Liquidity: conspicuous by its absence.

What equity investors should know about bond investing

Part 1: Bonds are Not Stocks; Ratings, Credit Risk and Political Risk

Part 2: Dividends and Interest; Low Rates Don’t Have to Mean Low Return; Liquidity Risk

Part 3: Bonds or Bond Funds; How About Bond ETFs?; Interest Rate Risk; How Will ____ Affect My Bonds?


Part 1

  • Bonds are Not Stocks
  • Ratings, Credit Risk and Political Risk

When in Rome, do as the Romans do, right? Why is that? Most of us want to blend in with the locals—to at least look like we know where we’re going. When visiting the Keys, that means flip flops, sunglasses and Jimmy Buffett tunes. (Well, Jimmy Buffett tunes are appropriate no matter where you go.) A visit to Rendezvous in Memphis can quickly reveal the visitor unschooled in the differences between Carolina, Tennessee and Texas BBQ. Wet or dry? Pork or beef?* And don’t go to 4th Base Restaurant in Milwaukee and ask for a Budweiser. (Miller High Life is brewed nearby.) Cultural ignorance may not be costly in dollar terms when you are on a vacation, but on a business trip, not blending in can have monetary implications. So, for example, preparing for a business trip to Asia can mean new business cards and a class on cultural awareness.

Similarly, when an equity investor brings only their equity investing approach to the bond market, it can cost real money—depleting hard-won principal and imperiling future returns and possibly the ability to stay on track towards a planned goal.

Let’s examine some of the important contrasts between stock and bond investing.

Because many investors simply avoid bonds, let’s begin by asking why to even own bonds. That answer should come from answering the bigger question of why do you have a portfolio? In most cases, a portfolio is built to help pursue some long-term goal—growth to fund a future need, or generate income, or both. No matter what the goals are though, the longer the time frames, the greater the exposure to future uncertainty. To help mitigate the risks of future unknowns, it is prudent for the stock investor to have at least some exposure to bonds. (The proportions will depend on a variety of factors. Please see “Timing Interest Rates” for more thoughts about allocating between stocks and bonds and within the fixed income asset class.)

Bonds have a part to play in the investment plan—just as car insurance is part of your transportation plan. Car insurance doesn’t make sense without a car, and without insurance, operating a car can be a very risky proposition. Failing to allocate a portion of your overall transportation budget to buying insurance would be imprudent. In most situations—perhaps for years at a time, you may not need car insurance, but even for the safest, most conservative drivers, it provides peace of mind and is most appreciated at the most inopportune times. Some drivers have sufficient assets to be able to self-insure, but most of us cannot afford the small risk of a major claim.

Similarly, in a portfolio, most (but not all) of the long-term performance will be provided by the equity allocation of the portfolio. Although they can also provide capital gains, bonds are typically counted on to provide cash flow and liquidity. (Income oriented investors may decide to hold a higher percentage of bonds and income producing assets.) Even if you do not need the income from bonds, cash flow is the great antidote for uncertainty and volatility. In fact, isn’t that how most investments are priced? The greater the uncertainty, the greater the yield that is demanded by the market. The predictable cash flow provided by bonds can help reduce the risk of being forced to sell at an inopportune time and can be a source of new capital to be put to work put to work in the future—a feature that can be particularly welcome when equity markets are volatile.

Bonds are not stocks.

The board of directors of a company owe a fiduciary obligation to the shareholders—to do what is in the best interests of the owners of the company. To lenders, the board has only the obligation to honor the contract agreed to when money is borrowed—in fact, going beyond the original terms of the loan would be against the interests of the company and a violation of the duty owed to stockholders. The only obligations on which bondholders can rely are those that are found in the indenture. (While there is generally not a duty of a borrower to maintain a particular level of creditworthiness, some bonds do include financial covenants; for example by stipulating a minimum debt service coverage ratio.) Over the long-term as companies evolve and markets change, stockholders benefit from the best efforts on their behalf by the directors and management of the company, but the bonds remain secured only by the promise agreed to in the governing documents. While the ability to make good on that promise may vary—the date of the promise is fixed.

Ratings, credit risk and political risk

Because a bond is only as good as the promise of the borrower to return the principal at maturity, understanding credit risk is crucial. Most professional managers have in-house research teams to evaluate and follow the financial health of the borrowers they hold or will consider buying. No manager has the capacity to follow an entire market, so they will be selective about which issuers they will follow, and invest from within that list.

Each rating agency uses their own criteria to rate issues, but broadly speaking, the credit ratings reflect their opinion of the ability of an issuer to pay their debt when due and the amount of protection that is provided to bond holders. Investment grade bonds are seen as having sufficient resources to meet their obligations. The lower the investment grade bond rating, the less protection there is against future adverse circumstances. Bonds whose payments are subject to sufficient uncertainty may be considered to be non-investment grade (also may be referred to as speculative grade, high yield or junk).

Even for investors who conduct their own credit analysis, the published opinions from the ratings agencies remain an important data point. When the credit quality of an issuer is in flux—getting stronger or weaker—the market activity and prices are likely to anticipate ratings changes from the agencies. By the time a rating is changed, market participants have frequently already priced in the change.

An often-overlooked element of credit risk is political risk—the willingness of an issuer to honor their obligations and the legal ability for a lender or bondholder to enforce those obligations. Heightened political risk should be intuitive for investors in emerging market and non-U.S. debt. Historically, though, political risk has been of little concern for municipal bond investors. However, an important wake up call has been sounded recently by several high-profile municipal bankruptcy cases (Detroit; San Bernardino, CA; Jefferson County, AL), demonstrating that forming an opinion about credit risk may need to consider political risk as well. Municipal bond investors should be aware of the different constitutional, legal and regulatory environments in each state where they invest—particularly for less credit-worthy issuers. (The Federal Courts website has a helpful introduction to municipal bankruptcy.)

A bond does not have to default for an investor to lose money. An increase in credit risk will be reflected in a decline in the market value of the bonds and a possible decline in liquidity. While a decline in market value may not be a concern for the investor planning to hold to maturity, reduced liquidity can be costly concern for the investor forced to sell. (See the discussion below about Liquidity Risk.) A decline in market value will also be reflected in a lower total return.


PART 2: 

  • Dividends and Interest
  • Low Rates Don’t Have to Mean Low Return
  • Liquidity Risk

Dividends are not the same as interest payments

Investors under-weighting their fixed income allocation in order to over-weight dividend paying stocks may find they are adding to the overall volatility of their portfolio.  While many thriving companies have been known to increase their dividends, there is no guarantee that they will continue do so because dividends can be reduced or eliminated. Just as with high-yield bonds, the highest dividend yielding stocks may be “cheap” because of other dynamics—such as an out of favor sector or company that is under stress.

Yield is not the same as return

Low interest rates do not necessarily mean low returns. While buy and hold bond investors have a good indication of what they will earn over the lifetime of their investment (based on their purchase yield and the coupon rate on their bonds), there can be opportunities to capture gains. Taking advantage of those opportunities when they present themselves means that some bond market investors may be able to earn a total rate of return that is higher than prevailing interest rates.

Recently, most of the bond market total return indices have exceeded prevailing interest rates, indicating that market volatility provided capital gains opportunities to active bond market investors. (Total returns include coupon interest and changes in market value.) For example, through the 12-months ended March 31, Barclays calculated a 6.62% total return for their municipal bond index—that’s more than 2 1/2% higher than the 4.00% average yield on the Bond Buyer 20-year index as reported for a similar period by the Federal Reserve. **

Liquidity risk

There are almost 9,000 listed stocks from which to choose, and over 1,700 exchange traded funds (ETFs). While those are large numbers, listed markets are typically quoted based on a recently executed last trade. The bond market, however, consists of millions of individual securities, most of which trade only very rarely. Except for actively traded and quoted securities, many market quotes or statement prices may be based on algorithms rather than on actual “last trade” activity in matching securities.

There is no quoted measure of liquidity—which is defined as the ease with which an investment can be converted into cash. Because of the continuous open auction involved in a listed market, an investor can get a sense of the current liquidity in a security. But in an over-the-counter market like the bond market, it can be more difficult to have a good understanding of liquidity. Since the financial crisis, the amount of capital provided by the investment banks to buy and sell in the bond market has declined. As a result, in many bond market segments, there can be fewer bonds offered for buyers to select from, and fewer bidders competing to buy bonds. An investor who is less active, such as many individual buy-and-hold investors, may be unaware of this decline in liquidity until they go to sell and only then discover it is not as easy, quick or efficient to sell as it may have been in the past.

Just as some stocks and ETFs are more actively traded and more liquid, the ability to get in and out of a bond can vary significantly from one CUSIP to the next, and even from day-to-day (or minute to minute) as market conditions fluctuate. Because of the typically lower prospective return associated with bonds, investors should prudently structure their maturity dates (and coupon income) to coincide with when they will need their principal returned, rather than expose themselves to the risk of a low-liquidity market environment when they need to sell. Planning for future liquidity needs should be a part of the portfolio implementation planning. The worst thing that can happen to any investor is to be forced to sell when they do not want to. Just as horses are said to be able to see the fear in a rider’s eyes, so too do the markets seem to detect desperation in sellers. Of course some bonds can be very liquid, but in challenging market conditions, even U.S. Treasury notes and bonds can become much less efficient and more difficult to exit.

One way of dealing with higher liquidity risk is to select investments for which there may be greater demand. For example, in the municipal bond market, there is strong demand from institutional buyers for premium bonds with strong call protection. Demand may be strong enough that yields may actually be lower for premium bonds than for discount or par bonds; a possible indicator that portfolio managers may be willing to “pay up” (by accepting less yield) in order to have greater confidence of good liquidity in the future. Buyers of less popular bonds may relish the additional yield, but should also be aware of the potential for lesser liquidity if and when it comes time to sell.


Part 3:

  • Bonds or Bond Funds
  • How About Bond ETFs?
  • Interest Rate Risk
  • How Will ____ Affect My Bonds?

Bond funds are not bonds

Owning shares of stock in a bond fund is different from directly owning bonds. The benefits of investing through a bond fund can include full-time professional portfolio management, supported with access to research and trading that may be difficult or impossible for some investors to replicate. Additionally, bond funds can also offer very broad diversification and ease of automatic reinvestment of cash flows. However, they can be more volatile than individual bonds since they do not have a fixed maturity date and the amount of income can fluctuate based on market conditions and investor flows in and out of the fund. Using bond funds may be especially appropriate for smaller or irregular investments.   (For more complete information about specific mutual funds including objectives, restrictions and investment process, always review the fund’s prospectus before investing.)

Bond ETFs are not the same as equity ETFs

In a market weighted fixed income ETF, investors are giving their biggest weightings to the largest borrowers. (In traditional market weighted equity ETFs, the market weighting means that the holder has a heavier weight in the companies that have the a larger share of the sector.) Investors inclined to use bond market ETFs may wish to explore smart beta or more active strategies to manage their credit risk exposures.

There are several potential benefits of using Exchange Traded Funds to access the fixed income market. Simplification is one—by adding the ETF wrapper to a “basket” of bonds, it becomes more easily tradeable because the investor is able to gain exposure to multiple individual securities by using a single security. Additionally, the ETF market can be more liquid than the bond market. While sellers of individual bonds will generally find bids from only the bond dealers, a seller of a fixed income ETF benefits from a market with a variety of participants: individual and institutional investors, broker dealers, investment banks, hedge funds, arbitrageurs, speculators, high-speed traders and others.

Keep in mind though that the deeper liquidity in the ETF market does not eliminate the other sources of risk that an investor needs to manage, and consequently, a change in pricing or volatility in the underlying securities will affect the pricing of the ETF. From an asset allocation and risk perspective, fixed income ETFs should be treated the same as the underlying bonds.

Investors and traders

If the talking heads say don’t buy bonds because they’re going down this week, it does not mean that investors should sell their bonds. Neither does it mean, though, that they should ignore the talking heads or the influence of conventional wisdom. The near-term view of the market should be combined with economic and interest rate trends to inform and influence portfolio decisions—but the driving force in those decisions should be the investment plan or policy statement.

The selection of managers or specific investments and the timing of those decisions should be the result of a thoughtful diagnosis of the investor’s needs combined with an understanding of market conditions and trends. Ben Graham (in The Intelligent Investor, chapter 20) suggests that investment decisions “should be based not on optimism but on arithmetic.”  I would also add a note of caution to beware of undue or excessive pessimism as well. In other words, the talking heads should be a data point, but taken in the context of your own view and analysis of your goals and the market conditions. Graham counsels, “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and your reasoning are right.”

Interest rate risk and portfolio strategy

Interest rate risk is among the top concerns of bond investors—so much so that many investors try to time interest rates, and end up raising their overall portfolio risk in the process by under allocating to fixed income.   Of course, managing a portfolio should reflect the realities of the economic and market environment, but for most investors, the asset allocation should be a function of the goals and not the market.

Concern about exposure to interest rate risk can be managed through the selection of securities (or managers) and portfolio structure. There are three basic types of fixed income portfolio structure: the bullet, the ladder and the barbell.

The bullet portfolio has all of the bonds concentrated in a single maturity date or range. This strategy is most appropriate for the investor who is making a specific interest rate call and wants to maximize their exposure to that part of the yield curve. The bullet portfolio may not be appropriate for investors who are sensitive to changes in the market value of their portfolios.

The laddered portfolio has equal amounts of principal maturing each year throughout the life of the portfolio and is considered an interest rate neutral strategy, because it favors neither a rise nor a fall in interest rates. By having bonds rolling off on a regular basis, an investor may be able to avoid missing the opportunity of locking in attractive rates when yields are high, or having too much of a portfolio locked into lower rates.

Rather than having identical amounts of principal maturing every year—as with a laddered portfolio—a barbell portfolio is heavily weighted toward the long and short ends of the maturity range. Investors anticipating a rise in rates may prefer a barbell strategy (to a bullet strategy) because they may be able to reduce their portfolio volatility without having to liquidate all of the long bonds from their portfolio. Thus being able to take advantage of the longer (and higher yielding ) sector of the yield curve without taking on too much interest rate risk. As rates move higher, some or all of the maturing short-term bonds can be reinvested in longer-term maturities.

How does _________ affect my bonds?

An economic factor that is good for stocks may be bad for bonds. The reverse can also be true, which is why most long-term investors seek a balanced portfolio so that market declines in one asset class can be offset by increases in others. Deciding on asset class weights should include a consideration of correlations—how sensitive is the pricing of one asset to the moves of another. Beware that correlations are not fixed—they can vary over time, and perhaps in unexpected ways.***

For example, the recent decline in oil has been bullish for stocks as lower energy costs get priced into the economy. More growth and business activity should strengthen the creditworthiness of corporate bond issuers and be reflected in higher bond prices and tighter credit spreads. A decline in oil prices though, would not be a positive for the energy companies. With high fixed costs, they could be expected to underperform the rest of the bond market. Investors who have been chasing yield by overweighting high yield bonds may find themselves with a no longer desirable exposure to energy bonds. Even users of indexed strategies may find their performance is reduced by that exposure.

The list of factors that will affect interest rates, credit spreads and the bond markets is limitless. (For a start on the list, see my article, “Timing Interest Rates.”)

Because it is impossible to anticipate all the possible future events that may influence bonds and the bond market, a good starting place for a portfolio implementation strategy is “core and explore,” which includes a portion of the fixed income allocation invested in a broad and liquid part of the market, with additional smaller weights allocated to opportunistic sectors of the bond market.


An old bond trader’s maxim says that you make your money when you buy—not when you sell. Selecting bonds or a bond manager uses many of the same business decision-making processes as are used in the equity portfolio, but because of the different characteristics of the two classes of assets, investors need to bring a different perspective to how they recognize and manage risks.

This article—while lengthy, only scratches the surface of how to manage these risks. There are many other questions that we have not considered here—such as bond structure, duration, rolling down the yield curve, etc., etc., etc. Your questions are welcome, and you may also wish to have a deeper conversation with your financial advisor or a fixed income manager or analyst.


To learn more about managing risks in a fixed income portfolio, you may find these books to be helpful:

Inside the Yield Book, by Homer and Liebowitz

Managing a Family Fixed Income Portfolio, by Aaron Gurwitz

The Handbook of Fixed Income Securities, edited by Frank Fabozzi







*Their dry rub pork ribs are fantastic, and their web address made me chuckle when I looked it up:

**Bond buyers should keep in mind what restaurant patrons all know—there is no free lunch.   Selling appreciated bonds to capture gains may mean reinvesting the principal at rates lower than the bond(s) sold. A professional manager’s total return performance is only one element of a good manager evaluation process, which should also examine the investment decision-making methods and market conditions that were prevailing during that time span. As always, investors must keep in mind that what goes up must go down, and that past performance is not a guarantee or predictor of future performance. Please click here for additional insight about selecting a professional manager.

***Many investors have observed that asset correlations all seemed to break down in the 2008 financial crisis, and that therefore, Modern Portfolio Theory (MPT) is dead. Similar to Winston Churchill’s observation about democracy, I tend to agree that MPT is the worst way to manage a portfolio—except for all the other ways. What happened in 2008 was that liquidity left the market place, so historical correlations became irrelevant. History can be a guide, but it needs to be informed with judgment. Correlations and MPT are helpful tools, just as a road map or GPS are helpful tools. If a bridge is closed, it doesn’t affect your desire to get to your destination, but it can mean that those who planned ahead may be able to get to their goal with minimal disruption. So too with your portfolio and your bond allocation. Plan ahead and be prepared.


Bonds are Not Stocks

Income Investor Perspectives

Exploring ideas of interest to the income investor

March 25, 2015

The opinions expressed and the information contained herein is based on sources believed to be reliable, but its accuracy or appropriateness is not guaranteed. Past performance is interesting but is not a guarantee of future results. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Investments in bonds are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. Additional information available upon request.

©2015 Patrick F. Luby

All Rights Reserved.