Is Now Finally the Time to Buy Bonds?

Is Now Finally the Time to Buy Bonds?

24 Mar, 2023 | Stock Insight

The age-old investing wisdom was always to maintain a portfolio consisting of 60% equities and 40% bonds (commonly referred to as the “60/40 portfolio”). Bonds have been out of favour since the Global Financial Crisis though, as TINA (“there is no alternative”) took over and investors piled into more risky assets.
US Savings Bonds. Savings bonds are debt securities issued by the U.S. Department of the Treasury.

The main reason for this was the incredibly high prices, or inversely, the incredibly low yields that bonds offered investors for most of the past 15 years. (The price and yield of a bond are inversely related. For example, when the yield of a bond increases from 1% to 2%, the price of that bond falls).  In fact, bond prices (yields) had steadily increased (declined) for about 30 years up until 2020.
US Treasury Yields vs. Long-Term Inflation Rate

Notorious Bonds and the Tale of Silicon Valley Bank

This has been a hot topic of late given the collapse of several U.S. banks, including the high profile failure of Silicon Valley Bank (SIVB). SIVB had a large portion of its balance sheet invested in long-term bonds, predominantly mortgage-backed securities with a 10-year duration. Without getting too much into the weeds, the main issue here was that these bonds were purchased during the pandemic at extremely high prices (with yields of 1.70% to 1.80%, for example). During this time, central banks such as the U.S. Federal Reserve and the Reserve Bank of Australia had cut benchmark interest rates and implemented other measures such as quantitative easing to lower interest rates, stimulate the economy, and reduce the risk of deflation. This was quite effective, and the yields on fixed income securities fell sharply. With a huge influx of deposits from a boom in technology, venture capital and special purpose acquisition companies (SPACs), along with very little loan demand, SIVB’s management felt that they had very little option but to invest in these otherwise “safe” (but expensive) securities.

Fast forward to 2022 and the economic environment is vastly different: restrictions on movement have eased, the economy has roared back to life and central banks now have to combat the challenges of low unemployment and higher levels of inflation. As a result, they rapidly increased interest rates – at the fastest rate on record. Higher market interest rates cause these bonds offering low yields to significantly decline in value. Simultaneously, SIVB’s deposits begin to decline as the bank’s clients fall on harder economic times and have a greater need to use their funds. Eventually, SIVB needed to sell a portion of its bond portfolio, which at today’s interest rates, were worth substantially less than when the bank purchased them.

Are Bonds Lower Risk?

Putting the extreme example above to one side for a moment, bonds are widely regarded as being a less risky asset class than shares. There are two main reasons for this. Firstly, bondholders are legally entitled to receive a regular fixed payment (with the exception of zero-coupon bonds, which are discussed more below). This differs from a dividend for shareholders, which is optional and can be modified or eliminated at the discretion of the Board of Directors (although they generally try to avoid this circumstance). Secondly, in the event of bankruptcy, bondholders are entitled to receive proceeds from the remaining funds before shareholders – who are typically last in the capital structure.  (While this is not always the case and we did see a special situation this week with holders of Credit Suisse’s additional tier 1 or “AT1” securities wiped out while equity holders stayed afloat in the takeover by UBS, it is generally true. It certainly pays to read through the details contained in a prospectus, even though they can sometimes be more than 600 pages long!).

How Do I Make Money from a Bond?

The bond market is enormous (much bigger than the equity market) and there is huge variety in the types of fixed income securities available: hybrids, convertibles, some with warrants attached, et cetera. However, sticking with some of the more basic vanilla bonds for now, there are a few main types.

  • Zero Coupon Bonds: the bond is issued at a discount to par (e.g., 97%) and the investor receives the full amount at the maturity date (e.g., 100%).
  • Fixed rate securities: similar to a term deposit from a bank, these pay interest in the form of coupons on a regular basis and the principal (initial capital investment) is returned to the investor at the maturity date;
  • Floating rate securities or floating rate notes (FRNs): pay interest based on a benchmark rate that changes over time. This benchmark is often the Bank Bill Swap Rate (BBSW), which is basically the rate at which banks borrow from each other for different periods of time. The spread (or the margin over the benchmark) is set at the beginning. As with fixed rate securities, the principal is returned to the investor at the maturity date.
  • Index-linked securities: similar to FRNs, these pay a variable interest rate based on an inflation index such as the Consumer Price Index (CPI). They can be capital-indexed bonds (where the initial capital investment is increased according to the index) or index annuity bonds (which are similar to mortgages, where the investor receives regular payments that include both principal and interest).

In addition to receiving the coupon payments and/or higher capital amount at maturity, investors can also profit if market interest rates decline. Lower interest rates increase the value of certain bonds (such as fixed rate and zero-coupon securities), and instead of holding the bond to maturity, an investor may be able to sell the bond in the secondary market for a profit.

Who Issues Bonds?

Both governments and large corporations issue bonds, while smaller companies (like consumers) typically do most of their borrowing from banks. Governments such as Australia (who maintain their own currency and borrow in that currency) are largely considered ‘risk-free’ because they can always increase taxes to pay off any debts. The U.S. government is the largest issuer globally, and investors can buy securities ranging from 1 month through to 30 years (collectively referred to as the ‘yield curve’). There is also a larger market for corporate bonds in the U.S., while in Australia it is mostly limited to the ASX 50, including companies like the big four banks and the largest mining and infrastructure stocks. The interest rates that these companies pay are based on their perceived risk, which commonly involves a premium or margin over the government bond rate (referred to as a ‘credit spread’).

Alphabet Soup – Is Your Bond Investment Grade?

Fixed income securities are given a grading by credit rating agencies Standard & Poor’s (S&P), Moody’s and the lesser-known Fitch. S&P/Moody’s copped a lot of flak for their performance during the GFC, however, one clear trend from their track records is that companies that are given a grading of “investment grade” (BBB- for S&P/Fitch, Baa3 for Moody’s) are much less likely to default (meaning investors don’t receive all of their interest or principal payments). As a result, companies that do not receive an investment grade rating pay much higher interest rates. The securities issued by these companies are often called ‘high yield’ or ‘junk’ bonds, and have become increasingly popular from both companies and investors, including billionaire Howard Marks. While some sub-investment grade companies are high-quality (often emerging) businesses, caveat emptor.

No Time Like the Present?

The rapid rise in interest rates over the past year has finally provided investors with more attractive yields on fixed income securities. While the world of bonds might seem complex at first (and there is a huge variety of options, some with very detailed provisions), now might be the time to introduce yourself to the more ‘plain vanilla’ types and consider adding a portion to your portfolio. As investors, management and stakeholders in Silicon Valley Bank can attest, it’s important though to consider the price (yield) on offer, and importantly, how that compares to inflation.

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