Basics of Financial Investing – Part 6

Investing in the Debt Market

Debt securities, primarily bonds, constitute the principal security market alternative to stocks. Bonds have many uses. This asset class that should not be overlooked by individual investors. Bonds were once thought of as almost exclusively in the province of institutional investors. More recently, however, bonds have begun to appeal to individual investors, even small individual investors. Indeed, the rather poor performance for stocks compared with the much stronger performance for the bond market over much of the 1999–2002 time period drew increasing numbers of small individual investors into the bond market. The markets do, to be sure, run in cycles. In 2003 bond market yields were at historically low levels and the stock market performed very well. In both 2004 and 2005, long-term interest rates were expected to rise, but when they didn’t, bonds turned in a rather good performance.

The debt security market is itself divided into a number of sectors, including short, intermediate, and long-term; corporate, government, and state and local; as well as investment grade, junk, and distressed. While direct investment in debt securities is one way to participate, many investors prefer the convenience of mutual and closed-end bond funds.

Understand and take advantage of the short-term end of the debt securities market

The short-term end of the debt securities market is called the money market. The money market appeals to investors who prefer its safety and security, as money market instruments have little risk of default or significant price drops. Such securities are structured automatically to turn back into spendable dollars soon after they are purchased, usually with little risk of loss. A number of different types of underlying securities are designed to trade in this market. Treasury bills, debt instruments issued by the federal government for terms of up to one year, are the best-known money market instrument. Because of the government’s power over tax collections and the money supply, Treasury bills are considered to be essentially devoid of risk. Because they are viewed as being especially secure, the rates offered on Treasury bills are below those of other money market instruments and generally lower than longer-term Treasury debt instruments as well.

Banks and other types of depository institutions issue marketable CDs (certificates of deposit), which constitute another significant piece of the money market. Such CDs are insured by the FDIC for up to $100,000 per holder per bank. As a result of this insurance, CDs can be very nearly as safe as Treasury bills. Those CDs that are not covered by FDIC insurance (that portion over $100,000) can default, but only if the issuer bank itself fails. Default losses on large CDs are rare, but they do occasionally occur. If the issuer (e.g., bank) fails, holders of uninsured CDs are likely to recover only a portion of their CDs’ face value. This recovery percentage is determined by how much value of the failed institution remains relative to its debts. When a bank fails, it is seized by the regulators and then either sold to another bank or its assets are liquidated. The proceeds from this process are then paid out to uninsured creditors on a pro rata basis. Investors might recover anything from 0 percent to 100 percent of face, depending on how deeply insolvent the issuer of the CDs was at the time it failed. The FDIC makes up the shortfall for insured but not for uninsured creditors (e.g., depositors of the failed bank). Suppose you had $200,000 invested in CDs at an FDIC-insured bank that failed. If recoveries on the bank’s assets permitted the FDIC receiver to pay out 80 percent of allowed claims, you would recover 100 percent of the first $100,000 and 80 percent of the remaining sum, or, in this case, a total of $180,000 of your $200,000 investment. The FDIC’s insurance fund would make up the difference on the insured accounts. You would suffer a loss on the uninsured portion. The FDIC’s insurance fund is financed from the premium payments made by banks that are members of the FDIC system. All commercial banks are required to be members of this system.

Those large corporations that the market views as being very secure are able to issue short-term debt instruments called commercial paper. Such paper is underwritten by investment bankers according to strict standards. Usually, backup lines of credit are required by the underwriter as take-outs. The commercial paper issuer must pay a fee for the backup line of credit. This fee adds to the cost of the funds. Still the total of the interest cost and the line of credit fee is generally below that of any alternative funding source. In the unlikely event that the commercial paper issuer cannot refinance the debt as it comes due, the take-out line of credit is tapped to pay off the maturing commercial paper. Accordingly, commercial paper almost never defaults. And on those rare occasions when it does, the underwriters are likely to be sued for failing to uncover the problem.

Two other components of the money market are Eurodollars and bankers’ acceptances. Eurodollars are dollar denominated deposits in financial institutions based outside the United States. Bankers’ acceptances are company-issued IOU’s that have been guaranteed by a bank. Such acceptances often arise as part of the payment process in an international transaction.

The vast majority of money market instruments, whether government-issued or not, are viewed by the marketplace as being extremely safe. Only very secure borrowers can issue and sell their own money market instruments.

Moreover, these instruments (which by definition must pay off within a year) always mature soon after their issuance. Accordingly, very few issuers of money market instruments can get into very deep financial difficulty in the short amount of time between issuance and maturity. Defaults in the money market are extremely rare. Those issuers whose credit quality declines appreciably soon find the money market closed to them. Their outstanding money market instruments mature at a time when the issuers are usually still healthy enough to pay them off (often utilizing their backup banks’ lines of credit). Therefore, these former issuers of money market securities cannot issue new ones unless and until their credit quality improves sufficiently.

Unlike bonds, which are structured to pay a coupon every six months and repay principal at maturity, almost all money market instruments are sold at a discount from their face value (par) and mature at par. They do not make coupon payments. The return or yield on such instruments is derived solely from the difference between their initial price and their par value, which is paid out at maturity. For example, a one-year T-bill might be issued at a price of $9,500 and mature at $10,000. The buyer of such an instrument will earn $500 on the $10,000 face value T-bill, for a discount yield of 5 percent.

Note that a discount yield (only one payment, which occurs at the bond’s maturity) is a slightly different concept from the more familiar coupon yield (coupon payments every six months). For example, one could earn $5,000 on a $95,000 one-year investment for a 5 percent discount yield. A 5 percent coupon yield would result from earning $5,000 on a $100,000 investment. So we see that a 5 percent discount yield is slightly more attractive than a 5 percent coupon yield. In this particular example, earning a 5 percent discount yield on $95,000 is approximately equivalent to earning 5.26 percent on $100,000 (0.05/95 = 0.0526). The actual computation is a bit more complicated because of the impact of the semiannual payment on the coupon bond.

One can participate directly in the money market by buying, holding until maturity, and sometimes selling the various money market securities. Most small investors will, however, find indirect participation in the money market to be a much more convenient approach. The minimum denomination of money market securities is high ($10,000 for Treasury bills, $100,000 for large, marketable CDs, and larger still for the others). Moreover, the market for individual investor participation is not well developed. Indeed, with the exception of T bills, the minimum denominations are very high and the markets are almost exclusively the preserve of institutions, large corporations, and large individual investors. Thus the money market is not well suited to direct participation by small investors. And yet many small investors would like to invest in the very safe short-term securities that make up the money market. Responding to this reality, a number of instruments have been developed to provide the small investor with indirect access to the money market.

One alternative to direct participation in the money market is to access the market via an intermediary such as a money market mutual fund. Such funds assemble and maintain large, diversified portfolios of money market instruments. The net returns (after subtracting fees and expenses) are passed through to their fundholders. Their fees and expenses typically amount to between 20 and 50 basis points annually. That cost is, however, a rather small price to pay for the convenience and diversification provided by money funds. Fundholders have immediate access to their funds via check-writing privileges. Because the portfolios are composed of very-short-term, highly secure debt instruments, losses on those types of diversified money market portfolios are almost nonexistent.

To compete with the money market mutual funds, banks offer a product called a money market account. In addition to paying a yield tied to money market rates, these accounts provide check-writing privileges and immediate access to the investors’ funds, much like money market mutual funds. Money market accounts are as easy to open and operate as standard bank accounts. Such accounts are FDIC insured up to the $100,000 maximum. This FDIC insurance makes these accounts even safer than most money market mutual funds. At times the interest rates offered by the banks are below, and at other times above, those offered by the money market mutual funds. Most of the time the money funds have offered the better rates. When, however, overall rates fall to very low levels (2003–4), the banks tend to be more competitive. One special type of money market mutual fund is the governments only fund.

This type tends to pay a slightly lower yield than the standard money fund. It does, however, have two significant advantages over other types of money market mutual funds. First, the portfolio of a governments only fund consists exclusively of government securities. Accordingly, it is even safer than other types of money funds. Second, the interest income from government securities is not subject to state income taxes. If you live in a state that has a high income tax rate, governments only funds may offer you a more attractive after-tax yield than the standard (taxable at the state level) money fund.

Money market mutual funds and money market accounts at banks are two major ways for individual investors with modest resources to participate in the very short-term debt securities market. Short-term unit investment trusts represent a third approach. Unit trusts own self-liquidating portfolios of short-term debt instruments. Because their portfolios are not managed, the fees and expenses of unit trusts are quite low. Accordingly, the investor’s net portfolio return tends to be closer to the gross return on the portfolio than is the case for money market mutual funds. Unit trusts do, however, lack the convenience (e.g., check-writing privileges) of money funds and money market accounts. Unit trusts are structured to have a specific maturity such as six months from their date of issuance. At maturity the fund is liquidated and the proceeds are distributed. The only way one can access his or her funds prior to the trust’s maturity is to sell the units in a market that is not especially liquid.

Yet another approach, short-short funds, maintain portfolios of debt securities whose maturities are longer than those held in money funds but shorter than four other types of bond funds. A money fund portfolio would have a weighted average maturity of perhaps sixty days. A short-short fund’s average maturity, in contrast, might be six months or a year. By assembling a portfolio of investments with longer terms than a money fund, short-short funds may be able to obtain somewhat higher yields. Such longer terms do, however, involve the risk of taking some small losses if market interest rates rise and thus the market values of the short-short funds’ holdings decline. Put another way, when market interest rates rise, the yields on short-short funds are slower to adjust upward than are the yields of money funds. On the other hand, when interest rates fall, short-short funds’ yields decline more slowly than do money funds. Like other types of mutual funds, short-short funds are very liquid.

Finally, investors may choose to purchase small-denomination bank CDs, or hold other types of depositor accounts (e.g., savings accounts) at a financial institution such as a commercial bank, savings and loan association, credit union, and the like. The traditional bank savings account (passbook or statement) tends to offer relatively low rates. Small-denomination bank CDs may be more attractive, but one needs to shop around in order to obtain the best rates.

The Money Market for Small Investors

  • Money Market Mutual Fund: Convenience, diversification, very low risk
  • Governments Only Money Fund: Slightly lower yield than standard money funds; sheltered from state tax; very safe
  • Money Market Account: Bank product, FDIC-insured; very safe
  • Unit Investment Trust: Very low fees, not managed, illiquid
  • Short-Short Funds: Less liquid than money market mutual fund, but offers somewhat higher yields
  • Savings Accounts and CDs: Safe, FDIC-insured, liquid; shop for best yields

For small individual investors, bond funds provide an attractive vehicle for entering and participating in this market.

Most bonds are sold in $1,000 face value denominations. A typical small purchase would involve at least five to ten bonds, or a $5,000 to $10,000 commitment. Rarely would you see bond trades involving less than five units. To be reasonably well diversified, a portfolio of bonds should contain a minimum of eight to ten separate issues. Thus, $40,000 (eight issues with $5,000 invested in each) to $100,000 (ten issues with $10,000 invested in each) would be needed to assemble a diversified portfolio of bonds. Most investors who participate in the bond market also own a portfolio of stocks. For such an investor to have equal amounts invested in a reasonably well-diversified portfolio of stocks and bonds, perhaps $200,000 in investible funds would be needed. Two hundred thousand dollars represents a substantial sum of money for most individual investors.

One attractive alternative to assembling your own portfolio of individual bonds is to purchase shares in a mutual or closed-end fund that owns and manages a portfolio of bonds. A small investor may start by buying as little as a few thousand dollars’ worth of shares of a bond fund. The investor can then add to that sum over time. The bond fund’s income can also be automatically reinvested in the fund. Bond funds (mutual or closed-end) provide such individual investors with the opportunity to participate in the bond market with as little as $500 to $1,000. Thus, for a relatively small sum, an individual investor can obtain all the diversification benefits of the fund. As with any such funds, fees and expenses are passed through to the fundholders. Thus the net return on the bond fund will always be below the gross return on its portfolio. Bond funds come in many different varieties. Choose one that fits your needs.

Bonds are issued by three primary categories of borrowers: the U.S. Treasury (governments), state and local governments (municipals), and corporations (corporates). Short, intermediate, and long-term bonds are available for each type of issuer. All government bonds are regarded as being extremely safe. The risk levels of municipals and corporates can, however, vary substantially. Such bonds can and sometimes do default.

Bond funds exist for each of the categories outlined above. So, for example, you could buy a long-term government fund, an intermediate-term high-grade (low-risk) municipal bond fund, or a long-term high-risk (junk) corporate bond fund. As with stock funds, bond funds are available in both actively managed and index fund types. Bond mutual funds come in both load and no-load types. Closed-end bond funds are also available. Each type of fund has its own set of advantages and disadvantages.

Bear in mind that a rise in market interest rates corresponds to a decline in bond prices.

Almost all bonds are structured to make a fixed coupon payment every six months. Thus, a 7 percent bond promises to make a coupon payment equal to 3.5 percent of its face value, twice a year. The market value of this payment stream ($35 every six months on a $1,000 bond) depends upon the rate at which the marketplace discounts (present values) it. If, for example, the market were to apply a discount rate of 7 percent, the payment stream would be worth (have a market price of) $1,000, the same amount as its face value. Put another way, if the market price of the 7 percent coupon bond is $1,000, the market must be applying a 7 percent discount rate to the bond’s promised income stream. If, however, the market-determined discount rate for this bond is higher than 7 percent, the present valuing process applied to the projected payment stream would result in a market price that is below the bond’s face value. Looked at from a different direction, if the market price of the 7 percent bond was below its $1,000 face value, that would imply that the market is applying a discounted rate above its 7 percent coupon rate.

The mathematics get somewhat complex. As an example, if a long-term bond with a 7 percent coupon is priced to yield 8 percent, it might (depending upon its maturity) sell for about $900. Suppose you had purchased the bond at its original issue price of $1,000 when the corresponding market discount rate was 7 percent. Thus you would have paid the face value of $1,000 for the bond. If the appropriate market discount rate for this bond rose to 8 percent, your investment would now be underwater by $100 per bond. You would still have a bond with a face value of $1,000 and it would still pay you $35 every six months. You could hold on to your bond, collect your coupon, and would (assuming it does not default) receive the bond’s face value at its maturity. In that instance, however, the sum of money that you originally invested in that bond will not be earning the current market rate of 8 percent for a bond of this risk level. Moreover, if, prior to maturity you needed to raise cash, you would have to sell the bond at a loss.

The accompanying table illustrates how different market discount rates will impact the price of bonds with differing maturity dates. We see that a twenty-year bond with a 7 percent coupon will be priced at 100 points, when discounted at 7 percent. A price of 100 points corresponds to $1,000. Bonds are priced in points, with one point equivalent to $10. If market interest rates on this type of bond (maturity, coupon, risk) increase to 7.5 percent, the bond’s price would fall to 94.84 in points, or $948.40 in dollars. At 8 percent the market price falls to 90.10 and at 9 percent to 81.60. On the other hand, if market interest rates on bonds like this one were to fall to 6 percent, this bond’s price (assuming it can’t be called) would rise to 111.56. Now compare the market prices for a ten-year bond that also has a 7 percent coupon rate. It, too, would be worth its par value of 100 if discounted at 7 percent. At an 8 percent discount rate, the ten-year bond’s price would be 93.56 (compared with 90.10 for the twenty-year bond). At 9 percent the prices are 86.98 versus 81.60 for the ten- and twenty-year 7 percent bonds, respectively. The price impacts of differing market interest rates on five-year bonds are even smaller. For example, the 7 percent, five-year bond will be priced at 95.94 at an 8 percent discount rate compared to 93.5 for the ten-year and 90.10 for the twenty-year bonds. Clearly, shorter-term bond market prices are less affected by changing interest rates than are the market prices of long-term bonds.

The above discussion illustrates one very basic point: bond prices move inversely with interest rates in the marketplace. When market interest rates rise, bond prices decline. That relationship between market interest rates and bond prices creates a major risk for bond investors. If you purchase a bond when market interest rates are relatively low and subsequently they rise, your bond’s market price will go down. The longer the term of the bond, the greater the price impact of this type of risk. On the other hand, when market interest rates go down, bond prices go up. So you can benefit from a favorable move (decline) in interest rates. The potential benefit is, however, limited by the right of the issuer (if available) to call the bond early. Moreover, declining interest rates will also have the effect of reducing the income that you can earn on any coupon payments that you receive and then reinvest.

TABLE 1.1. Market Prices for 5-, 10-, and 20-Year 7 Percent Bonds for Various Discount Rates

Discount Rate Market Price 5-Year Bond Market Price 10-Year Bond Market Price 20-Year Bond
5% 108.75 115.59 125.10
6% 104.77 107.49 111.56
6.5% 102.11 103.63 105.55
7% 100.00 100.00 100.00
7.5% 97.95 96.53 94.86
8% 95.94 93.50 90.10
8.5% 93.99 90.03 85.19
9% 92.01 86.98 81.60
9.5% 90.23 84.09 77.80
10% 88.42 81.31 74.26
11% 84.92 76.10 67.91
12% 81.40 71.33 62.36

The market prices of short-term bonds are much less sensitive to interest rate moves than are those of long-term bonds.

The market-determined price of a bond is equal to the present value of its expected payment stream. The impact of the discounting process increases as the payment to be present valued is moved further into the future. For example, a payment of $100 to be received a year from now is worth $96 if discounted at 4 percent and $95 if discounted at 5 percent, a $1 difference. A $100 payment to be received twenty years from now is worth $45.61 with a 4 percent discount rate and only $37.51 when discounted at 5 percent, a difference of more than $8. In percentage terms, a 1 percent change in the discount rate (from 4% to 5%) changes the present value of a payment one year off by a little more than 1 percent. When, however, the payment is to be received in twenty years, a 1 percent change in the discount rate (from 4% to 5%) causes the present value of the payment to change by almost 18 percent.

The point of the above analysis is as follows: You are much better positioned to limit the risk inherent in a potential interest rate increase if you hold short-term rather than long-term bonds. An interest rate rise will have a marginal impact on the market value of a short-term bond, but a substantial impact on the price of a long-term bond. The same relationship applies to short- versus long-term bond funds.

Opting for short-term bonds or bond funds does, however, have its own drawbacks. First, if interest rates decline, the lower yield’s return impact will be quickly felt by a portfolio of short-term bonds. As soon as the existing bonds mature, the investor will need to reinvest the funds at the lower rates now available in the marketplace. With longer-term bonds, in contrast, the investor will (if the bonds are not called) continue to receive the higher coupon rate until the bonds mature. Second, short-term bonds often offer lower yields than longer-term bonds of similar risk. Thus, by opting for the short end of the market, you may be sacrificing something in terms of yield. When interest rates fall, call rights may limit the profit potential of bonds, particularly long-term bonds.

Most bonds include a provision that provide the issuer with an option to repurchase the debt securities from their owners prior to maturity at a fixed price specified in the indenture (the contract between the borrower and lender). Just as you want to have the ability to refinance your mortgage when interest rates fall, bond issuers want to be able to refinance their debts if market interest rates fall (or if their own credit quality improves). Call provisions are designed to provide the bond issuer with that refinancing opportunity. In the absence of these call rights, a substantial decline in market interest rates could cause the market price of such bonds to rise much higher than their face value. The pre-specified call price tends to limit that potential for appreciation. In other words, the call rights tend to put a ceiling on the bond’s market price.

Most bonds are issued with an initial period of call protection (e.g., five years). During this period, the bond issuer is barred from calling its bonds. Thereafter, the bond issuer can demand that the bondholders surrender their bonds in exchange for a cash payment whose amount is specified in the bond’s indenture. The amount of this payment is usually equal to the bond’s face value plus a modest premium. This premium is typically equal to one additional year of coupon payments. Thus a 6 percent bond might be sold with a call provision that allows the issuer to buy it back at 106 percent of its face value.

These call rights provide the bond issuer with a mechanism for replacing high-yield bonds with lower-cost debt when market interest rates fall. Such a provision allows companies to raise debt capital in a high-interest-rate environment and yet position themselves to refinance that debt at lower coupon rates if interest rates in the marketplace fall. That is, if market rates fall, the bond issue can be called and then replaced with a lower coupon instrument. A feature such as call rights provides an attractive option for the bond issuer. The issuer will exercise the call options only when doing so is attractive to the issuer. That same feature is potentially detrimental to the interests of the bondholder. If your callable bond is never called and does not default, you will continue to receive its coupon until its scheduled maturity date. If, however, your bond is called, you will be paid off early on your high-yield bond. You will now have cash in place of the bonds that were called before their scheduled maturity. The bonds had been yielding an attractive return. Until it is reinvested, that cash payment produces no income. If you are to continue earning a return, the cash that you now have must be put back to work. When your bond is called, market interest rates are quite likely to be lower than they were when you first bought your bonds.

To illustrate this point, consider an example. Suppose you assembled a small portfolio of callable bonds yielding 8 percent when interest rates in the marketplace were relatively high. Therefore you had $100,000 invested in twenty-year, 8 percent callable bonds producing an annual income of $8,000. You were expecting to receive $8,000 a year for each of the next twenty years. What happens if market interest rates for bonds of this risk level fall to 6 percent? If your twenty-year, 8 percent bonds could not be called, they would trade for about 123 (corresponding to $1,230) when priced at a 6 percent yield to maturity. Your 8 percent callable bonds are, however, very likely to be called. You might be paid $108,000 (face plus one year’s interest income) for your holdings. The extra $8,000 represents the call premium that the issuer must pay in order to repurchase the bonds. But if you can earn only 6 percent on the money, your cash income on the $108,000 would fall from $8,000 to $6,480 per year. That new sum is $1,520 less than the $8,000 that you had been earning. The issuer who called your bonds would save on debt service cost, but you would have to give up the income that you were earning on your high-yield bonds. That is how call risk operates. If after the bonds are called and the payoff funds are reinvested at 6 percent, market interest rates rise back up to 8 percent, that is just too bad for the bond investor. The payment stream will stay at $6,480 a year. Moreover, the market value of the bond portfolio will fall to reflect the higher level of market interest rates. Other things being equal, the riskier the bond, the higher its promised yield and the greater the chance that it will default.

Bonds issued by the federal government and backed by the U.S. Treasury are considered to be so safe as to have essentially no risk of default. All other types of bonds are thought of as having at least some risk of defaulting. Technically, a bond defaults whenever it fails to live up to any of the provisions in its indenture. The indenture is the contract that the issuer enters into with the bondholders. For most of our purposes, however, the only default that matters is one involving a failure to make coupon or principal payments when they are due. Such a failure is a serious matter. Unlike a failure to pay a dividend to shareholders, a failure to pay creditors the coupon and/or principal payments as specified in the indenture usually leads to a bankruptcy filing on the part of the debtor (the bond issuer). In some instances, the issuer may cure the default or undertake an out-of-bankruptcy workout settlement with its creditors. In a workout, creditors make measured concessions to the borrower in an attempt to preserve value for the benefit of the lenders. A successful workout will avoid the expense of bankruptcy. Because participation by individual creditors must be voluntary (per the Trust Indenture Act of 1940), out-of-bankruptcy workouts are difficult to accomplish. Each creditor is likely to prefer to hang back and hope that the other creditors are willing to make the requested concessions. In other words, everyone is hoping for a free ride.

Clearly, bond issuers would prefer not to be put into bankruptcy. The managers of the bond issuer (e.g., firm) don’t want their employer to be placed in bankruptcy, so their creditors and the bankruptcy court are looking over their shoulders and second-guessing their every move. So the bond issuer generally makes its scheduled debt payments as long as it is in a position to do so. And yet sometimes the resources needed to service these debts are simply unavailable. Once the debtor runs out of cash, it has no choice but to stop paying its creditors. Such a payment default is bad news for the bondholders. Not only does it mean that the coupon and principal payments stop, it is also almost always accompanied by a bankruptcy filing and a large decline in the market value of the bonds.

The bond market is well aware that a bankruptcy proceeding tends to be a very expensive process. The cost of administering a company while in bankruptcy consumes a significant amount of value that would otherwise be available to distribute to the creditors. So when a bond issuer defaults, its asset base is already inadequate to cover its liabilities. Then the bankruptcy process further diminishes the bond issuer’s asset values. A bond issuer who defaults on a payment is almost certain to be forced into bankruptcy. The bondholders then become claimants in the bankruptcy proceeding. The legal proceedings involved in a bankruptcy case typically take about two years to play out. During that two-year time period the bondholders generally do not receive any cash payments. When the proceedings are completed, the creditors are awarded a distribution based on two factors: (1) the resources available from the issuer (relative to the amount of debt outstanding) and (2) The priority of their claim. Holders of defaulted bonds could receive a distribution from the bankrupt estate equal to anything from a full recovery of the creditor’s claim (almost always limited to the face value of the claim as of the date of the bankruptcy filing with no accrual of interest during the period of the bankruptcy) to nothing at all. Payouts in corporate bankruptcies tend to be in the range of 40 to 60 percent of the face value of the claim, but are frequently above or below this range. Payments may be in the form of cash and/or securities. Often the consideration that is distributed to creditors in payment for their claims is in the form of shares of stock in the newly reorganized company.

Default risk is a serious concern for bond investors, particularly those who invest in high-risk (e.g., junk) bonds. Accordingly, bond investors need to understand and assess the risks associated with the bonds that they consider investing in.

Notwithstanding their higher risk, a diversified portfolio of high-risk, high-yield (junk) bonds tends to produce attractive returns, most of the time. The market tends to compensate investors who are willing to accept high risk. It does so by providing them with relatively high expected returns. Low-quality, high-risk bonds have a significant chance of defaulting. They must be priced such that the bonds offer a high enough promised return to compensate for their high default risk. Put another way, the number of willing buyers will be sufficient to absorb the available supply of high-risk bonds only if the anticipated return is large enough to offset the negative impact of the high risk. Even after the typical loss from default is subtracted from the high level of promised returns, the net yield on junk bonds still tends to remain attractive. Thus, after subtracting losses from defaults, a junk bond portfolio’s net return is generally higher than the net return on portfolios of lower-risk bonds.

While the average return on diversified portfolios of junk bonds tends to be relatively attractive (to compensate investors for the high risk), the return has also tended to be quite variable. That is, the market for high-risk bonds can be and often is quite volatile. When investors’ confidence in the economy’s future is increasing, junk bond prices tend to rise, thereby producing attractive performance for junk bond portfolios. When, however, the economic outlook is poor and declining, weak firms are more likely to fail. When weak firms are at a greater risk of failing, junk bond prices tend to fall, often by substantial amounts. Worse still, default rates tend to rise, further reducing portfolio values. This fluctuation in junk bond prices can lead to very volatile returns for portfolios of such bonds. Even well-diversified portfolios of such bonds tend to produce not only high but also very volatile returns. Thus, for any given holding period, the returns on junk bond portfolios can be well above or well below the long-term averages.

Diversification is every bit as important with bond portfolios as with stock portfolios, particularly for portfolios of junk bonds.

Bond investors are exposed to several different types of risk. When market interest rates rise, bond prices decline. That effect has an impact on the entire market for bonds. Individual bond values are also adversely affected by a decline in the issuer’s credit quality. Such a decline may involve a default but most of the time it does not. Sometimes an investment-grade bond is downgraded to junk bond status. What had been thought of as a strong issuer becomes viewed by the investment community as considerably weaker. For example, AT&T’s stocks and bonds were once considered to be very safe investments. Its stock was considered to be a blue chip and its bonds were rated AAA (the highest possible risk rating). In 2004 its bonds were downgraded to junk bond status (BB).

A downgrade in a bond’s credit rating does not mean that the issuer’s bankruptcy is inevitable. The issuer may very well avoid default even though the credit quality has fallen and the risk of default has risen. Thus, payments of coupon and principal will continue, at least initially, even though the market now views the bond as having a greater risk of default than when it was rated investment-grade. When such a downgrade occurs, the bonds’ price and yield will adjust to its lower credit quality. The downgraded bond will, however, still maintain a substantial value. Thus a bond that was priced at close to par ($1,000 face value) when considered investment-grade, might fall by, say, 20 percent (to around $800 a bond) if downgraded to junk bond status. The downgraded bond will remain obligated to pay its same coupon and principal at maturity regardless of its rating. The investment would, however, have suffered a loss in market value as a result of the decline in the bond’s credit quality. That loss (on paper) would turn into a realized loss if the bondholder had to sell or if the bond subsequently defaulted.

Bonds may, on occasion, be upgraded. A company may have originally issued high-yield junk bonds when it was a relatively weak credit. Later it may have appreciably increased its revenues and profitability and thereby enhanced its credit quality. If its credit quality rises sufficiently, its bonds may be upgraded from junk to investment-grade (or from lower investment-grade to higher investment-grade, etc.). Generally, however, far more bonds are downgraded than upgraded. Moreover, when a company does succeed in enhancing its credit quality, it may also choose to call in its old bonds. By calling these high-yield bonds, the now stronger firm can refinance its outstanding debt at lower interest rates.

So we see that individual bond values may go up or down as their investment qualities change over time. Careful credit analysis of the issuer may help you avoid some negatives (e.g., bond downgrades) in your bond portfolio. Most such changes, however, are the result of unexpected developments. A bond portfolio consisting of only one or a few bonds is particularly vulnerable to isolated events having an adverse impact on one or more of those few bond issues. A bond portfolio containing similar amounts of eight to ten or more different bond issues should be sufficiently diversified to spread the risks reasonably well. As a result of that diversification, isolated events are much less likely to have a major impact on portfolio performance. Thus we see that diversification is an important device for spreading the risks inherent in a bond portfolio.

When one company acquires another company, the target company’s bonds are often downgraded. Be cautious with the bonds of potential takeover candidates.

When one company acquires another company, it frequently uses debt to finance part, or in some instances, all of the purchase of the target company’s shares. The assets of the target company are used to collateralize the new debt. The target company’s existing bonds are usually also left in place. The acquisition process is, however, very likely to increase the combined firm’s leverage. Such acquisitions are called leveraged buyouts or LBOs. As a result of the LBO’s increased leverage, the credit quality of the bond issuer generally declines. This lower credit quality affects the value of not only the bonds issued to finance the acquisition but also of the bonds of the target company that were already outstanding before the takeover. Thus the shareholders of the target company may receive a nice premium for their shares while the company’s bondholders are made worse off. Accordingly, bond investors need to be cautious about investing in bonds of companies that are potential takeover candidates. Identifying potential takeover candidates is discussed elsewhere in this article.

Agency bonds, FDIC-insured CDs, and collateralized mortgage obligations (CMOs) holding government guaranteed mortgages represent an attractive alternative to U.S. Treasury bonds.

The market views the bonds issued by the U.S. Treasury to be the safest and most secure bonds available. Such bonds are backed up by the full faith and credit of the United States government. Given the taxing and borrowing capacity of the U.S. government, coupled with the power of the Federal Reserve to manage the money supply through its open market operations (trading in Treasury bills), nothing short of a revolutionary overthrow of the government, a U.S. loss in a nuclear war, or a successful invasion from outer space is thought at all likely to lead to a default of Treasury debt obligations. Clearly, Treasury bonds are extremely safe. They are viewed by the marketplace as being much safer than the safest corporate or municipal bond. The latter two bond types are known to default on occasion. Even the highest-quality corporate and municipal bonds are viewed as having some risk of default. Thus, investors who wish to own the ultimate in safe bonds should buy U.S. Treasury issues.

In addition to Treasury issues (called ‘‘governments’’), three other types of debt instruments are, in many cases, almost as devoid of default risk as governments. Agency securities (called agencies) are debt instruments issued by U.S. government agencies such as the Government National Mortgage Association (GNMA). The bonds issued by these agencies are, in some cases, backed by the same full faith and credit of the U.S. Treasury as governments. For most of the other agency issues, the market assumes the existence of an implied backing by the Treasury. Therefore, both their past history (devoid of defaults) and their association with the federal government imply that these agency debt issues are very safe.

A second category of extremely safe debt issue are FDIC (Federal Deposit Insurance Corporation) insured certificates of deposits (CDs) sold by banks and other government-guaranteed depository institutions. The FDIC insurance is, however, limited to $100,000 per depositor, per issuing institution. The FDIC collects insurance premiums from member banks. In most years these insurance premiums far exceed the FDIC’s costs of operations. The FDIC has utilized the excess from these payments to build and maintain a substantial reserve fund. This reserve fund is available and, when necessary, to be used to cover what would have been the losses of insured depositors of failed banks. The FDIC can also borrow funds from the U.S. Treasury if need be to perform its insurance functions. Finally, Congress demonstrated in the S&L crisis of the 1980s a willingness to bail out the financial system with additional funds when necessary.

FDIC insurance has a flawless record of protecting insured deposits. Since its formation in the 1930s, no one has ever lost money in an FDIC-insured account. Thus FDIC insurance makes a debt issue very safe. The $100,000 per institution, per depositor limit on FDIC insurance is a relevant constraint when substantial sums of money are involved. One can, however, assemble a large portfolio of insured CDs by purchasing one $100,000 CD from each of a number of issuing banks. For example, a portfolio of fifty $100,000 CDs issued by fifty different banks adds up to $5 million of fully FDIC-insured funds.

The third category of very safe debt instruments consists of collateralized mortgage obligations (CMOs), which contain only government-guaranteed mortgages. Both the Federal Housing Administration (FHA) and the Department of Veterans’ Affairs (VA) provide federal government guarantees to qualified borrowers seeking mortgages. Such FHA and VA-guaranteed mortgages have a number of layers of protection: First, the (creditworthy) borrower’s ability to service the mortgages, then the (appraised) collateral value of the mortgaged property, and finally the government guarantee all provide protection to the CMO investor. CMOs are pools of mortgages that are assembled and sold to investors. These CMO investors receive their pro rata share of the mortgage pools’ cash flows, minus a small sum deducted for administrative expenses.

Notwithstanding their safety and relatively high yields, mortgage pool investments do have one significant disadvantage. With a bond, the payment stream (dates and amounts of coupon and principal payments) is precisely defined in the indenture. Barring a default or early call, a bond investor knows exactly what the payment stream is to be. While the payment streams of individual mortgages are also specified with precision, individual mortgages are often paid off early. Homeowners are particularly likely to prepay their current mortgages in periods of falling interest rates. Thus the actual payment stream on a portfolio of mortgages is much less certain than that of an otherwise similar portfolio of bonds.

Very Safe Types of Bonds and Depositor Accounts

U.S. Treasury Issues (governments): Treasury bills, notes, and bonds are backed by the full faith and credit of the U.S. government. In light of the government’s power to tax and the Fed’s control over the financial system, these debt instruments are considered as safe as possible.

U.S. Agency Securities: Agencies are set up by the U.S. government. Most agencies were established for a special purpose by an act of Congress. Many of these agencies are allowed to borrow money (issue bonds) in their own name. Their securities may or may not be backed by the full faith and credit of the U.S. government. The U.S. government is unlikely, however, to allow any of its agencies to fail. Accordingly, the risk of a default on such issues is remote. FDIC-Insured CDs and other types of Depositor Accounts: Banks and thrift institutions issue debt instruments (CDs) and offer accounts (e.g., passbook savings accounts) with FDIC insurance covering the first $100,000 per investor, per issuing institution. The government-backed FDIC insurance makes these types of instruments extremely safe from default losses.

Government-Guaranteed Collateralized Mortgage Obligations: CMOs contain pools of real estate mortgages. Most CMOs are very safe investments because of the quality of their collateral. CMOs that contain only government-guaranteed (VA & FHA) mortgages are particularly safe.

The market views these three types of non-Treasury debt instruments to be neither as safe nor as liquid as governments. Accordingly, their yields tend to be significantly higher than otherwise similar governments. That is, the interplay of supply and demand results in a market price that corresponds to a somewhat higher yield for these types of government-guaranteed or government-related instruments than is the market-established yield established for otherwise equivalent governments. These three government-associated debt instruments (agencies, FDIC-insured CDs, and government-guaranteed mortgage pools) are, nonetheless, still very safe. Thus, one who is willing to tolerate a di minimus amount of additional default risk should take a close look at them as a substitute for governments.

Because of their low risk, all of the above mentioned types of debt instruments offer somewhat lower yields than otherwise similar but higher-risk debt instruments such as corporates. Compared to Treasury issues, however the other types (CDs, agencies, and particularly CMOs) tend to offer somewhat higher yields.

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