traditionally all interest rates have been tied to the rates paid by US Treasuries and Notes.  One would therefore expect bond prices to fall, and the interest rates paid by corporate bonds to rise, should the debt ceiling not be raised and the credit rating of the US declines, causing the interest rates demanded of US debt to rise.  In fact one might expect the interest rates of everything to rise, causing borrowing costs for everyone to rise, resulting in layoffs, decreases in business purchases, dogs sleeping with cats, and financial Armageddon.  But not so fast.

First of all, a failure to raise the debt ceiling would not necessarily result in a default or a decrease in the US credit rating.  Because the interest on current debts is only about 10% of current revenues, the US could easily continue to pay the interest on the debt even without additional borrowing as long as making the interest payments was a high enough priority.   One would assume that avoiding a default would be a top priority since defaulting would result in the need to pay much higher rates for future borrowing.

Like a borrower who goes deeper and deeper into debt, if the US continues to raise the debt ceiling and continues to take on more debt, that might actually be more likely to cause the credit rating of the nation to decline.  As one knows, one cannot keep borrowing indefinitely to maintain one’s standard of living.  Eventually the interest payments on the debt will become so big one can only afford to pay interest and nothing else.  Likewise, continuing to borrow to pay for interest and current programs will only decrease the credit worthiness of the country.   The debt is already more than 80% of GDP – the “salary” of the US.  Once it reaches about 120%, the chance of avoiding a Greece-style default become slim to none.  The warnings issued by the credit rating agencies recently were not that the debt ceiling might not be raised, but that the size of the deficit was continuing to grow such that the debt was becoming unwieldy.

Second of all, the rate on corporate bonds may not necessarily rise, or conversely the price of corporate bonds fall, if the rates on US treasuries rise because of a decrease in the country’s credit rating.  While it is true that bond rates and other consumer rates tend to be tied to the rates on Treasuries, such that rates will increase if the Federal Reserve starts sucking up available cash and driving up Treasury Rates, the rates on corporate bonds would not necessarily rise if the cause of the increase in US Treasury rates was due to a decrease in their safety.  The reason that bond rates rise if the rates on Treasuries rise now is because Treasuries are considered the safer investment.  If one can get 5% from a “safe” Treasury, one would not buy a “less safe” corporate bond unless one received a higher return –  8% in interest, say.

If Treasuries became less safe, however, the price premium enjoyed by Treasuries might disappear, meaning that corporate bonds might pay the same interest rate. In fact, investors looking to sidestep a US default might move their money into corporate bonds, causing corporate bond rates to actually decrease and the price of corporate bonds to rise even as the prices on Treasuries fell.  Note that stocks would also rise in this case.

The biggest risk for corporate bonds in the event of high levels of US debt would be hyperinflation.  For example, if the US started printing money to pay off its debts, thereby devaluing the currency.  The fact that gold prices have risen so much lately, and the fact that the Canadian Dollar is now worth more than the US dollar,  indicates that the dollar has undergone significant devaluation.  To guard against some of the risks of hyperinflation, one can include US stocks and foreign stocks in one’s portfolio.  While US stocks would take an initial hit should hyperinflation occur, share prices would eventually rise with inflation.  This is because the “value” of the companies would be maintained – the ability to sell lots of computers, hamburgers, or business services,  would still be a valuable thing – so more dollars would be needed to buy shares if dollars were becoming worth less each day.

So, a failure to increase the debt ceiling would not necessarily be a bad thing for corporate bonds.  A continuation in the increase in US debt is more worrisome since it could lead to hyper-inflation, which would cause bond prices to drop.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.comor leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The Risks of Investing in Bonds

Bonds are often considered a safe investment.  Many people talk about adding bonds to a portfolio in order to reduce risk.  There are special risks to the bond investor, however, that the invest must understand.

The Basic of Bonds First the basics.  A company, a city, or another entity issues bonds when it wishes to borrow money to pay for something.  A bond is a loan made to a company or another entity which pays typically a fixed interest rate for a period of time.  Bonds to companies are called “corporate bonds,” while those to a city are call “municipal bonds.”  Most bonds are listed by the interest rate that is paid to the initial buyers of the bond, called the coupon, and an expiration date, called the maturity date.  For example, if AT&T issued a bond that matures in 2020 that pays an initial rate of 9%, it would be called an AT&T 2020 9% bond.  At&t may have a whole host of bonds of different maturity dates and interest rates.

On issue a bond normally sells for $1000 per bond.  The coupon is set at whatever rate is expected to be needed to sell all of the bonds.  Just as a consumer who has a high FICO score can often get a better rate on loans, a company that has a very good credit rating will be able to issue bonds with a lower coupon.  Companies that have sterling credit are said to issue “investment grade” bonds, while those with poor credit are said to issue “junk bonds.”  The higher interest rate paid by the junk bonds makes up for the greater risk of default.

Once the bond is issued, investors can trade the bonds on the open market.  It is very rare for an individual to hold a bond all of the way from first issuance to maturity.  Because the bond pays a fixed amount of money each year – for example our AT&T 9% bond would pay $90 per bond each year – if the price of the bond declines the interest rate that the new investor will get increases.  Likewise, if the bond goes up in price the interest rate that the new investor receives will decrease.   Because the investor holding the bond when it matures will receive the par value – normally $1000 per bond – a person who buys a bond below the par value will receive an additional amount of income if he/she holds the bond to maturity.   Likewise, if one buys a bond above par value the effective yield is less.  The yield taking into account this price differential is called the “yield to maturity.”

Risks for bonds 

Default:  Obviously the primary risk with a bond is that the company that issues the bond will be unable to pay and default on the bond.  When this occurs, sometimes the company will issue shares fo stock to repay part of the loan, sometimes the company will repay the loan but at a later date, and sometimes the company will just default and not pay.  In general when a company defaults on a bond the investor should expect to get little or nothing back.

Interest Rate Rises:  Because bonds are primarily bought for the interest they pay they are very sensitive to changes in interest rates.  For example, if banks start paying higher interest rates, because a bank account is less risky than a bond, many investors will sell their bonds and invest their money in the bank.  Because of this, the price of bonds will decrease, causing their interest rates they pay to increase (remember that bond interest rates go int eh opposite direction as the price of the bond).  b]Buying bonds at periods like the present time, where interest rates are rock bottom and only likely to go up, therefore is especially risky.  On-the-other hand, buying bonds when interest rates are very high and most likely to go down is a sound strategy.  As interest rates decrease the price of the bond will go up.  This will provide income in addition to the relative high interest rate that will be locked in when buying the bond.

Early Call:  If interest rates are sufficiently low many bonds will trade above their par value. This is because investors will go to bonds in order to increase the amount of interest they make when bank accounts are paying nothing.  Many companies have call provisions that allow then to repay the bonds early.  If interest rates are very low they may well call the bonds, paying the par value, and then issue new bonds at a lower rate.  this is much like a person refinancing their home.  When this happens, if you’ve bought at above par value you will lose the difference.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment for this blog.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and general information on picking stocks, handling money, and growing wealthy. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

Are Bonds Less Risky than Stocks?

Often one will hear financial advisors talking about asset allocation.  Often there will be talk about investing some portion of a portfolio into stocks and then putting a portion, considered the “safe” portion, into bonds.  A rule-of-thumb, in fact, is to hold a percentage of a portfolio in bonds equal to one’s age with the rest in stocks.  The idea here is that as one gets closer to retirement one can no longer afford the risk of the volatility of the stock market and therefore one should retreat to the safety of bonds.  Many of the target date mutual funds perform this function for the investor, although the actual amounts of bonds that these funds hold varies by fund, and some use more exotic derivatives to hedge positions.

I saw a great table in a book by Jane Quinn Bryant that showed the relative volatilities of a portfolio made up of different proportions of stocks and bonds.  (Volatility is a measure of how much an asset moves about in price.  In general the higher the volatility, the higher the risk.  Stocks tend to have much more rapid price changes than do bonds, and therefore higher volatilities.  Higher volatility tends to lead to greater gains, but the ride is much more bumpy.)  The table showed that by adding more bonds, the volatility (and thereby the risk) of the portfolio declined, but the likely return also fell.  The portfolio with all stocks had the greatest return, but also had the greatest volatility and risk.  That with all bonds had a return several percentage points below that of all-stocks, but the volatility was also about half that of the all-stock portfolio.  The idea of the table was to look at how much volatility one could stand and then set one’s stock-bond ratio accordingly.

In general it is true that portfolios of bonds, or mutual funds of bonds, will be less risky than portfolios or funds of stocks.  This is for two reasons.  The first is that a bond by its nature pays a substantial interest rate.  This is because a bond is a loan to a company (or government) and therefore the company pays interest during the life of the loan.  Because the interest rate goes up if the price of the bond goes down, people will be more likely to buy the bond as it declines in price and therefore there is a natural amount of support for the price.  Bonds will therefore not go down as far during recessions as will stocks.

The second reason is that bonds, also by their nature, have fixed lifetimes, at the end of which the investor will be made whole.  When the bond matures, typically after a period of about 20 years, whomever holds the bond will be repaid the original price of the bonds (typically $1000 per bond).  Market forces may drive the price all over the place, but in the end the company will pay whomever is holding the piece of paper $1000.  With a stock there is no guaranteed rate – it is always up to whatever the market is willing to pay.  For this reason the difference between the market price and the pay-off price for a bond tends to shrink as a bond nears maturity (because the closer you come to the maturation date, the more likely the investor will receive the face value of the bond)

Before going out and loading up on bonds, however, one must be aware that not all bonds are created equal, and there are some specific risks in buying bonds.  One must remember that a bond is a loan to a company.  If the company goes bankrupt or simply decides that they will not be able to pay back the bonds, an investor can lose the whole value fo the bond.  While the bond holder generally has first rights to the assets of a company when it goes bankrupt  (GM bonds were an exception that sent the shivers down the backs of bond buyers), in general there are usually not many assets to be had.  Typically one can expect to receive $30 or so from a $1000 bond. 

Bonds in companies that are more risky (more likely to default) also will tend to fluctuate in price more than those in companies that are more stable and reliable.  Companies that have financial troubles and become more of a risk will also see their bond prices decrease rapidly as investors demand a greater interest rate before they will purchase the bonds.  Remember that the lower the price, the higher the effective interest rate the bond pays (because the actual amount paid is fixed), so bonds will go down in price when investors require a higher interest rate before making a purchase.

Another risk that bonds face are due to changes in interest rates.  Whenever interest rates go up bond prices will tend to go down.  At times like the present where interest rates are at historic lows it seems that the likely direction of bond prices will be down since interest rates will not stay this low forever.  Interest rates on longer-term bonds, in fact, have already begun to rise as investors expect interest rates to be higher in the future.

So how does one tell if the bond he is buying is more risky than other bonds or even blue chip stocks?  The interest rate is a key indicator.  Because of the wonders of market pricing, the relative price of a bond (and conversely the interest rate paid) will be set based on the perceived risk, taking into account all public information, of default.   This means that a bond that pays a higher interest rate will be more risky than one that pays a lower one.

In general there are a set of bonds in solid companies that are considered to be of low risk.  These are called “investment grade bonds” and will have good marks from the rating agencies.  These bonds will all be paying the lowest interest rates, but these bonds are very unlikely to default.  These bonds will also be priced near par value of $1000 (or $1.00 in the bond tables).

Bonds that are at more risk of default will pay interest rates several percentage points above the investment grade bonds.  These bonds are called “junk bonds.”  If investment grade bonds are paying 6% interest, junk bonds may be paying 10% or more.  A bond that is trading at $500 may be paying 15% or more, but people obviously are not expecting the bond to mature.  At 15%, one would need for the company to continue to pay the interest rate for about 6 years before defaulting to gain one’s money back.  In some cases these companies do continue to pay and their price will eventually reach $1000 if the bond matures.  This leads in both a good return in interest and also a good return from the appreciation in price.  Many times, however, the market knows what they are doing and these types of bets will not pay off.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment for this blog.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How Stocks Are Priced, Part 3 – Comparative Factors

This is a continuation of the series of posts on stock pricing.    The first post of the series is here:

http://smallivy.wordpress.com/2010/12/06/how-stocks-are-priced-part-1/

Today I will  talk about the effect if the returns of other investment choices on stock pricing, which I call Comparative Factors.  As stated in the last post, the future returns of stocks are not foregone conclusions.  Many things can happen either at the company itself (for example, fraud or missteps by management).  The industry as a whole could suffer a setback.  At times, the entire economy can falter, dragging all stocks with it.

Because of these risks, the price of a stock is set such that the return will be greater than it would be if the exact return (which is basically the future earnings divided by the share price) of the stocks was known ahead of time.  The price of the stock will follow the fundamental factors – earnings and dividends, such that the price will rise if a company increases earnings or raises the dividend, but it will always remain low enough such that the investor will earn more than she could if invested in some security with a more predictable return.  This discount in the price, which is called the risk premium, is the extra reward that is necessary for investors to take on the additional risk.

The amount of this risk premium, however, is not set in a vacuum.  The risk of a given investment will always be compared with those of other investments.  The more risky the investment, the greater the risk premium.  (Note that sometimes more risky investments are sold to unsuspecting investors as low risk investments, usually through late-night commercials, offers in the mail, and the like.  Keep in mind that the level of return is always proportional to the level of risk.  If someone ever says that great returns can be had for low risk, run, don’t walk, away.)

For example, bank account typically pay returns that are 1-2% less than the inflation rate (yes, by keeping money in savings, 1-2% of your money will be eroded each year).   Investment garde bonds (bonds in companies that most analysts expect to be able to repay the loan) typically pay a few percentage points more than bank accounts.  Junk bonds – bonds in companies that are more likely to default on the bonds) will trade in the range where they pay several percentage points more than the investment grade bonds.  Note that companies that have shaky balance sheets when the bonds are issued will need to offer greater interest rates initially to get people to buy the bonds.  If a company gets into trouble after bonds are issued, the price fo the bond will drop, causing the effective interest rate to increase.  The longer the amount of time until the bond will mature and the loan will be paid back, the higher the interest rate will be. 

Common stocks will typically trade such that their return (based on future earnings and dividends) will lie somewhere between investment grade bonds to and beyond the return for junk bonds.  The return of the stock will depend on the risk involved.  Strong, established companies with predictable earnings will typically have a smaller risk premium than young, start-up companies that have not yet established market dominance.  Buying the blue chip stocks will typically result in smaller fluctuations in account value, but the returns will be reduced over those of the smaller companies over time.   For this reason, better returns can typically be had in the small and mid-sized companies than in the large caps.  There are times, however, when investors are fearful about the economy when large-caps will do better than small-caps.

In the next post I go into what I call the emotion factors.  http://smallivy.wordpress.com/2010/12/10/how-stocks-are-priced-part-4-emotion-factors/

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment for this blog.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.