Bond Basics

A bond is a loan for which the investor is the lender. They are like IOUs. When you purchase a bond, you are lending money to the government, a company, or some other organization. Bonds are sold in fixed increments, normally $1000. The organization that sells a bond is known as the issuer. Like other loans, there is an amount borrowed (face value or par value). There is an applicable interest rate (coupon rate), and a specified time when the bond must be paid off (maturity date). Bond maturities can range from days to decades. The bonds that typical individual investors purchase have maturity dates that are years to decades in length. Interest is paid to the bond owner on a schedule specified by the bond – typically every six months, although quarterly or monthly payments are sometimes specified. Because the cash flow from them is fixed, bonds are also known as fixed-income securities. On the maturity date, the face value of the bond is returned to the bondholder.

(Example: You buy a bond with $1000 face value, 5% coupon rate, and 5 year maturity date. Purchase of the bond costs you $1000 plus any sales fees. Every six months – as specified by the bond -- you are paid $25 in interest payments. Five years from the date of purchase, you get your $1000 purchase price back.)

Long-term investors include bonds in their portfolio to provide stability, not higher returns. For long-term investment periods (25 years or longer), the stock market has always beat bond performance. For periods of a decade or less, however, stable bond interest can outperform the more volatile stock market. For most investors it makes sense to have part (but not all) of their portfolio invested in bonds.

Bonds are debt while stocks are equity. This distinction means that equity holders are owners of a company while bondholders are creditors. Legally, the creditors (bondholders) have a higher claim on assets. In case of bankruptcy, a bondholder will get paid before a stockholder. An organization’s bonds carry less risk than their stock certificates. Since the bondholder is taking less risk, he or she almost always receives lower returns. The relationship between risk and reward (ie. higher reward requires taking greater risk) is the underlying principle for all investments.

Not all bonds carry the same risk. The more risky the bond investment, the higher the coupon rate of the bond. Companies sometimes default and fail to pay back bonds. Large, stable company bonds tend to pay less than those of small, volatile companies. Government bonds are the least risky and also tend to pay the lowest rate.

Time is also a factor in bond risk. A bond that matures in 30 years is much less predictable, and therefore more risky, than a bond that matures in 1 year. For this reason, longer time to maturity is usually associated with higher interest rates. Bond investors should consider underlying risk before investing in a bond.

How does an investor evaluate bond risk? -- Bond ratings can be useful in evaluating the default risk of bond issuers. Bond ratings are developed and published by two major rating organizations in the United States: Moody’s, and Standard & Poor’s (S&P). These ratings are similar to a report card on the issuer’s stability. The highest grades are awarded to the government since they are the closest thing to a risk-free investment available. Large, blue-chip firms tend to receive fairly high ratings because of corporate stability. Financially unstable companies receive low ratings.

Moody’s Ratings in order from least to most risk are Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C. S&P ratings (low to high risk) are AAA, AA, A, BBB, BB, B, CCC, CC, C, D. Bonds with ratings of higher risk Ba or BB are referred to as junk bonds. These bonds offer high yield, but at greater risk.

A bond can be sold before its maturity date. When bonds are sold like this, it is on the secondary market. The price of such sales can fluctuate from the face value. If a bond is bought at face value, the yield is equivalent to the coupon rate of the bond. If the bond is purchased at a price greater than face value, the payments remain fixed, providing a yield less than the coupon rate. Similarly, a bond purchased at below face value will produce a higher yield than the coupon. The yield to maturity (YTM) is the return an investor will receive from a bond purchased on the secondary market at a price different than the face value. YTM can be larger or smaller than the bond coupon. Bond prices and bond yields are inversely related.

The entire bond market can be categorized along a dual continuum. The classifications that apply to bonds are maturity and credit rating. Conventional maturity classifications are long (greater than 10 years), intermediate (4 to 10 years) and short (less than 4 years). Credit rating is the Moody’s or S&P’s credit rating as discussed above. As an example, a U.S. treasury bond with a 20 year maturity would be classified as a long-term, low-risk bond, while a bond from a financially struggling small company with a 3 year maturity would be a short-term, junk bond.

In addition to the maturity and credit rating, bonds can be divided into US or foreign debt. Non-US bonds can be further classified either as emerging or as developed country debt. Bonds can also be classified by the business sector of the company.
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adapted from Engineering Your Retirement, Golio, Wiley, 2006. http://www.golio.net/EngineeringYourRetirement.html

Asset Allocation vs Market Timing

The underlying, fundamental principle that describes investments is that greater return comes with greater risk. The underlying cause for this relationship is that investors expect to be compensated for taking on additional risk. A U.S. Treasury bond, for example, provides lower return than a corporate bond. The reason for the difference in returns is that the risk of a corporation going bankrupt is higher than the risk that the government goes bankrupt. The corporation has to pay a higher rate than the government to entice investors to buy their bonds rather than government bonds. The risk-return continuum that applies to government and corporate bonds also applies to stock, mutual fund, real estate and commodity investments. All investment choices need to consider an individual’s comfort level with risk and his/her requirements for reward.

Investment strategies can be classified along a continuum between asset allocation and market timing. Asset allocators are investors who focus first on managing risk by maintaining fixed percentages of their portfolio in various asset classes – each associated with that class’ risk. For example, a simple asset allocation plan might be to keep 30% of investments in US stock market investments, 30% in international stock investments, and 40% in short-term bonds. A pure asset allocation strategy would involve establishing a portfolio with this mix of investments, then periodically (once a year, for example) re-balancing the overall portfolio to maintain the asset classes at the same levels. Asset allocators accept that they cannot predict what the markets will do and choose instead to manage risk.

In contrast, market timers focus first on return. Buy low; sell high is the goal of the market timer. Market timing is a seductive strategy. Engineers who are used to optimizing performance understand that maximizing yield must involve picking equities and bonds when they are underpriced and selling them when they are overpriced. Unfortunately, this is easier said than done. In order to successfully time the market, the investor must 1) identify a bargain correctly before anyone else has done so. Once others identify the bargain, the market will immediately increase the price until it is priced appropriately. 2) buy the bargain at the right time. 3) sell the bargain at the right time. If a market timer misses on any of the above tasks, they can completely eliminate their profit advantage.

Countless studies have looked at various investments strategies and compared the resulting performance. Over periods as short as 5 years, most asset allocators outperform market timers. As the time period gets longer, the performance advantage of asset allocation grows. For periods of 2 or 3 decades, only a small fraction of market timers are comparable to pure asset allocation strategies.

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Investing Basics

When it comes to investing, people don’t agree on anything. Investors disagree on what to buy, when to buy it, and how long to hold it. Some trade individual stocks or bonds, others only invest in mutual funds. There are disciples of real estate, commodity traders . . . you name it. Some investors believe in using a pure asset allocation strategy. They maintain specific target percentages of their portfolio in specific asset classes (X% stock, Y% bond, Z% real estate,. . .) regardless of what the markets do. Other investors try to time the market (buy low, sell high). Regardless of what method they use, most investors believe that their method is best and every other investment style is inferior.

But here’s the truth. The "best" method to use is one that you understand and can live with. Trying to emulate the success of someone else probably won't work for you unless you have the exact same knowledge and temperament that they have. Here’s another fact: Most investors who think they have the best method are fooling themselves and are almost certainly underperforming the markets.

For the vast majority of successful investors, the key to asset accumulation is to 1) Live Below Your Means (LBYM), 2) Invest regularly, and 3) Let time in the markets work its magic. Obsession about trying to beat the market is more likely to hurt your chances of success than to help you. If you avoid throwing your money at get-rich-quick schemes, invest regularly, and follow a few simple guidelines, the choices of what specifically to invest in are less important than many investors fear.

The simple guidelines:

1) Diversify. Don’t put all your investments in a handful of stocks, for example. Index funds are a great way to do this. They diversify investments across an entire market index.

2) Minimize Fees. If you buy mutual funds you should be looking at the expense ratio (expenses/assets expressed as a percentage). Different mutual funds will have expense ratios that vary from as low as 0.15% to over 4%. Countless studies have shown that over periods of a few decades or longer, fees are the single best predictor of which funds will do best. Higher fees mean poorer performance. It’s that simple. If you buy stocks or bonds directly, look for discount brokers. Fees matter.

3) You don’t have to beat the market to get rich. Timing the market is hard. Despite what your neighbors, colleagues or broker may tell you, the vast majority of people do not beat the market. And the longer the period of time you consider, the fewer the number who actually do. The truth is that your neighbors, colleagues and broker probably spend too much money, have too much debt, and don’t have a clue how their portfolio really did against the market. If you invest in index funds, you will (by definition) match the markets (minus fees). If you put your money in low fee index funds and let time do its magic, you can achieve the nest egg you need to retire. You have better things to do than read corporate 10K forms, study charts and call your broker. If you do choose to try to time the market, you will need to understand your greed/fear levels and control them well as your investments rise and fall. Invest in a good program that will keep track of your returns and be honest with yourself. Studies show that most people who invest this way dramatically overestimate the actual performance of their portfolios.

4) Understand your risk tolerance. Your investments are at risk. Regardless of how you have chosen to save (stocks, bonds, commodities, annuities, houses, or buried in a jar in the back yard) there is a chance you could lose all or part of your investment. The underlying principle that drives investment results is that there is a direct relationship between risk and return. Greater investment risk brings greater potential returns (long term). The underlying cause for this relationship is that investors expect to be compensated for taking on additional risk. It is hard to understand risk and its effect on comfort until an investor actually experiences significant declines in their portfolio. Risk tolerance before a market decline is like courage before a battle. Until it is tested, it is difficult to distinguish someone who is brave from someone merely showing bravado. Establishing your appetite for risk involves gauging the potential impact of a major loss on both your portfolio and psyche. You need to make sure you have balanced your high flying investments with enough less volatile investments to let you sleep at night in the event of a catastrophic market crash.

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Fees matter . . . a lot.

Minimizing cost is critical to achieving long-term investment success. Unlike future performance of your investments, costs are predictable and controllable. Countless studies and mathematical analyses have shown that higher costs do not lead to higher returns. Dollars spent on management fees, trading costs, and taxes are dollars lost to the investor. Market rewards are finite and investment expenses come off the top before the investor gets their share. Smart investors should be concerned with finding investment products, with low fees.

In one recent study of mutual fund performance (Financial Research Corporation, 2002, Predicting Mutual Fund Performance II: After the Bear) the predictive value of several fund metrics were examined. The possible indicators of future returns that were examined included: a fund’s past performance, Morningstar rating, alpha, beta, as well as expense ratio. It turns out that the fund’s expense ratio was the most reliable predictor of its future performance. In other words, low-cost funds delivered better performance. This was true for all of the periods considered by the study.

John Bogle, Founder and Former CEO of the The Vanguard Group talked about another study when he spoke in 2003 to the Society of American Business Editors and Writers. The study quantified the relationship between the total costs of equity funds and their returns by looking at the returns of 803 diversified U.S. equity funds. Using the Morningstar database, each of the funds investment returns along with its costs were compared. The average expense ratio for these funds was 1.3%, and their average portfolio transaction costs were estimated at 0.7%, for a total of 2.0%. The funds were then divided into quartiles by cost (fees). The results included these important facts:
-The high-cost quartile of funds, with all-in expenses of 3.4%, provided an average annual return of 6.8%.
-The low-cost quartile, with expenses of 1.0%, provided an average annual return of 10.2%, earning an advantage of 3.4 percentage points per year.
-On a fund-by-fund basis, the inverse correlation between cost and return was remarkable: minus 0.60%.
-Funds with the highest costs also assumed the highest risks, generated the highest turnover, and produced the poorest tax-efficiency.
-Funds with the lowest cost had an even greater advantage in risk-adjusted return and an amazing advantage of 4.0% per year in after-tax return.

Fees as they impact returns are also the subject of an article by Nobel Laureate, William Sharpe: The Arithmetic of Active Management in Section 6.2( http://www.golio.net/Chapter6.html). Here’s what Sharpe concludes:
If "active" and "passive" management styles are defined in sensible ways, it must be the case that
(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and
(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar

These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.
As an individual investor, how can you reduce fees? Using a low cost mutual fund provider should allow you to assemble a portfolio with an expense ratio on the order of 0.20%. Fixed income investment (bond) requirements for your portfolio can be satisfied using a short to intermediate term US Government bond fund. An S&P500 or Wilshire 5000 index fund can be a good choice for the stock portion. Other low cost index funds can provide further diversification if desired.

The average mutual fund has an expense ratio of about 1.30%. Fees of this magnitude result in significant drag on your portfolio performance. The figures and analysis below provide an estimate of how much can be gained from using low fee funds rather than average or high fee funds.

The figure labeled “Effects of fees while saving” considers an investor that invests $2500 per year for 40 years and earns 7% per year on the total investment. The 5 curves illustrate the effect of fees on the portfolio value. Fees of 0.2% are typical of low cost index funds. Managed funds average over 1% fees. Some managed funds have fees as high as 5%. Over a 30 year investment period, the cost to an investor investing in funds with a 1% fee is over $32,000 compared to the investor using mutual funds with a 0.2% fee. Compared to an ideal “no fee” return on investments, the investor gives up over 16% of the gains on his/her own money over this period of time. The investor takes all of the risk, but pays over 16% of their gains to the mutual fund company.

At the end of 40 years, 1% fees have cost the mutual fund investor over $93,000 compared to the low cost investor. The investor has now paid almost 30% of his/her investment gains to the mutual fund company.


The figure labeled “Effect of fees in Retirement” illustrates how fees affect a retiree during the distribution phase of investment history. The figure assumes a retiree starts retirement with a $1M portfolio, spends $45K the first year and adjusts this spending upwards by 3% per year to match inflation. The unspent portfolio is assumed to earn 7% return per year. The investor who is invested in mutual funds with 0.2% fee survives over 40 years in retirement. At a 1% fee level, the retiree runs out of money in year 34. An investor using mutual funds with a 4 % fee runs out of money in year 22.

The road to investment success is improved when expenses are minimized. Your portfolio performance is driven primarily by
- your saving rate,
- your asset allocation and
- amount of time in the market.

Personal values and frugal living drive your saving rate. Asset allocation is a matter of establishing your personal risk-return comfort level. Time marches onward for all of us. This leaves little or no reason to diminish your returns through commissions and fees. Even a 1.00% management fee costs a lot in terms of reduced nest egg and retirement income. Spending the small amount of time required to learn about financial markets and managing your own retirement assets should reap significant rewards.

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