The Bond Q&A
I’m pretty sure this is the first ever Q&A issue we’ve done in The 10th Man. Since I started the Bond Series, a not insignificant number of emails have been landing in my inbox, week after week.
Turns out bonds generate a lot of questions. That doesn’t surprise me.
Anyway, from convexity and liquidity to the best income investing to the economics story of the century, I’ve answered as many questions as I can here. Enjoy.
Q. Why do people use yield, rate, price, coupon interchangeably?
The coupon of the bond is the actual cash that the bond spits out semi-annually. The coupon rate is the percentage of par (face value) that the coupon represents. The current yield is the coupon divided by the current price of the bond (which may not be par). The yield to maturity is the theoretical rate of return you get if you hold the bond to maturity. The price is, well, the price.
Q. Please explain convexity like I’m 5 years old.
Convexity means that when yields go down, bond prices go up more, and when yields go up, bond prices go down less.
A 5-year-old probably doesn’t know what a bond is, but this is the best I can do.
Q. How does liquidity affect the bond market? When do I need to worry about liquidity?
In the old days, liquidity was not much of a concern. The high yield bond fund I had with Vanguard years ago had checkwriting privileges. Imagine that!
The bond market is not terribly liquid these days, and that is mostly because of regulation and capital requirements for financial institutions.
If you own individual bonds and you want to sell them during times of stress, the bid-ask spread may be very wide, or you may not be able to sell them at all. This is especially the case with off-the-run muni bonds or less liquid high yield bonds. A good guide here is “sell when you can, not when you have to.”
If you own bond funds, the likelihood that redemptions could be gated is not zero. This is a much larger issue that regulators are trying to deal with. When it comes to liquidity, open-end funds are actually more dangerous than ETFs.
Q. If I want to own bonds for income, what do I do in this interest rate environment?
Income investing is hard—you want to do it in a smart, sustainable way. People’s instincts are usually wrong on this—since yields are low, they like to take on additional risk to get more yield. But the reason yields are low is because risk is underpriced—and this often does not work out well.
I would resist the urge to take on additional credit risk for more yield, and just make do with things like Treasurys and munis. By the way, all the good income investing is in stocks these days.
Q. How reliable are the bond rating systems?
Bond rating systems are good but they tend to be a bit backward-looking. They tell you where the company/country has been, not where it is going. Enron and Lehman Brothers were both AA credits, for example.
Q. What is the role of TIPS vs regular government bonds vs other inflation hedges like gold in a portfolio?
Actually, the one interesting thing about TIPS that is not being discussed is that they cannot pay you a negative yield, unlike straight bonds. If yields continue to decline, TIPS will become very, very interesting.
Q. I’m in my 30s. If the market goes down 50% next year, so what? We use wages to fund our current life. So, how should someone in my situation think about bonds?
True—you have a lot of time left on the clock to invest in stocks.
You invest in bonds for diversification purposes—it reduces the volatility of your portfolio and increases the risk/return characteristics.
Q. I've read that bonds should go in your tax-sheltered retirement accounts and stocks in your non-retirement accounts due to the tax treatment of bond interest. This seems a little unintuitive to me… Can you explain?
I’m not the expert on taxes, but I know this much: don’t put muni bonds in your IRA.
Q. Jared, as of today you can get 2-2.5% on cash in savings programs. Why is that not an appropriate alternative to bonds? What is wrong with a 65% cash 35% equities investment?
Congratulations—you have just discovered the yield curve! Right now, you are getting approximately the same yield on short maturities that you do on long maturities. Why take on the additional duration risk of long maturity bonds if you are not being compensated for it? Your instincts are correct—if you can get 2+% yields on a savings account, you are probably better off with that.
Q. Over the last few months, I’ve assumed a large percentage of stocks that are dividend plays, as I’m starting to think of these as similar to bonds. Am I embarking on a journey into a world of volatility or can I think of these stocks as low volatility plays that will provide a consistent income?
REITs and Utilities are similar to bonds, as are high-yielding telecoms and tobacco stocks. They’re actually better income plays at this point than bonds.
Q. What’s your outlook on interest rates both in the US and worldwide over the medium-term?
I expect short-term interest rates to decline globally, and I expect long rates to stabilize once central banks have communicated that they are acting aggressively enough.
Q. If we got to negative yields in the USA, what likely impacts do you see on all financial markets?
There will be distortions, some that we can see (hoarding cash, gold prices skyrocketing), and others that we can’t.
One interesting thing that is happening is that we’ve had a huge drop in mortgage rates and it really hasn’t stimulated the housing market at all. People call this “pushing on a string.”
Q. What are your thoughts on demographic factors in USA, Japan, and Europe driving demand for bonds?
Honestly, I think one of the reasons that yields are dropping is because of the demographic factors that were being discussed in 2012. Population growth is slowing a lot faster than people anticipated. This is really the economics story of the century.
I don’t think demographics are the whole story, but the implication is that it is going to be very difficult for yields to rise in the future.
Q. What if anything would make you sell out of your bond investments?
If I believe that inflation was likely to ramp, or that the Fed would be able to resist both Trump and market pressures and keep interest rates high. Neither of these is likely.
Q. What scenarios should you not be invested in bonds?
When there is lots of inflation.
Q. If I want to increase my allocation to bonds, should I wait until this rally ends?
It doesn’t make any more sense to try to market-time the bond market than it does the stock market. If you don’t have an informed opinion on the direction of interest rates, the best course of action is just to dollar cost average—just like you would do with a stock fund.
Q. I want to educate myself on bonds – what sources do you recommend, particularly books?
You can get one of the Fabozzi books on bonds off of Amazon, but they tend to be pretty impenetrable.
I have actually found that there are not many great sources, especially for individual investors. I think that’s one of the reasons there is such a knowledge gap about bonds.
I am working on that though.
Q. Bonds yes, but what type of bonds?
See above. An important announcement is coming you way soon. More next week.
Jared Dillian
Scroll down for comments.