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I’ll be Franc with you (A primer on bonds)

By Robert O. Weagley, Ph.D., CFP®

I like to listen to National Public Radio, while I exercise in the mornings.  This week, one of their pieces was on the Swiss franc.  The Swiss franc is being seen as a safe haven, European currency.  So much so that the Swiss are able to issue bonds with a negative interest rate with maturities of up to eleven years[i].  The bond buyers are either buying the bonds as a safe haven or in anticipation of the Swiss franc gaining in value against other currencies (i.e., exchange rate risk).  Even Apple has got into the mix by issuing corporate bonds denominated in the Swiss franc, with a yield of 0.25% for bonds with nine years to maturity.  It didn’t take long.  Today (12 February 2015), the Swiss National Bank stopped trying to control the value of the franc.  As a result, its value increased by 15% (http://www.marketplace.org/topics/world/swiss-national-bank-gives-ghost ), giving us a great example of exchange rate risk can work to the benefit of investors with franc denominated investments.

The fact is that a lot of people find bonds to be a wonderful place to invest.  Bonds have less risk than common stocks and, typically, pay interest to the owner every six months.  Since a bond has less risk, the likely return is less but the stated promise to pay the periodic interest and to repay the principal at maturity is coveted by many.  These certainties are particularly true when the owner needs the income and/or the owner has little time to recover from a potential loss.

What other risks exist in bonds? The following table, reflecting the yield to maturity an investor can earn on tax free municipal bonds[ii] (4 February 2015), will be used to shed light on the risks of bonds.

Years until Maturity

AAA Rated Yield to Maturity

AA Rated Yield to Maturity

A Rated Yield to Maturity

10 years

1.55%

1.80%

2.35%

20 years

2.35%

2.75%

3.10%

30 years

2.50%

3.10%

3.40%

Business Risk

Bonds are rated by bond rating companies such as Moody’s, Standard & Poor’s, and Fitch.  They follow similar procedures where bonds rated AAA, for example, are less risky than a bond rated A.  Risk, in this case, is greater the greater the likelihood of default (the nonpayment of interest payments or principal).  This could occur from the Business Risk of the municipality, where tax receipts are insufficient to meet the debt payments, or Financial Risk, where the municipality is so over indebted that they are seen as more likely to suspend payments.  We can see in the above table that, if we hold the years until maturity constant (the rows), that the yield to maturity increases as we move from less risky to more risky bonds (left to right).  In fact a 20-year A-rated bond pays about 32% more in interest (e.g., (3.10/2.35)-1), than its AAA-rated brethren.

Market Risk

Bonds also experience Market Risk, as investors find the fixed payments of bonds to be less (more) attractive if, for example, they expect inflation to increase (decrease), increasing (decreasing) market rates of interest.  (More on these in a moment.)  Or, like today, they believe market forces will make the debt more or less valuable than previously thought.  It is also the case that when the stock market begins a downward trend, many investors will decide that they need the safety of bonds.  As these buyers enter the bond market, demand increases the price of the bonds resulting in a decrease in the yield to maturity[iii].  Since bonds are actively traded in a market (i.e., marketable), their price can change in anticipation of changes in interest rates.

Inflation Risk (or Purchasing Power Risk)

While the buyer of a bond has greater certainty of receiving the interest payments than a shareholder has of receiving dividends, they have no way of knowing what those payments will purchase.  Inflation can erode the purchasing power of the bonds’ fixed periodic payments.  Let’s look at the following table of rates of inflation for each decade over the past 100 years.  We can plainly see that inflation has been as low as a -2.08% in the 1930s to as high as 9.80%, 100 years ago.  Recently, the rate of inflation has been subdued, recently averaging 2.29% for 2010-12, with a 100 year average of 3.21%.  Using the 100 year average of 3.21%, we find that current markets allow one to earn interest at the rate of 3.40%, when we invest in an A-rated, 30-year bond.  Simply put, if we invest $100 today in a 30-year bond instead of consuming the $100, we would have $103.40 to purchase a market basket of goods now costing $103.21.  So you are deferring consumption for a year and being paid $0.19 per $100 of consumption you defer (i.e., money you invest).[iv]  Moreover, your money has been lent to the municipality for 30 years, unless you sell the bond.

bonds

Interest Rate Risk

The lender (bond owner) might realize interest rate risk, should they decide to sell the bond prior to maturity.  Bonds promise a fixed payment, while market interest rates are not fixed.  As market interest rates increase, the present value of the series of fixed payments plus principal must decrease.  Similarly, as market interest rates decrease, the value of a series of fixed payments plus principal at maturity must increase.  Let’s look at another table to help us understand this phenomena. We will use both a 10-year and 30-year bond, to demonstrate the effect on their price from both a 1% interest rate increase and a 1% decrease in interest rates.  For sake of this example, we will look at AA-rated bonds and assume annual interest payments and that the bonds are currently selling for face value, which we will indicate as a percent, or 100.  What do we see?

Years until Maturity

AA Rated Yield to Maturity

A 1% increase:

 Value (% decrease from 100)

A 1% decrease:

 Value (% increase from 100)

10 years

1.80%

91.4 (8.6%)

109.6 (9.6%)

30 years

3.10%

82.9 (17.1%)

122.1 (22.1%)

A couple of principles are in place for us to observe.  First, we confirm the fact that the present value (i.e., market price) of the bond decreases with increases in interest rates and increases with decreases in interest rates.  Importantly, this change in value is greater with the longer maturity bond (30 years as opposed to 10 years).  We also see larger changes for lower rated bonds as higher interest rates are more challenging to weaker firms.  (This has not been shown.)

What is the take-away?  Today’s interest rate environment is one of the lowest we’ve seen.  As such, interest rates are much more likely to go up than down.  The Federal Reserve Bank has been talking of doing just that in the summer of 2015.  I know we’ve been saying this for several years, and as stubborn as world economies are being, we might be saying it for a lot longer.  Yet, investing long term in bonds in a low interest rate environment can be problematic, regardless of the attractiveness of higher yields.  Before you invest make sure you understand the risks of bonds and how you plan (need) to use the money.  If rates do increase and you need the money invested in the bonds, you will lose money.  You will lose more money, the greater the duration of the bond, the lower the coupon rate of the bond, and the lower the quality of the bond.

Risks are everywhere.  Learn to love them.  Embrace them – all of them – and maintain a disciplined, diversified approach to your future.


[ii] The same information would apply to non-municipal bonds.

[iii] This is different from your certificate of deposit at the bank, where the certificate cannot be sold to another and, thus, there is no market risk.

[iv] We should note that this does not take into account the cost of purchase/sale, which would lower the “gain”.