To be sure, bonds (fixed-income products) play an important role in any investment strategy, providing specific characteristics, such as predictable coupon/interest payments (usually fixed), fixed maturities and return of principal. These factors, in combination, are essential for effective financial planning and overall asset allocation. Additionally, and perhaps most importantly, bonds provide a necessary counterbalance, acting as a low-correlation asset to the higher-volatility equity portion of a portfolio.
With today’s ultra-low yields, it’s safe to say that every income-producing rock has already been turned over. If there were a foolproof way to generate extra income without additional risk, investors would already be all over it, pushing up the security’s price and pushing its yield down. Instead, higher yields are invariably a signal that a security type entails more risk than its lower-yielding counterparts.
Why would an investor pay a central bank to hold their money? There are only two reasons I can think of. One, you are speculating that another investor will come along and pay a higher price to buy the bonds from you (current European Union Central Bank scenario) or two, you are seeking safety in a very unstable environment where your only concern is the return of your principal.
Today’s negative yields are the manifestation of central bank policy pushed to an extreme.
Germany sold two-year government debt at a record low yield of minus 0.38 per cent on Wednesday, in a move reflecting expectations of further monetary easing for the eurozone next month. The policy-sensitive two-year bond offers a coupon of zero,
At the 2015 CFA Institute Fixed Income Management Conference in Boston, I learned that almost every speaker is concerned about the liquidity of corporate bonds. Many pointed the finger at Dodd-Frank and Basel III, which require greater amounts of high-quality capital. This means that investment banks, long-time facilitators of corporate bond-market making, are doing very little of it as they are reluctant to hold the inventory. This flies in the face of evidence that the bid-ask spread is narrowing. Speakers pointed out that much of the liquidity is being provided by hedge funds running algorithms designed to make money based on mispricing. But what happens when the conditions in which algos normally trade are violated? Most of the speakers think there would be no liquidity. Ouch!
When rates start to rise what will happen to the bond mutual funds? Could the lack of liquidity in bond markets and a market structure of requiring a broker to execute trades lead to a liquidity crisis?
There is a difference between owning individual bonds and owning a bond mutual fund.
When it comes time to sell, it can
be hard to find a buyer, and vice versa. PIMCOs
chief investment officer for U.S. core strategies, Scott
Mather, has compared the bond market to that for real estate. Few people list their houses on a website and expect to find a buyer. Instead, they pay an agent, who may
know a young couple interested in a fixer-upper next to the
railroad tracks. Both bonds and houses are far from
homogeneous. Real estate brokers have maintained their grip on
their market, despite consumers buying everything from
groceries to puppies online. “You can’t force every
house to be the same or force every issuer to issue the same
bond,” says Mather. Since the financial crisis, though,
players in the bond market have become more receptive to
technology and new solutions. They’ve had to as banks have
been regulated out of playing their traditional role as market
makers and, in a pinch, providers of liquidity.
An interesting article by Jason Zweig in the Wall Street Journal brought up an important concept that most investors pay little attention to, the current yields on the bonds in their portfolios, and which yield should be considered when deciding what bonds to purchase.
There are several different yield calculations for different kinds of bonds. For example, calculating the yield on a callable bond is difficult because the date at which the bond might be called (the coupon payments go away at that point) is unknown. There is the yield to maturity, which is the yield from holding the bond to maturity (assuming that you can reinvest all the coupon payments at the same rate as the bond’s current yield.) And there is also the current yield, which is the one a bond buyer should use when comparing different bonds to purchase.
The current yield is defined as the ratio of the coupon interest to the current market price and is what you can expect to receive by buying that bond today at the currently quoted price.
Current Yield = Annual Cash Flow / Current Bond Price
However, if the bond were to be sold at a capital gain or loss, or if the bond is called (bought back before maturity by the issuer) then the current yield would not be realized by the holder.
In today’s low rate environment I would favor evaluating bonds based on their current yield, using the yield to maturity measure may not be an accurate representation of the return the holder will receive given that it will be difficult to reinvest the cash flow from the annual coupon at the same rate.