Alister’s Investment Notes
While bond funds have some of the same positive characteristics of other mutual funds: spreading risk through diversification, professional management, etc., bond funds generally do not offer the key benefits that are characteristic of individual bonds.
Most investors are attracted to bonds for two reasons: Preservation of capital if held to redemption, and to lock in a known, steady stream of income. Bond funds do neither! Bond funds are shares of an entity that go on into perpetuity trading, leveraging, etc. a bunch of securities, many of which are bonds, but there is no end date when you get back your principal, nor is there a guaranteed stream of income. Keep in mind that any guarantees are subject to the paying ability of the issuer. As a bond fund owner, you are simply a shareholder of this entity, and its dividends may be changed at any time in response to market conditions.
Treasury Yield Curve
A treasury yield curve simply plots dots representing treasury bill, note, and bond yields at each different maturity. When the dots are connected, we have made the yield curve. Yields longer than one year are determined by investor demand: What payment they feel they need to receive at each maturity date for taking the risk that inflation will erode away their earnings at each maturity range. A treasury yield curve hardly ever “curves” like we imagine a street curving! Instead, it has a “slope,” like a hill. The slope of the yield curve can be “steeper” or “flatter.”
What is depicted here might be called a “normally sloping yield curve.” We call it “normal” because it is the slope or shape that occurs most of the time in the treasury market. It depicts longer-term securities offering higher yields than shorter-term securities.
Compare the solid line to the dotted line: We would say that the curve is “steepening.” This indicates investors are receiving higher yields for longer-term securities than they previously were receiving. This would suggest that inflation has become a bit of a worry for the longer term, and investors need to be paid more to take the risk of investing longer term.
There are many different “shapes” of the yield curve, each meaning something different about investors’ expectations of inflation. Entire books have been written on the subject! This is just one illustration and does not represent current rates.
Did you know that “bond calls” may be found on any type of bond? A bond with no call attached to it is said to be “non-callable.” With a non-callable bond, the Yield-to-Maturity is the yield you will earn if you hold the bond until its maturity date.
A bond call gives the issuer the right to call your bond from you on a set date, at a set price, sometime before maturity. Once the calendar has arrived at the first call date, the bond is callable on that date and on any date thereafter, until maturity, at the issuer’s discretion. Because of this, you have to want to own a bond at its lowest possible yield, whether that’s yield-to-maturity or yield-to-call, before making the decision to buy it.
|Moody’s Ratings||Standard & Poor’s|
|Speculative “Junk” Grade||BaB||BBB|
“Housing bonds” are a special category of municipal bonds, and they may provide a substantial yield advantage to investors of, say, from one-half to three-quarters of a tax-advantaged percentage point over “vanilla-type” munis. Housing bonds generally have a higher yield because they carry the risk of early and unpredictable calls, and investors need to be rewarded for taking on this risk.
Housing bonds are issued by a Housing Finance Authority to raise funds to make mortgages for large housing projects or for single-family housing. Multi-family and Single-family housing bonds have distinct differences of which you should be aware. But the key to prudent investing in these potentially attractive muni bonds is calculation up front of the effects of an early call, to be sure that the yield advantage is not eliminated by the early call.
The Business Cycle and the Fed: A Historical Constant
Believe it or not, you just may get a bargain by paying a premium for a bond! A premium bond is one that sells at a price higher than its face value. Because people are generally resistant to paying a premium for anything, premium bonds frequently will be offered at a yield which is a few basis points higher than a comparable par or discount bond in order to “entice” investors to buy them.
We often say that premium bonds are “more defensive” because they can hold their value better than par or discounts when rates are rising. This is because of both math and the fact that its coupon is already ”up there” in the direction rates are going.
Premium bonds also may enable one to earn more “interest-on-interest,” because higher coupon payments provide more cash for reinvestment (and thus more interest payments received on the reinvestment).
However, it should be noted that callable bonds will have a yield to call that is lower than the yield to maturity.
Municipal Bond Security Features
Not all AAA-rated municipal bonds are the same! The credit enhancements listed here that support municipal bonds are ranked from top to bottom as “safer” to “less safe.” Understand, they are all good credit support features, it’s just that some AAA-rated bonds are safer than others. (See Investment Strategy Article by similar name.)
Municipal Bond Credit Enhancements
- Escrowed to Maturity (ETM)
- Pre-refunded (Pre-res)
- Direct Collateral (GNMA, CDs, etc.)
- Government Insured (FHA)
- High Grade Rating (AA, AAA) of the issuer without enhancement
- LOC from AAA-Rated Bank
- Municipal Insurance
Bond Ladder Considerations
A “ladder” structure of bonds is one in which the bonds in a portfolio are redeemed at different times over a period of years, with each bond becoming due at a different “rung” or year on the redemption ladder. In this way, the portfolio is sure to have a mix of short, mid, and long-term bonds. This is an easy and reliable way to help insulate a portfolio from some interest rate risk. But how do you determine where on the ladder to place a particular bond: By its call year? Its sinking fund year? Its maturity year? How do you determine whether to weight one time segment of the bond ladder more or less heavily than the other segments, and by how much? These are issues that must be addressed in building a bond ladder.
Bond laddering does not assure a profit or protect against loss in a declining market. Yields and market values will fluctuate, and if sold prior to maturity, bonds may be worth more or less than the original investment.
Government and Agency Securities
Government securities are backed by the full faith and credit of the United States, whereas federal agency securities are not. The agencies have a perceived tie to the federal government as institutions established under federal legislation, but carry greater credit risk than those guaranteed by the U.S. government.
*As of September 2008, the Federal Housing Finance Agency became the conservator of two housing mortgage insurance agencies: Federal National Mortgage Corp. and Federal Home Loan Mortgage Corp. As such, the U.S. Treasury has committed to provide necessary funding to support the net worth of these agencies. How long the Treasury will continue this program is unknown.
Municipal Bonds are generally thought of for their tax-free characteristic, but there is a small segment of the muni market that is made up of taxable municipal bonds! This includes bonds that were issued under The Build America Bonds (BABs) and have 35% of their interest payments guaranteed by the federal government. Interest income earned from taxable munis is subject to Federal income taxes.
The market for taxable munis is smaller and less liquid than the market for tax-frees, which make up the majority of munis. But the yields on high-grade taxable munis tend to be attractive when compared to other high-grade taxable bond investments. For those times when investors can buy-and-hold a bond to maturity and they need taxable income, taxable municipal bonds may be worth considering.
GNMA Bonds Illustrative Payments
Certificates of Deposit (CDs)
Many investors buy CDs because they don’t understand bonds. They think that CDs are a “safe” alternative because they are insured by the FDIC, an agency of the U.S. Government. Certificates of Deposit are considered relatively safe, as are the bonds issued by other government agencies like the Federal Farm Credit Bank, Federal Home Loan Bank, Sallie Mae, etc. But CDs have restrictions on the amount you can purchase, have restrictions on early redemptions, and may include penalties that reduce or eliminate the interest that is paid to the investor. In the event of a bank’s bankruptcy, the creditor of last resort for CDs is the FDIC. Bear in mind, the Federal Deposit Insurance Corporation (FDIC) is an Agency of the government and like all government agencies (i.e., Federal Farm Credit Bank (FFCB), Federal Home Loan Bank (FHLB), etc.) its budget is approved by Congress. The FDIC is not a Department of the government, and therefore, its financial obligations do not carry the full faith guarantee of the government as all obligations of Departments do (i.e., Department of Agriculture, Department of Defense, etc.). Think of the early 1990s when the Federal Savings and Loan Insurance Corporation (FSLIC) was facing bankruptcy. It was Congress that, after much debate and discussion, decided to adjust the budget to the FSLIC in order to keep it from going under. Congress could have decided to let the FSLIC go under! Government agencies that might sometime face bankruptcy would be subject to a Congressional review as to whether to provide financial support.
Collateralized Mortgage Obligation (CMO) Basics
A CMO is a mortgage-backed security made up of several classes of bonds backed by the same mortgage collateral or a group of mortgage-backed securities (MBS). The CMO is segmented into a number of different “tranches,” each with a different repayment schedule and risk. This illustration depicts a simple “Sequential” style of CMO.
Each month principal and interest from the underlying group of mortgage loans is paid into the CMO. The CMO is divided into different tranches, each of which is designated to receive interest and principal repayment in a different payment order than the other tranches. Which tranches will receive principal repayment first, second, etc. has been designed to allow greater predictability of “average life” or “maturity”; however, yield and average life will fluctuate depending on prepayments and changes in current interest rates and may be significantly affected by such changes. It also sets various interest rates per tranche to distribute the interest coming into the CMO. Most classes/ tranches of bond holders will receive interest monthly. Class A bond holders will receive principal repayments in addition to its interest payments, until Class A bonds are completely redeemed. Then Class B will receive principal until it is paid out entirely, and then Class C starts redeeming, etc.
Note that the defined classes do not, by design, use up all of the principal and interest coming into the CMO. Because we cannot predict exactly the monthly mortgage repayments or interest flows, room is left for residual cash flow to use in order to enable the defined tranches to be paid as predicted for their specific class. These residual cash flows can also be carved into various classes, which would be called “companion classes.” Companion classes are among the least predictable tranches of all.
Please contact your financial advisor for information on CMOs and how they react to different market conditions.
Municipal Bond Insurance
Many investors say that they “will only buy insured bonds.” But do they really know what bond insurance promises? Issuers of insured bonds generally have a lower underlying bond rating which has compelled them to buy insurance to be able to make the bond issue more attractive to buyers. Be advised, though, the bond insurance only guarantees the timely payment of principal and interest over the life of the bond, and these guarantees are subject to the paying ability of the insurer. The insurer is not obliged to repay principal immediately upon the issuer’s default. They are not obliged to call the bond early. They are not obliged to pay any premium price for the bond, and they do not guarantee the market price of the bond, which will fluctuate prior to maturity. Buying insured bonds is a good thing, but other AAA-rated bonds, like treasury or government-backed, or those rated AAA on their own, also ought to be considered by those who buy “insured bonds only.”
- Municipals USA
- Municipals U.S. Territories
- Very, very, very few corporates
Certain tax-free bonds may be subject to state and alternative minimum taxes, and capital gains tax may apply for bonds sold prior to maturity.
Click for Types of Bonds PDF
“A Good Time for Bonds?”
Many people ask “When is the best time to get into bonds?” My answer is: Whenever you’re building an investment portfolio! In general, people buy high-grade bonds for two reasons: Preservation of capital and a fixed stream of income. Even though the market value of bonds will move up and down with interest rate fluctuations, the bond investor has the option of holding a bond until its redemption date, when he or she will receive back the full face amount of the bond. And while the investor waits for the bond’s redemption date, by call or maturity, coupon interest is regularly paid. Of course, repayment of principal and interest is based on the paying ability of the issuer. Usually, an investor’s expectations of where interest rates are headed will affect the weighting of bonds along the portfolio’s ladder of maturities, not whether or not to own bonds.
Should You Buy Tax-Free or Taxable Bonds?
Generally speaking, all ERISA accounts like IRAs, Pension and Profit Sharing accounts, and other retirement accounts should invest in taxable bonds. Also, individuals who are in a tax bracket below about 25% should invest in taxable bonds as there is no additional tax advantage beyond what is already offered in these accounts. Almost always, the amount of interest you get to keep after paying taxes is more than you would receive from tax-free bonds.
If you have entered the 25% tax bracket or higher, tax-free bonds may be appropriate for you in your non-ERISA accounts. However, be sure you are using taxable bond income for your earnings up to the threshold of that 25% bracket.
Click here for an outline of which bonds are Taxable or Tax-Free
How to Calculate From Taxable Yield to Tax-Free Equivalent
What yield do I have to make in a tax-free bond to be equal to or better than the yield of a particular taxable bond?