Bonds have a generally good reputation for being safe investment vehicles. But there are risks, some of which proved costly to investors in the 2008 financial crisis.
Marvin Appel wrote and published his book, "Higher Returns from Safe Investments: Using Bonds, Stocks, and Options to Generate Lifetime Income," in the wake of that crisis. In chapter three, he outlined several standout risks for bondholders and offered suggestions for dealing with them.
Drawdowns
First is drawdown risk, which refers to the amount a bond’s principal falls in an adverse situation. It is measured from a high point to a subsequent low point, and is shown as a percentage. Appel created this chart to show drawdowns on a long-term bond between 2002 and 2009:
This is a long-term, 20-year bond, so it will be more susceptible to drawdowns than a short-term or intermediate-term bond. In his next chapter, Appel discussed bond ladders, which help moderate drawdowns and increase coupon rates (bond ladders are a blend of different maturities; the coupon rate is the interest rate specified for the bond).
Interest rates
The coupon rate or interest rate quoted on a bond is locked in upon purchase. In other words, a 20-year, 3% bond will pay 3% per year, every year from the year purchased until the year it matures.
Where the broader interest rate makes a difference is in setting the principal value of the bond. The values of existing bonds go up when interest rates fall and vice versa.Ă‚
The author wrote, “The take-home message is that you should not buy long-term bonds unless you are certain that you will be satisfied with the level of interest income because if rates rise after you invest, you will be down a lot of money.”
He added, “As a general rule, bonds that mature in longer than ten years expose you to price risk that is excessive compared with the added increment in yield with bonds that mature in seven to ten years.”
Defaults
Appel called default the worst thing that can happen to a bond portfolio, and for good reason. Default is the equivalent of bankruptcy and means you may not get your scheduled interest payments. In a worst-case scenario, it also could mean partial or full loss of your principal (capital).
Still, he says that defaults are rare, and after a bond defaults there are usually negotiations aimed at recovering at least some of the original investment. On average, defaulted bonds have returned 40% of investors’ capital, but that’s an average. Actual returns can be significantly lower or higher. For example, bonds that defaulted in 2009 were expected at the time to pay back only about 20% of their face value.
In his role as an investment manager, Appel checks a bond’s credit rating and the prospects for a change in its rating. He also reviews a company’s earnings capacity to see if it can cover its loans (GuruFocus subscribers have access to many tools to assess a company’s financial strength, including its interest coverage ratio and Altman Z-Score).
And he suggested that such risks ought to be put into context. “When it comes to the risk of defaults, there is good news and bad news," he wrote. "The good news is that, on average, the risk of defaults by any investment-grade bond is normally so low that you do not need to worry about it if you are well diversified. The bad news is that 2009–2010 is not a normal time, with the risk of default higher than normal.”
And, of course, for Treasury bills, there is no risk at all, since federal governments can print money.
Credit ratings
When you buy a bond, you will normally have access to the credit ratings issued for it. These credit ratings come from one of three independent agencies that the issuer pays for an opinion: Moody’s MCO, Standard & Poor's and Fitch Ratings.
The rating companies use letter grades to summarize the creditworthiness of bonds. This table shows the categories and default rates for each grade:
These are the primary grades; within each of them are sub-grades that help differentiate risk more precisely. Appel wrote, “Even though we have seen examples of companies that collapsed suddenly, it is far more common that companies that defaulted did so only after several years of deteriorating credit ratings.”
Appel did not cover the criticism of the ratings agencies in the wake of the 2008 crisis, but all three were criticized harshly — and sued — for their optimistic ratings of subprime and structured loan products.
Credit downgrades
In normal times, a credit rating agency keeps an eye on issuing companies or governments, and will issue a credit downgrade if warranted. Unless the bond market already priced in a downgrade, the price of the bond will then go down (that is, the principal value will drop).
If you feel there is a possibility a bond might be downgraded in the future, avoid it. Alternatively, you might want to wait until the official downgrade is issued and the price falls, then buy it at a discount.
Inflation
If you buy a stock and inflation increases, the company that issued the stock can usually increase the prices of its goods or services to keep up. Not so with bonds, because the profits are fixed in advance. This means inflation can erode returns, year after year, and there’s nothing that can be done about it. If the inflation rate is higher than the coupon rate, you’re stuck with a losing position.
Overall, though, coupon rates move in the “same broad direction” as inflation. Again, short- and intermediate-term bonds provide the best flexibility; Appel recommends maturity dates of five years or less.
He also discussed hedges against inflation. “Gold comes to mind, but there is an even more precise hedge that would historically have done a good job of preserving the purchasing power of your money," he wrote. And, “the best inflation hedge has been Treasury bills. If you had kept all of your money in three-month Treasury bills (in a tax-deferred account), you would have lost very little ground to inflation even during the worst of times.” Of course, you also would have earned almost nothing.
Liquidity
What if you need cash immediately, long before your shortest-term bond matures? In that case, you are likely going to suffer to some extent.
How much you’ll suffer depends on the state of the bond market at the time. In particular, if you’re selling when the herd is panicking, you’ll take a bigger hit. “If you sell a bond in response to unexpected bad news about the issuer, your losses can be very large—potentially reaching 5%–10% of the par value," Appel wrote.
Conclusion
One pattern that arose in this chapter was the longer the bond, the greater the risk. Similarly, the lower the bond rating, the greater the risk. But these are the types of bonds that offer the best yields, so what’s an investor to do? Appel concluded the chapter with this advice:
“The only way to completely avoid risk is to invest all of your capital in Treasury bills. However, at their current yield near zero, Treasury bills will not generate the returns you need to support yourself over the long term. Rather, your strategy should be to invest in a number of different types of bond investments so that your exposure to any one type of risk is limited.”
Disclosure: I do not own shares of any company listed and do not expect to buy any in the next 72 hours.
Read more here:Ă‚
Higher Returns From Safe Investments: Bond Basics, Part 2Ă‚
Higher Returns From Safe Investments: Bond Basics, Part 1Ă‚
Higher Returns From Safe Investments: Finding a Happy MediumÂ
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