Sunday, January 22, 2017

The Problem with Bonds....

Bonds are deceptively simple appearing, but are really very complex.

A lot of older folks like to invest in "fixed income" securities such as bonds.  Bonds are basically loans, where you are the lender, and the government, a corporation, or a municipal government, are the borrowers.

It seems like a pretty simple deal.   You lend someone money at 5%, and they pay you back, and you make a 5% profit.  Right?   Well, it gets more complicated than that.

For example, suppose you want to sell your bond before the maturity date?   Bonds can be bought and sold, just like stocks are, and their price can fluctuate, just like stocks - often dramatically.

We tend to talk about the price in terms of yield.  So, for example, when the Mohegan Sun Casino looked like it was going to go bankrupt, the yield of their bonds skyrocketed to 240%.   A lot of people thought they were going to lose their investment, so they sold off these bonds for pennies on the dollar.   As it turned out, in retrospect, that would  have been a hell of a buy, but since my time machine is broken, I can't go back and get that deal.   And at the time, the deal scared the crap out of me.  After all, all those really smart people were running away from it, right?  So it had to be bad.

Of course, buying and selling bonds without really understanding the nature of what you are buying and the financial strength of the company or entity behind the bonds, is little more than gambling.  And the same could be said of stocks as well.   So most of us buy and sell based on what is in the news, or what we hear online, and thus stock (and bond) prices go up with new product announcements, and go down when the CEO is caught in bed with a transvestite hooker.   Neither news event may really affect the underlying soundness of the business, but both will drive share price and bond yield one way or the other.

With bonds, interest rates also affect yield - or to be more precise, where the market perceives interest rates to be headed.   Rates right now are at an all-time low, so most folks think (reasonably) that in the future rates will go up.  They certainly can't go down much further.

So, for example, you buy a corporate bond that has a rate of 2%.    That's a pretty paltry rate, but it is the going rate for many companies these days.   However, the market perceives that before 2035 when this particular bond matures, rates will go higher.   As a result, folks don't think this bond is worth as much, and thus the price you would get for it on the bond market will be less than face value, thus lowering the effective yield for you, and raising it for the guy who buys it.

Now, there are other ways to play this game, of course, and one way is to keep bonds until they mature.  If you have a 5% bond, and you keep it until it matures, you get 5% back on your investment, regardless of whether the market says the bond is worth something else in the meantime.   And some have proposed structuring a bond portfolio in such a way that you get guaranteed fixed income over time.   They call this "ladder bonds" and at first, the idea mystified me somewhat.   To some extent, it is like creating your own annuity, hand-made.

The idea is to buy a series of bonds, each maturing a year later than the other.  So one bond matures next year, one the year after that, and so on, up to say, 30 years.  Or, if you are not going to retire for some time, you could set it up so the first bond matures in 10 years, the next in 11, 12, and so on.   Each year, you cash in the bond for that year, and you get X amount of income, plus interest.   You can alter the amount of each bond, so that the income for each year you cash in is level.   This means the shorter-term bonds will cost more up-front, but that the longer-term bonds will cost less to buy initially.

It is an interesting scheme, but there are two problems with it.  First, to do this for say, 30 years of retirement (or even 15 or 20!) would require an awful lot of capital to put into bonds.   You'd have to buy 30 bonds, each maturing in a different year, and each earning enough so that the amount you cash in will pay for your support in retirement (or a portion thereof).   You'd have to make your portfolio very bond-heavy.

Second, it means you might miss out on better opportunities.   While bonds go up and down in value, overall, they tend to under-perform stocks, which can skyrocket (or tank).   While the yield on that Mohegan Sun bond was 240% because it was crashing, the gain on my AVIS stock is still over 6,000%.   Over the long haul, there is more possible upside with stocks than with bonds.   So putting all your eggs in the bond basket seems to me, an overly-conservative move.

Third, it may not be much of a conservative move.   U.S. Government bonds earn paltry interest rates and thus are just a place to park money.  If you want to earn real money, you would have to go corporate bonds, or possibly municipals.   Both can go bankrupt and leave the bond holder with pennies on the dollar.   If this is your retirement income, can you afford to do without any income for one year?   Again, all the eggs in one basket doesn't strike me as a good idea.

Fourth, bonds are usually callable.   So if you set up this "bond ladder" you may find a number of rungs missing over time, and as a result, you will have to replace those with new bonds, which likely will cost more to replace, in order to get the same yield.

Fifth, it is a "scheme" and I hate schemes.    People like simple solutions to complex problems, and if you say, "If you just do THIS, you will be successful!" - as if one thing was the answer to all of your problems.    Life isn't like that.   The world won't fix itself if we went to a flat-tax, the gold standard, or whatever.  Our budget problems are not any one single thing, but a classic example of budget bloat across the board.

Investing is the same way.  You have to squirrel money into a number of things.   You can't just use a "system" and put it all into one.

Do I have some bonds in my portfolio?   Yes, of course I do.   But I have learned that bonds can go down in value in the short term.  Not only that,  but in an era of rising interest rates, a bond with a "high" rate today is barely keeping pace with inflation tomorrow.