Bonds Market (Part 2)

Asset Allocation within Fixed Income
Outperforming your average bond fund on a risk-adjusted basis is not a particularly difficult task for the savvy retail investor. Investing in bond funds is a flawed exercise--particularly in a low interest rate environment. High management fees on bond funds offset much of their active management and diversification benefits. Fixed-income fund managers tend to strive for performance that tracks a respective index rather than portfolio optimization. For example, the overall market capitalization of the U.S. fixed-income market is the basis for the most popular fixed-income index--the Lehman U.S. Aggregate.

How can it be so easy to beat Wall Street's best at their game? Let's take a look at how diversifying across the different classes is the basis of successful fixed-income investing, and how the individual investor can use this premise to gain an advantage over fund managers.
Types of Asset Classes
Fixed income can be broken down into five asset classes: government-issued securities, corporate-issued securities, inflation-protected securities (IPS), mortgage-backed securities (MBS), and asset-backed securities (ABS). An enormous amount of innovation continues within the world of fixed income. For the retail investor, IPS, MBS, and ABS are all relatively new additions. The U.S. leads the world in the range and depth of fixed-income offerings--particularly with MBS and ABS. Other countries are developing their MBS and ABS markets.

The key issue is that each one of these asset classes has different interest rate and credit risks; therefore, these asset classes do not share the same correlation. As a result, combining these different asset classes into a fixed-income portfolio will increase its risk/return profile.

All too often investors only consider credit risk or interest rate risk when evaluating a fixed-income offering. In fact, there are other types of risk to consider. For example, interest rate volatility greatly affects MBS pricing. Investing in different asset classes helps offset these other risks.

Asset classes like IPS, MBS, and ABS tend to give you yield pickup without degradation in credit quality--many of these issues come with an AAA credit rating.

Government bonds, corporate bonds, IPSs, and MBSs tend to be readily available to retail investors. An ABS is not as liquid and tends to be more of an institutional asset class.

Behavior of Asset Classes
Many investors are familiar with government and corporate bonds and their correlation during economic cycles. Some investors do not invest in government bonds because of their low yields, choosing corporate bonds instead. But the economic and political environments determine the correlation between government and corporate bonds. Pressure in either of these environments is positive for government bonds. "Flight to quality" is a phrase you will hear frequently in the financial press. Let us look at some of the other asset classes.
Inflation-Protected Securities
Sovereign governments are the largest issuer of these bonds, and they guarantee a real rate of return when held to maturity. In contrast, normal bonds guarantee only a total return. Real rates of return should be the focus for investors rather than total returns. Real rate and inflation expectations are the drivers for this asset class. (For more information on IPS, see the article "Inflation Protected Securities – the Missing Link.")

Mortgage-Backed Securities
In the U.S. institutions such as Fannie Mae and Freddie Mac buy residential mortgages from banks and pool them into MBS for resale to the investment community. The structure and tranches of these pools usually leave little or no credit risk for the investor.

The risk lies in interest rate risk. Maturity is a moving target with these securities. Depending on what happens to interest rates after issuing the MBS, the maturity of the bond could shorten or lengthen dramatically. This is because the U.S. allows homeowners the ability to refinance their mortgages: a decline in interest rates encourages many homeowners to refinance their mortgages; a rise in interest rates causes homeowners to hold on to their mortgages longer. This will extend the originally estimated maturity dates of MBSs. When purchasing an MBS, investors usually calculate some degree of prepayment into their pricing.

This ability to refinance mortgages in the U.S. creates an embedded option in MBSs, which give them a much higher yield than other asset classes of equivalent credit risk. This option, however, means MBS prices are highly influenced by interest rate volatility (volatility is a major determinant in all option pricing).
Asset-Backed Securities
The concept of an ABS is similar to that of an MBS, but ABSs deal with other types of consumer debt, the largest of which are credit cards and auto loans. An ABS, however, can be created from almost anything that has material and predictable future cash flows. For example, in the 1990s, royalties from David Bowie's song collection were used to create an ABS.

The big difference between an ABS and a MBS is that an ABS tends to have little or no prepayment risk. The structure of most ABSs is at AAA, the highest credit rating. Because this asset class is relatively new, it has not been well tested through all kinds of market cycles. This makes ABSs defaults and prepayment assumptions susceptible to change during a severe economic recession.

Retail investors have difficulty understanding the ABS, and the liquidity of this asset class tends to be the lowest of the other five.

Conclusion
When building a fixed-income portfolio, investors should look at diversification the same way as in equity investing--diversification within the asset class is just as important. Equity investors tend to diversify across different sectors (finance, energy, etc.) of the market. Creating a portfolio with material representation from all fixed-income asset classes is one of the pillars of good fixed-income investing.

Mutual fund managers, however, generally don't adhere to this rule of thumb because they fear they will deviate too far from their respective benchmarks. Savvy retail investors can bypass this weakness and therefore gain an advantage in constructing their own portfolios. It's a matter of combining at least five high-quality bonds with representation from all fixed-income asset classes into a laddered, buy-and-hold portfolio. (For more information on bond ladders, see the article "The Basics of the Bond Ladder.") Obtaining yield pickup with no loss of credit quality gives an investor the ability to focus on a limited number of bonds.

Once again, with a little bit of work, the savvy retail investor can beat Wall Street at its own game.

Basics of Federal Bond Issues
The world bond markets are many times larger than the collective stock markets, both in monetary value of bonds outstanding and in dollar value of bonds traded on a daily basis. And yet, investors seem to know relatively little about bonds as compared to stocks. The issue of federal bonds, (Treasury bonds in the U.S.) in particular compose a significant portion of the entire bond market, but they are not free from obscurity, even though they are considered the safest fixed-income investment. Here we shed some light on this unfamiliar area and explain the process by which the federal government issues bonds.
Preliminary Questions for a New Bond Issue
Federal bond issues are coordinated by the central bank. When it's anticipating a new federal bond issue, the central bank first conducts an informal survey about current market conditions and the type of issue investors might prefer. These informal discussions are held with investment dealers, banks and other market participants who have experience with bond issues of the size and type being considered.

Before the details of the new bond issue are decided, several important questions have to be answered. Most importantly, the federal government must determine the precise purpose for the issue. Often, it will relate to a specific capital project being planned by the government - a major new road or bridge, for example. But the purpose can also be something as general as refunding prior debt - that is, paying for past borrowing with new funds that are presumably borrowed at a more favorable interest rate.

Other preliminary questions concern the legal parameters surrounding the potential issue, as defined by federal legislation. There must be a legal precedent that outlines the conditions under which the bond issue can be undertaken. Such a legal precedent relates to the issue's purpose. When its purpose is to fund a capital project, the legal precedents must function to determine whether the funds raised are used for an endeavor that serves national taxpayers and the greater good of federal constituents. In the case of the refund of a prior debt issue, the question is whether or not the debt is refundable under federal tax rules.

Finally, government officials must decide how the bonds will be sold. In some cases, if the government has a pre-existing working relationship with a certain investment firm, it may choose that firm to be the sole underwriter for the bond issue. A single underwriter relationship can also make sense under other conditions - for example, if the issue is simple enough or if its denomination is small enough that involving multiple underwriters would be more trouble than it's worth. By contrast, if it is a large bond issue the government will host a bond auction and invite multiple underwriters to attend and participate in the bidding process.

Marketing Phase
Whether the government chooses to use one underwriter or several, the method chosen for the bond issue plays an important role in the marketing phase. The first step of this phase for the government, as the bond issuer, is to prepare a preliminary official statement, or disclosure document, to deliver to potential purchasers. The bond issuer typically employs the services of a specialized bond counsel firm to work with its usual solicitor on the legal aspects of the financing. Together the bond counsel and solicitor work on matters such as federal and state law and tax approvals, ensuring that proper legal procedures are being followed.

One of the most important legal requirements for a federal bond issue is that a public meeting be held after a reasonable marketing period. During this marketing period, usually lasting about a week, potential purchasers thoroughly review and evaluate the disclosure document. The procedure followed for the public meeting depends upon whether the government used a single underwriter or invited several underwriters to participate in a competitive tender.

In the case of a single underwriter relationship, the underwriter comes to the public meeting with a firm purchase proposal. The purchase proposal contains specific and precise terms of the bond issue, including the principal amount of the bonds, interest rates to be paid, the amortization schedule and details about any prepayment provisions. These matters can be further negotiated and refined at the meeting and the proposal can then be approved, making the meeting the official confirmation of terms. By contrast, if the government has invited several underwriters to participate in the issue, each group submits its purchase bid on the day of the public meeting, and a full-fledged auction takes place until all the bonds are duly distributed.

Preparation of Closing Documents
In the last steps of the federal bond issue process, the underwriter or underwriters wire the purchase price for the bonds to the paying agent. The paying agent then pays the costs of issuance, at the direction of the issuer. The paying agent plays an important practical role in the bond issue: it sees that funds are properly distributed according to the intended purpose of the bond issue. For example, the paying agent applies the balance of the bonds' proceeds to the construction project's accounts, or it applies the proceeds to debt holders if the bond issue is meant to refund prior debt. After the closing of the bond distribution, the bond counsel distributes a complete set of closing documents to each participant.

This brings us to the final step in a federal bond issue: the preparation of closing documents. As you might expect, these documents are highly technical in nature, written according to a very specific legal framework. Without going into extensive detail about their contents, it suffices to say that closing documents reiterate the terms of the approved purchase proposal, in addition to laying out the procedure by which the bonds are paid for and distributed.

Conclusion
Why should you care about federal bond issues? Because from the perspective of any bond purchaser - including the retail investor - federal bond issues tend to be the safest fixed income investments available. After all, they are backed by the tax-generating powers of the government. However, the particular nature of each bond issue must still be closely analyzed. An encyclopedic knowledge of the processes and procedures surrounding a federal bond issue is not absolutely necessary to participate in retail bond purchases, but it is still useful to have some understanding of the oft-confusing bond market.

Governments have an obligation to purchasers to ensure that the issues are liquid, marketable and of a size sufficient to ensure easily tradable markets. Ultimately, all of these factors combine to improve the marketability of a particular bond issue and make it more attractive to potential purchasers.

Corporate Bonds: An Introduction to Credit Risk
Corporate bonds offer a high yield compared to some other investments, but the higher yield is not free. Most corporate bonds are debentures, meaning they are not secured by collateral. Investors of such bonds must assume not only interest rate risk but also credit risk, the chance that the corporate issuer will default on its debt obligations. Therefore, it is important that investors of corporate bonds know how to assess credit risk and its potential payoffs: while rising interest rate movements can reduce the value of your bond investment, a default can almost eliminate it (holders of defaulted bonds can recover some of their principal, but it is often pennies on the dollar).
Review Of Yield
By yield, we mean yield to maturity, which is the total yield resulting from all coupon payments and any gains from a "built-in" price appreciation. The current yield is the portion generated by coupon payments, which are usually paid twice a year, and, it accounts for most of the yield generated by corporate bonds. For example, if you pay $95 for a bond with a $6 annual coupon ($3 every six months), your current yield is about 6.32% ($6 ÷ $95). The built-in price appreciation contributing to yield to maturity results from the additional return the investor makes by purchasing the bond at a discount and then holding it to maturity to receive the par value. It is also possible for a corporation to issue a zero-coupon bond, whose current yield is zero and whose yield to maturity is solely a function of the built-in price appreciation.

Investors whose primary concern is a predictable annual income stream look to corporate bonds, whose yields will always exceed government yields. Furthermore, the annual coupons of corporate bonds are more predictable and often higher than the dividends received on common stock.

Assessing Credit Risk
Credit ratings published by Moody's, Standard and Poor's and Fitch IBCA are meant to capture and categorize credit risk. (For more on this topic, see the article What Is A Corporate Credit Rating?) But institutional investors in corporate bonds often supplement these agency ratings with their own credit analysis. Many tools can be used to analyze and assess credit risk, but two traditional metrics are interest-coverage ratios and capitalization ratios.

Interest-coverage ratios answer the question, "How much money does the company generate each year in order to fund the annual interest on its debt?" A common interest-coverage ratio is EBIT (earnings before interest and taxes) divided by annual interest expense. Clearly, as a company should generate enough earnings to service its annual debt, this ratio should well exceed 1.0 - and the higher the ratio, the better.

Capitalization ratios answer the question, "How much interest-bearing debt does the company carry in relation to the value of its assets?" This ratio, calculated as long-term debt divided by total assets, assesses the company's degree of financial leverage. This is analogous to dividing the balance on a home mortgage (long-term debt) by the appraised value of the house. A ratio of 1.0 would indicate there is no "equity in the house" and would reflect dangerously high financial leverage. So, the lower the capitalization ratio, the better the company's financial leverage.

Broadly speaking, the investor of a corporate bond is buying extra yield by assuming credit risk. He or she should probably ask, "Is the extra yield worth the risk of default?" or "Am I getting enough extra yield for assuming the default risk?" In general, the greater the credit risk, the less likely it is that you should buy directly into a single corporate bond issue. In the case of junk bonds (i.e. those rated below S&P's BBB), the risk of losing the entire principal is simply too great. Investors seeking high yield can consider the automatic diversification of a high-yield bond fund, which can afford a few defaults while still preserving high yields.

Other Risks
Investors should be aware of some other risk factors affecting corporate bonds. Two of the most important ones are call risk and event risk. If a corporate bond is callable, then the issuing company has the right to purchase (or pay off) the bond after some minimum time period. If you hold a high-yielding bond and prevailing interest rates decline, a company with a call option will want to call the bond in order to issue new bonds at lower interest rates (in effect, to refinance its debt). Not all bonds are callable, but if you buy one that is, it is important to note the terms of the bond. It is important that you be compensated for the call provision with a higher yield.

Event risk is the risk that a corporate transaction, natural disaster or regulatory change will cause an abrupt downgrade in a corporate bond. Event risk tends to vary by industry sector. For example, if the telecom industry happens to be consolidating, then event risk may run high for all bonds in this sector. The risk is that the bondholder's company may purchase another telecom company and possibly increase its debt burden (financial leverage) in the process.

Credit Spread: The Payoff For Assuming Credit Risk
The payoff for assuming all these extra risks is a higher yield. The difference between the yield on a corporate bond and a government bond is called the credit spread (sometimes just called the yield spread).
As the illustrated yield curves demonstrate, the credit spread is the difference in yield between a corporate bond and a government bond at each point of maturity (for a review of the yield curve, see this section of the Advanced Bond tutorial). As such, the credit spread reflects the extra compensation investors receive for bearing credit risk. So, the total yield on a corporate bond is a function of both the Treasury yield and the credit spread, which is greater for lower-rated bonds. If the bond is callable by the issuing corporation, the credit spread increases more, reflecting the added risk that the bond may be called.

How Changes In The Credit Spread Affect The Bondholder
Predicting changes in a credit spread is difficult because it depends on both the specific corporate issuer and overall bond market conditions. For example, a credit upgrade on a specific corporate bond, say from S&P BBB to A, will narrow the credit spread for that particular bond because the risk of default lessens. If interest rates are unchanged, the total yield on this "upgraded" bond will go down in an amount equal to the narrowing spread, and the price will increase accordingly.

After purchasing a corporate bond, the bondholder will benefit from declining interest rates and from a narrowing of the credit spread, which contributes to a lessening yield to maturity of newly issued bonds. This in turn drives up the price of the bondholder's corporate bond. On the other hand, rising interest rates and a widening of the credit spread work against the bondholder by causing a higher yield to maturity and a lower bond price. So, because narrowing spreads offer less ongoing yield and because any widening of the spread will hurt the price of the bond, investors should be wary of bonds with abnormally narrow credit spreads. Conversely, if the risk is acceptable, corporate bonds with high credit spreads offer the prospect of a narrowing spread, which, in turn, will create price appreciation.

But interest rates and credit spreads can move independently. In terms of business cycles, a slowing economy tends to widen credit spreads as companies are more likely to default, and an economy emerging from a recession tends to narrow the spread as companies are theoretically less likely to default in a growing economy. However, in an economy that is growing out of a recession, there is also a possibility for higher interest rates, which would cause Treasury yields to increase. This is a factor that offsets the narrowing credit spread, so the effects of a growing economy could produce either higher or lower total yields on corporate bonds.

Conclusion
If the extra yield is affordable from a risk perspective, the corporate bond investor is concerned with future interest rates and the credit spread. Like other bondholders, he or she is generally hoping that interest rates hold steady or, even better, decline. Additionally, he or she generally hopes that the credit spread either remains constant or narrows but does not widen too much. Because the width of the credit spread is a major determiner of your bond's price, make sure you evaluate whether the spread is too narrow, but also make sure you evaluate the credit risk of companies with wide credit spreads.
The Lowdown on Savings Bonds
Savings bonds are often overlooked by investors searching for that perfect investment; however, savings bonds represent a safe investing vehicle with added benefits that many products don't offer.
For those unfamiliar with or needing a refresher on these products, savings bonds are a debt obligation of U.S. government (or some other country's government), and bonds are backed by the Treasury Department and monitored by the Bureau of Public Debt. They are non-negotiable securities (unlike stocks, which fluctuate daily) that pay an interest rate that is compounded semi-annually and accrued monthly.

Because they are backed by the U.S. federal government, these bonds are considered to be one of the safest investments available. They provide a steady stream of interest income while preserving the value of your principal.

There are five main benefits of purchasing savings bonds:
1. While offering the highest of credit ratings, the U.S. government offers interest rates that are competitive with the market. Some bonds are adjusted for inflation while others are offered at a discount on an accrual basis, guaranteeing redemption of face-value after 17 years. In addition to this, all bond interest payments are compounded semi-annually and accrued monthly so that your investment grows faster.

This monthly interest accrual is something that is not usually found in most other bonds. For example in a corporate bond you receive your interest payment every six months. In the Series EE and Series I savings bonds, the interest is calculated monthly, and then reinvested rather than paid out. For calculation purposes, the government will use the value of the bond on the date that compounding is to take place to calculate the interest payment.
2. As the U.S. government issues these bonds in hopes of attracting more people to save, they sweeten the deal with added deferred and exempted tax benefits. All of the interest income earned on these bonds is completely exempt from state and local income taxes and postponed from federal taxes until redemption or maturity.

This can be an important issue for many investors, especially those in the higher federal tax brackets or those living in regions with high local and state taxes. Additionally, the interest may be exempt from federal income taxes if the bond is used to pay for educational expenses of the bondholder or his or her significant other or child.
3. Savings bonds also provide a convenience not readily found in other fixed income products. They are issued in eight different denominations starting at $50 and moving progressively up to $10,000. This produces flexibility for investors looking to invest sums of money in increments less than $1,000; furthermore, these bonds can be redeemed at any time after the initial minimum holding period of six months. Keep in mind that if you do redeem early (before the five year holding period), your principal will never decrease but there will be a penalty charged, equal to the last three months interest payments.
4. Even though these bonds are not marketable, like a stock or corporate bond, purchasing and redeeming savings bonds is relatively straightforward. You can buy these bonds at any bank, or, by using major credit cards, you can even buy them online at the Bureau of Public Debt's website; some companies even offer internal monthly purchase plans that deduct employee paychecks. Redeeming them is even simpler as most banks will redeem the bonds with proper identification, even if you don't hold an account with them.
Treasury Department offers Two Products

Series I
This series of bonds is indexed for inflation, which is based upon the for all urban consumers. These bonds pay a fixed base percentage of real interest that is determined when purchased and adjusted for inflation on a semi-annual basis. More simply, the interest on these bonds is comprised of two components: A and B. The A portion is set at purchase for the duration of the bond, and it is what you will receive for its life of 30 years. The 'B' portion is adjusted every six months according to the level of consumer inflation. By combining 'A' and 'B' together by means of a special formula derived by the U.S. Treasury, we come up with the composite rate, which represents the interest rate that you will receive on your bond.
Series EE
This series is accrual based, which means that you purchase the bond at a discounted price, and the interest earned accumulates so that the bond matures at face value or higher. Interest is based on 90% of the average yield on a five-year Treasury security, and it accrues monthly but compounded semi-annually. The EE savings bond is purchased at half of the face value because the bond is guaranteed to reach face value after 17 years, implying an average return of 4.5% over that time frame. After the 17 years, the bond will continue to accrue interest up until its maturity at 30 years from purchase.

All of these products are available to any U.S. citizen or resident with valid social security numbers. This includes residents of Puerto Rico, civilian employees of the U.S. Armed Forces and military personnel. Even residents of Canada or Mexico working within U.S. borders for companies that offer a company savings plan can purchase U.S. savings bonds. If you live outside the U.S., chances are that a similar savings bond exists in your country. Individuals that do qualify for purchasing these savings bonds are restricted to a yearly limit of $30,000 face value, but the purchase of one series does not affect subsequent purchases of the other.

While savings bonds might not be the most interesting financial topic, they provide excellent safety and tax advantages. We'll let you decide whether this type of investment suits your portfolio needs.

Junk Bonds: Everything You Need to Know
For many investors, the term "junk bond" evokes thoughts of investment scams and high-flying financiers of the 1980s such as Ivan Boesky and Michael Milken, who were known as "junk bond kings". But don't let the term fool you - if you own a bond fund, these worthless-sounding investments may have already found their way into your portfolio. Here's what you need to know about junk bonds.
What Is a Junk Bond?
From a technical point of view, a junk bond is exactly the same as a regular bond. Junk bonds are an IOU from a corporation or organization that states the amount it will pay you back (principal), the date it will pay you back (maturity date) and the interest (coupon) it will pay you on the borrowed money.

Junk bonds differ because of the credit quality of their issuers. All bonds are characterized according to this credit quality and therefore fall into one of two categories of bonds:
• Investment Grade - These are bonds are issued by low- to medium-risk lenders. A bond rating on investment grade debt usually ranges from AAA to BBB. Investment grade bonds might not offer huge returns, but the risk of the borrower defaulting on interest payments is much smaller.
• Junk Bonds - These are the bonds that pay high yields to bondholders because the borrowers don't have any other option. Their credit ratings are less than pristine, making it difficult for them to acquire capital at an inexpensive cost. Junk bonds are typically rated at BB/Ba or less.
Think of a bond rating as the report card for a company's credit rating. Blue-chip firms that are a safer investment have a high rating while risky companies have a low rating.
Although junk bonds pay high yields, they also carry higher than average risk of the company defaulting on the bond. Historically, average yields on junk bonds have been between four and six percentage points above those on comparable U.S. Treasuries.

Junk bonds can be broken down into two other categories:
• Fallen Angels - This is a bond that was once investment grade but has since been reduced to junk bond status because of the issuing company's poor credit quality.
• Rising Stars - The opposite of a fallen angel, this is a bond whose rating has been increased because of the issuing company's improving credit quality. A rising star may still be a junk bond but on its way to being investment quality.
Who Should Buy Junk Bonds?
There are a few things you should know before you run out and tell your broker to buy all the junk bonds he can get a hold of. The obvious caveat is that junk bonds are high risk. With this type of bond, you risk the chance that you will never get back your money. Secondly, investing in junk bonds requires a high degree of analytical skills, particularly knowledge of specialized credit. Short and sweet, investing directly in junk is mainly for rich and motivated individuals. This market is overwhelmingly dominated by institutional investors.

This isn't to say that junk-bond investing is strictly for the wealthy. For many individual investors, using a high-yield bond fund makes a lot of sense. Not only do these funds allow you to take advantage of professionals who spend their entire day researching junk, but these funds also lower your risk by diversifying your investments across different types of assets. One important note: know how long you can commit your cash before you decide to buy a junk fund. Many junk bond funds do not allow investors can cash out and see a payoff before a minimum of one to two years.

Also, there comes a point in time when the rewards of junk bonds don't justify the risks. Any individual investor can determine this by looking at the yield spread between junk bonds and U.S. Treasuries. As we already mentioned the yield on junk is historically between 4 and 6% above Treasuries. If you notice the yield spread shrinking below 4%, then it probably isn't the best time to invest in junk bonds. Another thing to look for is the default rate on junk bonds.

The final warning is that junk bonds are not much different than equities in that they follow boom and bust cycles. In the early 1990s, many bond funds earned upwards of 30% annual returns, but a flood of defaults can cause these funds to produce stunning negative returns.