THE BOND MARKET, A DIFFERENT ANIMAL
Investors are led to believe that investing in the bond market, an incredibly vast glut of Treasury, government, corporate and municipal debt securities, is a natural follow-up to investing in the stock market. Doing the leading here are bond salespersons at large brokerage houses, who like to include “bonds” in their asset allocations and who regularly encourage clients to take a “flight to safety” into the bond market when the stock market declines.
Such advice is grossly misleading because the stock market and the bond market are as different as night and day with stockholders owning instruments with growth potential and bondholders simply lending money. Let’s make the bond market the “night” because it’s a shadowy and confusing place, rife with added risks. Think of the bond investor as someone working his or her way through a dark room at night, stumbling over many obstacles and putting body at risk. By comparison, the stock market is bathed in the sunlight of simplicity, where the risks are genuine but are more above-board and easier to manage
What shadows lie over the bond market? Consider these:
ADDED RISK: Bonds are IOUs generated in the credit market. So we consider the bond market riskier than the stock market because all bonds at all times, even government-backed ones, are subject to interest-rate risk. On the other hand, such sensitivity applies only to certain stocks at certain times. So when general interest rates rise, all bond prices fall. There’s no escape. This intense risk often strikes investors who are least able to understand it and cope with it. Take, for example, income-oriented senior citizens lulled by a load-collecting salesperson into believing that Treasury bond funds are a safe haven.
We hear continuously from such people. Interest rates are up and they don’t know what hit them. The income they receive is often more than offset by a loss of principal value. Surely, when interest rates fall again, their principal will be slowly restored. But will it be completely restored, and when? Such questions plague them.
If this added risk would consistently result in a correspondingly higher return then it might be acceptable. But on a yearly average the bond market has sharply underperformed the stock market.
This invariably raises the question: if the bond market is so risky who are all those people with money in its vast confines? Well, they are either people who don’t know what they’re doing, or they are institutional investors (mainly insurance companies) who, with the aid of high-salary economists, play the interest rate game, eking what they can out of changing bond prices over time. (However, investors should note that many of the greatest financial scandals of the past century have been in the bond market, not the stock market.)
All bonds, except Treasury and government, are rated by rating services according to their credit risk. Such risk relates to the issuer’s financial ability to make timely interest payments and return principal at maturity. But, alas, raters are often wrong. But one advantage to the would-be bond buyer is that junk bonds, those rated below the fourth rung down, are clearly deliniated. While junk bonds pay inordinately high yields, they’re called junk bonds because they’re junk and in danger of defaulting.
Here’s an example that better describes interest-rate risk. If you buy a 30-year, $1,000 Treasury bond paying a 6 percent up-front interest rate, the government guarantees over the next 30 years to pay a fixed $60 a year to whoever owns that bond. But if interest rates rise to say 7 percent, anyone who owns one of those 6-percent bonds will want to sell it and buy a new one yielding 7 percent. But who is going to buy a bond paying 6 percent when they can buy one paying 7 percent? Well, when the price of the 6-percent bond is reduced by market forces to $850, from $1,000, then the $60 in income triggers a current and competitive yield of 7 percent. So as interest rates rose, the price of the old $1,000 bond declined.
MOSTLY UNDER WRAPS: Any investor would certainly be concerned if the commission they were paying on the purchase of stock was not fully revealed. Well, believe it or not, that’s the enduring problem in the purchase of bonds. When you buy a bond, the seller may charge a small commission or no commission at all. That’s generally a tip-off. The seller is making up for that in another way. That other way is in the price spread on the seller’s trades in the bond market. For a bond broker to sell you a bond he must first buy it from a bond dealer, who acts like a wholesaler. The difference is often great between what he pays and what he charges you.
WHERE ARE THE TABLES?: Can you image holding stock and not being able to check on their prices in newspaper stock tables every trading day? The Wall Street Journal carries a regular table on Treasury securities, but the tables carrying corporate and municipal bond quotes are microscopic in view of the vastness of the bond market. Insignificant daily changes dull the demand for such tables.
OTHER COMPLEXITIES: Add to those problems the fact that liquidity, the ease with which securities can be sold without significant delay or cost, can be a problem in the bond market, particularly in the more obscure municipal market. Also, some bonds are callable, meaning that the issuer has the right to redeem them and pay off bondholders at a prescribed time. The issuer is most likely to do this when interest rates are low and new bonds can be issued at a lower cost. Thus bondholders are getting their money back when income investment opportunities are at their worst.
BOND FUNDS are even a poorer deal. Two reasons for buying an individual bond are a fixed rate of return and return of principal at maturity. You get neither of those in a bond fund. Because of portfolio changes by the fund manager, a fund yield bounces all over the lot and a bond fund never matures.
MUNICIPAL BONDS are issued by states, counties, cities and political districts. They carry credit risk, but that’s not their chief danger. They are generally tax-free and thus lure investors whose hatred for the tax collector is greater than their tax problem. So they put tax relief above performance and buy bonds with inferior returns. Add to that interest-rate risk.
Most investors who don’t know what they’re doing get into the muni market through highly hyped municipal bond funds, paying hefty loads. Selling poor-performing muni funds to inexperienced investors should be outlawed. Anyone who truly has a tax problem should buy carefully selected individual municipal bonds. 'See what a discount broker has to offer.
OTHER BONDS: Inexperienced investors are often drawn to cozy-sounding inflation-adjusted bonds and/or U.S. Savings Bonds. These Bonds pay complexly-calculated interest rates. In other words, the investor doesn't know what he or she will earn.
If anyone wants information on disposing of Savings Bonds, call Treasury Direct at 1-800-722-2678.