The traditional and perhaps naive view is that bonds offer the safest way to invest. In some ways, that is accurate. In others, it’s way off the mark. If one is looking for essentially risk-less investments, the vehicle of choice is U.S. Treasury bills, which are obligations of the federal government that mature in under a year. At times when the economy is unusually weak, the yield on T-bills is the lowest available from all Treasury obligations.
So along with low risk comes low return. What lowers the risk is the assurance that Washington can continue to print money and pay off these debts at maturity and since the period is short there tends to be minimal price fluctuation along the way. High safety goes hand in hand with high quality and short maturity.
Risks and Ratings
Many investors, especially those depending on fixed-income generated by bonds, have little choice but to seek higher returns than those of say the T-bills, which typically means tying up funds for longer terms and/or accepting bond issues of lower quality. Longer terms can mean 10, 20, 30 years or more. The risk of an extended maturity is the increased likelihood of events that may have a significant impact on the interest rate environment. When the starting point is an extended period of low interest rates, such as that of recent years, the path of least resistance tends to be in the direction of higher interest rates. (For more, see: The High Dividend Stock Strategy: Pros and Cons.)
The corollary of higher interest rates is lower prices for bonds. That may not be a problem for investors prepared to hold until the bonds mature, but it will be a concern for those who cannot stand fast for the long haul. When interest rates have climbed in the past, there have been occasions when bond prices, even those of the U.S. government, had dropped 10% to 15% or more in relatively short periods of time.
Interest rate risk is only part of the problem. At least as important is the quality of the issuer. If the cream of the bond crop are those from the U.S. Treasury, government agencies are only a notch or so lower. As one would expect, their obligations have a slightly higher yield. The next step down is investment-grade corporate obligations, offering even higher yields. The very highest quality corporate bonds are rated AAA (by Standard & Poor’s) and investment grades come in as low as BBB.
Another step down from investment-grade bonds are those rated BB, which may be considered bad bonds. The ratings work their way down to a variety of Cs, a domain populated by what are euphemistically referred to as high-yield bonds. They are referred to more commonly as junk bonds.
Junk bonds tend to be issued by companies that have no other viable method of raising capital. To entice investors to buy these bonds, the companies offer interest rate returns that are well above those available in most other parts of the fixed-income universe. At times, these yields may be up in the double digits. The high returns are the quid pro quo for the significant risk of default that is part of the junk bond equation. That risk varies widely, but in most years it has been between 10% and 20% or lower. More recently, the default rate has been in the single digits. (For related reading, see: Investors: Don't Let Fees Reduce Your Returns)
Prospective returns from junk bonds can be quite substantial. During periods of economic stress, prices of these bonds will be under considerable pressure as default rates climb. Even so, the majority probably will not be defaulted and investors will end up benefiting from significant price appreciation as well hefty yields.
To take advantage of the kinds of opportunities that may be presented by junk bonds, one must be cognizant of the increased risk that is involved. When doing so, it would be appropriate to consider some for a relatively small portion of one’s total holdings.
One key to buying junk bonds is the spread between the interest rates on junk bonds and Treasury securities. When the spread is high – earlier this year it was more than six percentage points – junk bonds are more attractive. And when the spread is only a few percentage points, vice-versa.
A Built in Problem
Whenever investors are considering bonds, there is a built-in problem. Generally speaking, those who are looking to buy or sell bonds in small quantities are in a weak position to negotiate with traders. As a result, there will often be a sizable spread in pricing. When you are the buyer, the price offered by the trader will be higher and when you are selling, the price offered by the trader will be lower. A big spread means the investor is not getting the best possible price. By channeling one’s needs in the direction of mutual funds or exchange-traded funds specializing in bonds, however, the spread issue vanishes since the fund managers will be buying in quantities where the spread is insignificant.
And what’s the difference between a bond and a bond trader? A bond matures. (For related reading, see: Stock Picking: Keys to Successful Investments .)