Correlation benefits. Barclays Capital and Bloomberg report that between 1997 and 2005, the U.S. 10-year Treasury bond had a negative 38 percent correlation with the U.S. large-cap stocks (S&P500 index). Thus, when stocks fall then bonds typically rise (and vice versa). After the Internet bubble burst, for the years 2000, 2001 and 2002, the S&P500 stock index returns were -9.10 percent, -11.88 percent and -22.09 percent. During the same years, Lehman U.S. Aggregate bond index returns +11.63 percent, +8.44 percent and +10.25 percent.
During the period 1993 through 2006, the stock market did exceedingly well through 1999 and then suffered a severe meltdown. During this 14-year period, if your equities performed in line with the S&P500 index and 69 percent of your financial assets were allocated to bonds which performed in line with the Lehman U.S. Aggregate bond index, then you never would have had a down year. Because of this negative correlation, bonds have an important role to play in all portfolios.
Background. The three largest issuers of bonds in the United States and their unique characteristics are:
- Domestic corporations — debt may be publicly traded or privately placed, and it may be collateralized or unsecured;
- Municipal governments — debt may be general obligation bonds (GOs) backed by the full faith, credit, and taxing power of the government issuing them or "revenue bonds" which depend on the success of the particular entity (such as toll roads, hospitals, and water and sewer systems);
- Federal government and its agencies — such as Export-Import Bank, Federal Home Loan Bank and many others.
Mortgage-Backed Securities are securities whose cash flows depend on monthly payments of principal and interest and prepayments of principal from an underlining pool of mortgages. Ninety-eight percent of all these securities are guaranteed by "Ginnie Mac", a wholly-owned United States government corporation, and by "Freddie Mac" and "Fannie Mae", government-sponsored organizations.
Asset-Backed Securities are collateralized by assets other than mortgages. The three most common types of collateral are auto loans, credit card receivables and home equity loans. Credit enhancements are provided by letters of credit, recourse of the issuer, over collateralization and/or senior/subordination.
Risks Bonds' primary risks are the following:
- Interest-rate risk — The value of your bonds will fall if market interest rates go up. For example, assume the coupon rate of your non-callable bonds and the market rate are both 5 percent. Then, your bonds will be valued at par ($1,000 each). Next, let's assume economic conditions change and the new market rate of such bonds is now 6 percent. If you tried to sell your bonds, you must reduce your asking price so that they would have an approximate 6 percent yield to maturity. During the late 1970s and into the 1980s, interest rates rose dramatically and the value of bonds fell just as dramatically.
- Credit risk — When you buy bonds or other fixed income securities, you expect semi-annual interest payments and the return of the face value at maturity. Sometimes a borrower cannot meet its obligations and goes into bankruptcy. Moodys, S&P, Fisk and others provide credit ratings on bonds. These ratings can help you select bonds that fit your credit risk tolerance.
- Event risk — Serious and unexpected events include: natural or industrial accidents such as Katrina or a huge fire; and takeover or corporate restructuring such as a hostile takeover of a company through the use of junk bonds. These events can make interest or principal payments difficult to make and sometimes impossible.
The following is a summary of two major strategies used by active and passive bond managers:
- Active managers. They seek to outperform passive managers by employing both rate anticipation and sector valuation strategies. Rate anticipation involves the study of economic factors affecting interest rates, correctly anticipating future rates and acting on perceived opportunities. Change in interest rates impact the price of long-term bonds much more than short-term bonds. So if rates are anticipated to fall, then active bond managers will increase his or her exposure to long-term bonds and reduce short-term exposures (and vice versa). Sector valuations are affected by market conditions. Examples include discount versus premium bonds, industrial versus utility bonds and corporate versus mortgage-backed bonds.
- Passive managers. They seek to outperform active managers by having lower management and trading costs. A buy-and-hold strategy consists of buying bonds and holding them to maturity. Selling a bond before maturity can be costly. Frequently, a buy-and-hold bond manager will "ladder" the bond portfolio. Example: a bond portfolio with a targeted average maturity of five years may hold bonds maturing one, two … and 10 years from now. When a bond matures, he or she will reinvest the proceeds in a 10-year bond.
Another strategy is indexing. This is simply buying a low-cost bond mutual fund that seeks to mimic the performance of a bond index such as the Lehman Brother U.S. Aggregate bond index. The bond manager knows the bonds that are included in an index. He or she will simply hold bonds in its fund that will mimic the performance of the underlining index.
Next month: active versus passive investing.
June 2007
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