Since today is Thanksgiving, a time when we will all probably help ourselves to at least two servings of a delicious meal, here's another throwback. Keeping to this week's topic--different types of securities--Nancy discusses some of the ins and outs of bonds in this 1996 column. Happy Thanksgiving!
It seemed like a good idea at the time. I had watched, with fascination, as many kids and adults rollerbladed their way to fun and fitness. It looked simple enough... just one foot in front of the other. And, after all, I had been a crackerjack roller skater in my day. What could be easier?
So, I bought a mother/daughter set of rollerblades, along with all the appropriate padding. I was prepared. I was energized. I was stupid!
My daughter and I started out on our neighborhood streets, and while the going was a little tougher than I expected, it seemed deceptively safe. In no time at all, Heather was an expert, wheeling around curves without missing a beat. I thought I could keep up with her, but I forgot one little thing: the more than 20 years difference in our ages. Oh, and maybe I didn't get in quite as much practice time as she did.
One cool evening, I convinced Heather to go rollerblading with me. We strapped on our skates but decided to forgo the padding this one time. My driveway is on an incline, and standing at the top, I suddenly had a panic attack. How would I get down? Heather shouted, "Just watch me, Mom." And with that, she took off down the drive and around the bend out into the street. It looked simple enough.
So, I followed suit. Only, I'm not as young as Heather or nearly as good at this sport. When I hit the bottom of the drive, I didn't turn soon enough. My skates went from drive to grass to pavement to airborne. I landed on my one well-padded area... my backside. As I lay in the street muttering obscenities and wondering if I would be run over, I realized this was not as simple as it seemed to be.
That story reminds me of bond investing. It looks simple enough. Bonds appear risk-free. You don't seem to need a Ph.D. to figure out these securities. Time and again, I'm amazed at the number of naive investors who flock to bonds and bond funds thinking they have something that is guaranteed and without risk. These are people who would never consider investing in stocks because of the perceived risk, but readily buy bond issues without knowing what they're getting into.
Bonds are some of the most complicated securities out there. Each bond issue has its own set of rules and agreements. After all, a bond is a debt. And just like your car note or your mortgage payment, there is a debt contract. If you recall some of the loan agreements you've signed, you'll remember the abundance of fine print. With a bond issue, this debt contract is called an indenture and contains all the guidelines for the loan. When you buy a bond, you are agreeing to loan a company or municipality or the federal government an amount of money under the terms of the indenture. I'm no bond expert, but I'm told some of these indentures look like an unabridged version of War and Peace.
The indenture tells what rate of interest the bond will pay. It tells if the borrower can refinance at some point (callable bonds). It tells where the money will come from to pay off the bonds (revenue bonds versus general obligation bonds). These are just a few of the things you'll find in this agreement.
And as for that safety factor. Bonds do have risk. Generally, there are three types of risk associated with bond investing: (1) reinvestment risk, (2) credit risk, and (3) interest rate risk.
If you hold a bond which pays 7%, and each time you receive a coupon payment, you place the money in your bank money market earning 3%, you lower your overall return. This is reinvestment risk. Reinvestment risk is greatest when interest rates are falling because the chances of finding alternative ways to invest coupon payments at 7% or greater become slimmer.
Credit risk is the risk that the institution which issued the bond will default on the payments. It's the same risk the bank takes when it loans me money. Something may happen that prevents me from paying back the loan. The way to decrease this risk is by looking at the stability of the institution. Study the financials to make sure you're loaning your money to someone who has the ability to pay you back. Keep in mind that even in default, bondholders typically don't lose all their money. Also, remember the problems in Orange County, California. There was a time when a default in a municipality was unheard of. No more.
The third risk arises from our ever-changing economy. Fluctuating interest rates affect bonds. When interest rates begin to rise, as they have in the last few weeks, bond yields increase. That is, new bond issues coming to market must pay higher coupon interest to entice investors to loan them money.
If the current going rate for corporate bonds is 7%, and you hold an older bond paying 6.5%, the value of your bond will go down. Your lower paying bond is not worth as much as the new ones coming to market. Interest rates and bond yields are directly related. When interest rates increase, bond yields increase. Interest rates and bond values are inversely related. When interest rates increase, bond values go down.
If you plan on holding your bond until it matures, these ups and downs in interest aren't crucial. The problem comes when you have to sell the bond short of the maturity date. You could lose principal because of a rise in interest rates. Also, if you own a bond fund, you are particularly exposed to interest rate risk since you are buying a basket of bonds with varying maturities.
There are many other risks associated with bonds depending on the type of bond, the issuer, and the indenture. Remember, I said these were complicated securities. They seem simple enough at first glance but can leave you lying on your backside muttering obscenities if you don't know what you're doing.
After my fall on the rollerblades, I took those things off and put them on a shelf in my garage. I haven't ventured out since. Don't let a few falls with bonds scare you away. Know what you're getting into. Practice dealing with them. And if all else fails, leave it to the experts.
--Nancy Lottridge Anderson, Mississippi Business Journal, May 13, 1996