Basically Part 4Submitted by WWA Planning & Investments on January 31st, 2017
Many great fortunes have been made by purchasing the right stock at the right time but the risk inherent in the stock market means that there will always be a role for bonds to play. Investors who need to insure the safety of their principal and are comfortable accepting lower, but guaranteed, returns often find that purchasing bonds, certificates of deposit or annuities puts their minds at ease. Where should they start?
Perhaps the best known bond is the certificate of deposit. A CD differs from a savings account in that the investor has agreed to keep the money on deposit for a specified period of time. We learned years ago in Jimmy Stewart’s movie It’s a Wonderful Life that banks use the money deposited in their institution to finance loans for others in the community. Banks are typically willing to pay a bit more interest on a CD than a savings account to be sure that a significant portion of their deposit base won’t be withdrawn at an inopportune time. Guaranteed by the bank itself, then by the FDIC, CDs are one of the least risky investments available. Regardless of the rate offered, the FDIC guarantee never wavers – CD owners are insured up to at least $250,000 per person.
If the CD is the best known bond, the US Treasury is the most widely owned. The US government finances its day-to-day operations through a combination of taxes and borrowing, issuing bonds with maturities ranging from 90 days to 30 years. While shorter term CDs are available, Treasuries are the only government-backed option with extended maturities. Because they have been issued virtually every week for many years, it’s possible to find an older bond that matures on the exact day required to meet an investor’s specific timeline. While CDs are insured by the FDIC, Treasuries are backed by the full faith and credit of our government itself. They are generally considered to be the safest investment in the world. Does that sound like an accurate assessment considering the recent recession and our current political tumult? Well, take a moment to think about what happened when investors panicked following the Brexit vote. They bought Treasuries and this has happened over and over. Individuals, corporations and governments – even some governments that aren’t especially friendly to ours – look to US Treasuries when they become fearful.
Of course, other governments issue bonds in a similar fashion and, low as our current rates are, some are even lower. Right now, both Japan and Germany are offering bonds with negative interest rates. That is, investors will get back less at maturity than they invest. It’s easy to see why a bank would offer such rates but why would investors buy? Investors, perhaps frightened by global uncertainty, are willing to pay a small penalty to make sure they don’t lose even more. Negative rates are not unheard-of in the US but because bonds trade in the billions of dollars every day, such events are usually of short duration and resolve themselves as fears subside.
Like governments, corporations often choose to finance expansion by borrowing, especially when rates are as low as they are today. Let’s return to Wal-Mart for a moment. Although it’s publicly owned, it also borrows through issuance of bonds. During 2015, the company repaid over $6 billion in debt, bringing its total borrowing down to only about $39 billion. You might be wondering if doing business with a corporation, even one the size of Wal-Mart, is as safe as doing business with a government. Several companies attempt to answer that question by offering credit ratings on bond issuers. The best known of these are Standard & Poors and Moody’s Investors Service. These are the folks who provide the famous AAA (S&P) and Aaa (Moody’s) ratings. Their rating scales end further down the alphabet at C for Moody’s and D for S&P – what’s known as junk bond territory. Actually, the investment industry prefers that people use the term high yield instead of junk but both describe companies which are perceived to expose investors to significantly higher risk of default than most.
Since there’s relative safety in doing business with a government, why would anyone choose a junk bond instead? For the same reason that people invest in stocks – the potential for a greater return. While companies like U.S. Steel, Delta Airlines and Dole Foods currently have low credit ratings, investing in any of them might still be safer than making an unsecured loan to a relative.
Due to the constitutionally mandated separation of powers between local and federal governments, it’s possible to purchase a bond which pays interest that’s not taxable by the IRS. Known as municipal bonds, these are issued by cities, counties and states and their associated institutions: hospitals, universities, etc. Knowing that the income won’t be taxed, issuers are generally able to pay lower rates than are available on corporate bonds but there’s often an after-tax advantage to be gained so it’s an approach worth investigating.
For those who decide that bonds are an appropriate choice, the same purchase options exist as for stocks. An investor can select an individual bond or hire a manager to make the decisions by buying shares of a mutual fund or ETF. While bonds are often thought of as safer than stocks, there could be more risk involved in owning a bond fund than you might expect. While the typical bond mutual fund or ETF assumes very little default risk on behalf of its owners, the question of interest rate risk must also be considered. Suppose you’d purchased a long-term CD in 2000 when rates peaked around 6%. If you still had it (and there was an open market for trading CDs) you might expect to get a return of around triple your investment based on today’s rate of around 2%. Of course, the opposite is also true. If you buy a CD today, then try to sell it when rates have returned to 6%, you’d be offered about 1/3 of your principal.
While such a market doesn’t exist for bank-issued CDs, it does for government and corporate bonds. Rates have been falling since their peak of around 8% in late 1994, so portfolios containing those older, high rate, bonds have increased in value. At some point in the near future, rates will rise again and when they do, we’ll see the opposite. Current, low-rate bonds will be worth less than newer, higher-rate bonds so the value of fund shares will begin to fall. I don’t expect this to be sudden but I do expect it to be protracted. As bond fund share values fall, I imagine investors who simply bought last year’s best performing fund will begin to be concerned and decide to sell their shares. That will force managers to sell bonds to raise cash, tending to push prices down further, likely triggering the sale of more fund shares. In contrast, holding an individual bond to maturity will almost certainly involve some fluctuation in value along the way but all principal would be returned at maturity.
I mentioned earlier that buying a fixed annuity is similar to buying a CD but from an insurance company instead of a bank. Let’s unpack that comment and see if it holds up. If a CD is guaranteed by the FDIC, who guarantees an annuity? Of course it’s the issuing insurance company but, beyond that, most states have a pool to which insurance companies must contribute to create a reserve fund available in case of a company’s failure. Since no one wants that to happen, companies are carefully investigated by the state’s department of insurance before being allowed to sell policies. Indiana is quite strict about the companies which sell here and the state does maintain such a pool. Even in the case of a significant failure like Conseco’s, coverage was maintained and principal returned at maturity. While buying a fixed annuity is probably not quite as safe as a CD or Treasury, it’s safe enough for most investors and has the possible advantage that income earned but not taken isn’t taxed until the annuity is eventually cashed-in, unlike CD and Treasury interest which is taxed yearly.
The insurance industry also offers a product called a variable annuity. Those who are in the business of selling them suggest that they provide the best of both worlds: a stock mutual fund investment within an insurance contract. We find VAs to be quite unattractive to investors because they combine limited investment choices and high expenses: a much better deal for the salesperson than the investor.
In any complex situation, whether buying a used car or an investment, doing all you can to reduce the information imbalance is likely to improve your outcome. I hope this series of articles has helped people better understand their investment options. Please do your homework before investing so you don’t become one of those folks whom P. T. Barnum said were being born every minute.