Often one will hear financial advisors talking about asset allocation. Often there will be talk about investing some portion of a portfolio into stocks and then putting a portion, considered the “safe” portion, into bonds. A rule-of-thumb, in fact, is to hold a percentage of a portfolio in bonds equal to one’s age with the rest in stocks. The idea here is that as one gets closer to retirement one can no longer afford the risk of the volatility of the stock market and therefore one should retreat to the safety of bonds. Many of the target date mutual funds perform this function for the investor, although the actual amounts of bonds that these funds hold varies by fund, and some use more exotic derivatives to hedge positions.
I saw a great table in a book by Jane Quinn Bryant that showed the relative volatilities of a portfolio made up of different proportions of stocks and bonds. (Volatility is a measure of how much an asset moves about in price. In general the higher the volatility, the higher the risk. Stocks tend to have much more rapid price changes than do bonds, and therefore higher volatilities. Higher volatility tends to lead to greater gains, but the ride is much more bumpy.) The table showed that by adding more bonds, the volatility (and thereby the risk) of the portfolio declined, but the likely return also fell. The portfolio with all stocks had the greatest return, but also had the greatest volatility and risk. That with all bonds had a return several percentage points below that of all-stocks, but the volatility was also about half that of the all-stock portfolio. The idea of the table was to look at how much volatility one could stand and then set one’s stock-bond ratio accordingly.
In general it is true that portfolios of bonds, or mutual funds of bonds, will be less risky than portfolios or funds of stocks. This is for two reasons. The first is that a bond by its nature pays a substantial interest rate. This is because a bond is a loan to a company (or government) and therefore the company pays interest during the life of the loan. Because the interest rate goes up if the price of the bond goes down, people will be more likely to buy the bond as it declines in price and therefore there is a natural amount of support for the price. Bonds will therefore not go down as far during recessions as will stocks.
The second reason is that bonds, also by their nature, have fixed lifetimes, at the end of which the investor will be made whole. When the bond matures, typically after a period of about 20 years, whomever holds the bond will be repaid the original price of the bonds (typically $1000 per bond). Market forces may drive the price all over the place, but in the end the company will pay whomever is holding the piece of paper $1000. With a stock there is no guaranteed rate – it is always up to whatever the market is willing to pay. For this reason the difference between the market price and the pay-off price for a bond tends to shrink as a bond nears maturity (because the closer you come to the maturation date, the more likely the investor will receive the face value of the bond)
Before going out and loading up on bonds, however, one must be aware that not all bonds are created equal, and there are some specific risks in buying bonds. One must remember that a bond is a loan to a company. If the company goes bankrupt or simply decides that they will not be able to pay back the bonds, an investor can lose the whole value fo the bond. While the bond holder generally has first rights to the assets of a company when it goes bankrupt (GM bonds were an exception that sent the shivers down the backs of bond buyers), in general there are usually not many assets to be had. Typically one can expect to receive $30 or so from a $1000 bond.
Bonds in companies that are more risky (more likely to default) also will tend to fluctuate in price more than those in companies that are more stable and reliable. Companies that have financial troubles and become more of a risk will also see their bond prices decrease rapidly as investors demand a greater interest rate before they will purchase the bonds. Remember that the lower the price, the higher the effective interest rate the bond pays (because the actual amount paid is fixed), so bonds will go down in price when investors require a higher interest rate before making a purchase.
Another risk that bonds face are due to changes in interest rates. Whenever interest rates go up bond prices will tend to go down. At times like the present where interest rates are at historic lows it seems that the likely direction of bond prices will be down since interest rates will not stay this low forever. Interest rates on longer-term bonds, in fact, have already begun to rise as investors expect interest rates to be higher in the future.
So how does one tell if the bond he is buying is more risky than other bonds or even blue chip stocks? The interest rate is a key indicator. Because of the wonders of market pricing, the relative price of a bond (and conversely the interest rate paid) will be set based on the perceived risk, taking into account all public information, of default. This means that a bond that pays a higher interest rate will be more risky than one that pays a lower one.
In general there are a set of bonds in solid companies that are considered to be of low risk. These are called “investment grade bonds” and will have good marks from the rating agencies. These bonds will all be paying the lowest interest rates, but these bonds are very unlikely to default. These bonds will also be priced near par value of $1000 (or $1.00 in the bond tables).
Bonds that are at more risk of default will pay interest rates several percentage points above the investment grade bonds. These bonds are called “junk bonds.” If investment grade bonds are paying 6% interest, junk bonds may be paying 10% or more. A bond that is trading at $500 may be paying 15% or more, but people obviously are not expecting the bond to mature. At 15%, one would need for the company to continue to pay the interest rate for about 6 years before defaulting to gain one’s money back. In some cases these companies do continue to pay and their price will eventually reach $1000 if the bond matures. This leads in both a good return in interest and also a good return from the appreciation in price. Many times, however, the market knows what they are doing and these types of bets will not pay off.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.