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What Every Plan Sponsor Must Know About Bonds – Before They Crash!

October 07
00:38 2010

(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)

A brief tour of the three traditional asset classes.

The typical ERISA plan fiduciary can (or should) break down investments into three asset classes. (The financial services industry and their academic side-kicks like to create a greater number of asset classes, but, rather than with making things 767836_84874726_bonds_stock_xchng_royalty_free_300easier to understand for the plan sponsor, this has more to do with former’s ability to market products and the latter’s need to have some graduate students earn their PhD.) The three traditional asset classes include cash, bonds and stocks.

Cash offers a stable value and instant liquidity in exchange for a negligible rate of return. Bonds can offer some liquidity at the expense of removing the guarantee of principal preservation (due to price volatility). In order to take advantage of the guarantee of principal preservation, you must hold a bond until it matures, making it a virtually illiquid asset. Bonds offer a moderate rate of return that varies depending on the interest rate environment, financial security of the issuer and the length of the maturity. Stocks are generally liquid, but offer no guarantee of principal preservation, again due to price volatility. Studies have repeatedly shown stocks, among all the asset classes, offer the highest rates of return for the long term.

Bonds, like stocks, come in a variety of flavors. Ben Graham referred to some bonds as “risk-free” alternatives to stocks; thus, permitting investors to achieve different objectives with each class of securities. In addition, Modern Portfolio Theory separated bonds from stocks because these two classes of securities exhibited stochastic differences in terms of both volatility and long-term performance returns. For our purposes, we will focus on “risk-free” bonds. To do this, we need to identify the different types of securities which display bond-like characteristics and determine whether they can be classified as “risk-free” or not.

Definitions – Not all bonds are the same

Bonds differ in three main areas. First, the structure or nature of the bond refers to the precise promises made to the bondholder. Second, the issuer of the bond allows the investor to judge the relatively safety of the bond’s principal and interest promises. Finally, the maturity of the bond tells the bondholder how long he must hold on to the bond before receiving back the face value – the “principal” – of the bond.

Bonds may be structured in many different ways. We’ll only discuss the most common structures here. The standard bond pays a set interest and has a set maturity date that does not change. For our discussion, a risk-free bond must have these characteristics.

A callable bond represents a slight twist from a risk-free bond. Callable bonds allow the issuer to pay off the principal prior to the stated maturity date. An issuer might create a callable bond if it feels interest rates – what the issuer has to pay to the bondholder – will decline. Should the rates decline, the issuer “calls” the older bond and pays the principal to the bondholder prior to maturity. At the same time, the issuer will sell new bonds at the lower interest rate. In this way, the issuer retains use of the original principal but pays a lower interest rate. Given the unknown variable of the actual maturity date, callable bonds do not represent a pure “risk-free” bond and we will therefore ignore them for the purposes of our discussion.

Some folks aren’t sure if they want to buy a bond or buy a stock. Likewise, some companies aren’t sure if they want to take on debt (i.e., sell bonds) or if they want to give up equity (i.e., sell stocks). Well, the financial wizards of Wall Street created a security to address this indecisiveness. They call it a “convertible bond.” Convertible bonds, as their name implies, can be converted to stock given the attainment of certain criteria. Since this is not a “risk-free” bond and we are trying to keep our discussion at an easy-to-understand, easy-to-practice level, we will also ignore these bonds.

Any private or public individual or organization can issue a bond. We’ll focus on those bonds available from public sources and traded in public markets.

A bond issued by a corporation – a corporate bond – offers no guarantee the bondholder will see a lick of income or even get the principal back once the bond matures. Now, any business that defaults on its bonds will have problems (among many others) should they ever try to sell another bond, so businesses tend to keep their word by paying the interest regularly and giving back the principal once the bond matures. Still, if the company goes bankrupt, there is a chance the bondholder may lose both his interest and principal. Well, any good investor will want fair compensation for assuming added risk. Because of this risk, corporate bonds generally pay at a higher interest rate. For obvious reasons, we will not consider corporate bonds as “risk-free” bond.

Incidentally, you might recall the phrase “junk bond.” Junk bonds are corporate bonds promising to pay extremely high rates of interest. They are considered junk because the issuing corporation has either already defaulted on the interest payments or analysts have arrived at a consensus of opinion that the corporation will soon default on the interest payments. Investors can make a lot of money on junk bonds. They can also loose a lot. It’s a good idea to leave junk bond investing to the professionals – and, if you’re a conservative investor, avoid those professionals.

A bond issued by a state or local government – a municipal bond – also offers no guarantee that the income and principal will be paid. This may sound just as bad as corporate bonds, but wait. All governments have the ability to raise taxes. Presumably, any municipality (with the possible exception of New York City in the mid-1970’s and California more recently) will raise taxes rather than destroy its financial reputation by defaulting on a bond. (Some might feel this cure is worse than the disease, but that’s the subject of another article.) Municipal bonds have the added advantage of being tax-free. Because government is a zero-sum game, what they give you in one place, they take away in another. To a bond investor, this means tax-free government bonds pay interest at a lower rate than other bonds. Still, for our purposes, these bonds are not considered “risk-free” bonds.

Finally, we have bonds issued by good ol’ Uncle Sam. A bond issued by the Federal government – a Treasury bond – is guaranteed by the full faith and credit by the United States of America. For all intents and purposes, these bonds are considered risk-free. In order to link investment theory with investment reality, a bond must be a risk-free bond. [Dear reader: This is a literary technique known as “foreshadowing.” It’s when the author mentions a seemingly innocuous, indeed, if not out-of-place, fact that will have a major bearing in some future event in the plot. For those of you who missed it, I’ll repeat it: “For all intents and purposes, these bonds are considered risk-free. In order to link investment theory with investment reality, a bond must be a risk-free bond.”]

We now come to the third leg of the bond stool – the length of time until the bond matures. Bonds have a wide variety of maturity dates – even otherwise similar bonds issued by the same issuer can have different maturity dates. Bond investors consider longer maturity dates riskier than shorter maturity dates. Why? Simple. You probably have a real good idea precisely where you’ll be at noon tomorrow. Now, can you tell the members of our listening audience precisely where you’ll be at noon ten years from tomorrow? Most people find it more difficult to predict the distant future compared to their ability to predict the near future. As a result, generally, but not always, bond investors will seek some form of compensation in exchange for buying a bond with a longer maturity date. This means bond issuers usually offer a higher interest rate for bonds with longer maturities. For our purposes, we’ll go along with just about everybody else and refer to bonds as short-term, intermediate-term and long-term.

Short-term bonds generally suggest those bonds maturing within three years. For many reasons, a bond maturing within one year is pretty much the same as cash and is, in fact, considered equivalent to cash. Generally, the closer the bond moves to its maturity, the less price movement it experiences. That is why bonds maturing within a year are considered the same as cash – they are so close to maturity their price is nearly as stable as cash in a savings account. Since short-term bonds more closely approximate cash than their long-term brethren, for the sake of discussion we will consider them identical to cash. Some investors consider any bond maturing within five years to be a short-term bond. We won’t quibble. We’ll just move on.

Intermediate-term bonds generally mean those bonds maturing within three to ten years, or five to ten years, or three to seven years, or five to seven years, or, well, you get the idea. Intermediate-bonds tend to overlap the high end of the short-term bonds and the low end of the long-term bonds. Because they represent such a gray issue, and because they offer nothing substantially unique to our rather broad discussion, we will not consider them.

Long-term bonds usually denote those bonds maturing in more than five or ten years. Since they have the longest maturity, long-term bonds have the greatest price fluctuation. In order to really show the relationship between bonds and the investor’s portfolio, our hypothetical risk-free bond must be a long-term bond.

Part I: How the Fiduciary can Explain the Practical Differences Between Stocks and Bonds
Part II: Defining the Perfect Bond: What Every Plan Sponsor Must Know About Bonds – Before They Crash!
Part III: 401k Plan Sponsors Beware: Are You Lighting a Match in the Powder Room Despite 1995 Study?
Part IV: Will Plan Sponsors Believe Their Lying Eyes or Will They Still Believe Bonds are “Safe”?
Part V: How the ERISA Fiduciary Can Avoid the 3rd Deadly Sin – Bond Insecurity

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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