In this chapter, we will be covering the world of bonds. And by and large, given today’s economic realities and also the situation of the typical corporate executive, I can say typical bonds should really have a relatively modest presence in your portfolio, especially in your “earning years.” But first let’s just talk about bonds in general and later about what types of bonds you should consider given risks in today’s economy and financial markets.
In the world of bonds, I can tell you what bonds are like, how they work, and so on. But that’s fine if we’re doing a textbook education. The greater value would be over the pros and cons, given today’s economic realities.
First of all, a bond is an instrument of debt. When an executive, say, buys a $10,000 bond, that means to the corporate executive this bond (debt instrument) is an asset residing in their portfolio in their regular brokerage or retirement account. Meanwhile, that $10,000 is someone else’s liability. In this specific transaction, the executive is the creditor, and the debtor (the organization issuing this debt) has to pay the creditor back the principal plus the interest on this particular liability over the indicated timeframe.
The most common bond categories are:
• Corporate bonds. These are typically issued by public companies (listed on stock market exchanges). They generally have the higher interest rates among these three categories but also entail the greater risk. Interest is fully taxable.
• Municipal bonds. These are bonds issued by governmental agencies ranging from towns and cities to counties and states. Municipal bonds are “in the middle” of the three categories in terms of risk. Municipal bonds’ interest is generally free of federal taxes. Additionally, states and localities generally do not tax their own municipal bonds but different states may tax each other’s interest.
• Treasury bonds. These are issued by the federal government through the treasury department. Among the three general categories of bonds, this is considered the safest from a financial risk point of view. The interest is taxable at the federal level but tax-free at the state and local levels.
The bonds in all three categories are usually long term (up to 25 or 30 years) in maturity and the interest paid is typically fixed. If a bond paid, for example, 3 percent interest then that will be the interest amount for the life of the bond. A $10,000 bond maturing in 2040 and paying a stated nominal interest rate of 3 percent would pay $300 (usually in semiannual amounts of $150) every year for the life of the bond, and the bond-holder at the time of maturity would receive the full-face amount of $10,000.
The Bond Rating
Because risk and safety of principal is a primary consideration, bond investors should be very aware of the bond rating. The bond rating is where an independent agency analyzes the bond issued by that particular debtor on the basis of financial strength and the prospects of the principal and interest being paid as per the stipulations in the bond agreement. It boils down to whether this company or government agency has the financial wherewithal and credit worthiness now and in the foreseeable future, to pay the fill interest during the life of the bond and the principal on the date of maturity.
The bond rating is issued by independent bond rating agencies. The most prominent ones are Moody’s, Fitch Ratings, and Stand and Poor’s Global Ratings.
The highest quality (strongest) bond rating level is triple A (AAA) followed by AA and A. These levels are considered “investment grade” and are appropriate for conservative investors and those seeking reliable current income (such as retirees).
The levels go down to the Bs and Cs and lower. The lower you get, the more risk involved. Keep in mind that the rating directly affects the interest amount paid. The lower the rating, the higher the potential interest rates. There is a trade-off: you may get higher interest with lower-rated bonds but you will accordingly experience greater risk. And typically, you will be compensated for this greater risk with a greater return on your money or a greater interest rate for that particular security. So know full well that when you choose a triple A bond, corporate bond, and it’s giving you 3 percent and then you have the lower-rated bonds (or in some cases, unrated bonds), giving you 8 percent, these are not equal securities in terms of quality. If you are concerned about quality, and the ultimate payment of the principal and interest, then of course you would go for the safer securities as evidenced by the bond rating. But if you don’t mind taking on greater risk because you want greater income, then you may want to consider the lower-rated bonds but just understand what you’re stepping into. The potential for a corporation going out of business by the sheer dint of its structure as a private organization in the marketplace has greater risk involved with it, because it’s very rare that you see a municipality or the federal government, obviously, going out of business.
State and local governments and the federal government have the power of taxation. So they can have greater power to pay their liabilities or be able to back up their current and future debts through the mechanism of force, which is what taxation is all about. This in turn gives a greater level of safety. But, of course, that could also be abused.
There are many municipalities in the postpandemic period (circa 2021) that have seen their bond ratings decline due to the deterioration of their finances. Although taxation can be beneficial for municipal bond investors, the flip side is that if taxation becomes too burdensome, it will have a negative impact on municipal finance as taxpayers leave to go to more taxpayer-friendly jurisdictions.
In recent years, states such as California, New York, and Illinois have chased away individuals and businesses due to ever-increasing tax rates. This in turn meant less tax revenue coming in, which in turn meant lower bond ratings and subsequently greater risk for the investors of those specific securities. Meanwhile, low-tax states such as Texas, Florida, and Tennessee experienced a corresponding influx of new tax-paying individuals and businesses to their states which in turn strengthened their state’s financial prospects.
Keep in mind that when you are buying a bond, typically what will happen is that if you bought a bond, then you will typically receive semi-annual interest payments. So years ago, in the halcyon days of the 1980s and 1990s when interest rates were significantly higher, a retiree could easily gain adequate retirement income from municipal bond interest as they used their broker or financial adviser to structure a portfolio of bonds (or bond funds). So even though they are semi-annual payments, you can structure it so that you can typically get interest every month; you might find you might buy one or more bonds, whose interest payment comes say January 01 and July 01 during the course of the year. But then you can buy other bonds, hopefully with the same level of safety and reliability, where they are semi-annual issues; payments may be February 1, August 1, and so on. So this is what happened years ago and those days could return in the near future.
But what about today’s realities? In today’s realities, what corporate executives need to understand and what all of us need to understand is that the current economic conditions about the financial markets and the economy have a direct and significant bearing on the desirability of having bonds in your portfolio. Because we live in a period now of economic instability in the postpandemic years and you have more debt than ever before in all the major categories, there’s a significant quantity of debt out there, certainly in the trillions based on all the available data, but in addition, the interest rate environment is very low. And lastly, a great threat to bonds, again, is fixed-interest securities, which appear from inflation.
So, these three major conditions—excessive total debt, low interest rates, and the rising threat of inflation—make it very hazardous or at the very least a very dubious environment for owning long-term, fixed-interest debt securities, such as corporate, municipal, and treasury bonds. Inflation, for example, is an increasing concern. According to recent economic data in November 2021, the inflation rate surpassed 6 percent. And given that, when typical corporate bonds are earning in the neighborhood of 3 percent, now you’re seeing purchasing power risk. Now, the danger is that what happens to all the bondholders out there who are holding 3 percent debt, but they realize that we’re in a period where inflation is rising, and they are having diminished purchasing power with that particular bond they’re holding. And then you have to also realize that in many cases, rising inflation tends to force, sooner or later, interest rates to rise. So rising inflation and rising interest rates will be a just a double body slam to the value of the bonds in your portfolio. In that event, many bondholders will choose to sell their bonds which, in turn, mean that bond prices will drop and investors may experience losses in their portfolio.
These are the unique risk conditions that we face with debt securities (bonds) during 2022 and beyond. Corporate executives (and retired ones) need to minimize their exposure to (fixed-interest) debt. For retirees, fixed-interest rate bonds that are locked in at lower interest levels will mean the loss of purchasing power as the rate of inflation exceeds whatever interest rate they are getting paid.
Granted, 5 or 10 or 15 years from now, the picture for debt securities may be significantly different than it is today. Also, your bond income strategies will most likely change. But in today’s world, corporate executives who are still working should be avoiding bond (especially long-term, fixed-interest rate) securities and general debt securities by and large. But this is going to be an issue to analyze when the retirement years come along. And of course, during your retirement years, income securities, be they debt or stocks again, hopefully, are from a quality perspective that they will end up being a majority segment of your underlying asset portfolio because, at that point, we will be considering income. But now, let’s say that you’re a corporate executive today, and you are heading toward your remaining working years and you are hoping that within a year or two you want to start generating income as you either retire completely or possibly slow down your working pace (such as working part-time or working shorter days). Given everything I just wrote, don’t dismiss the power of bonds. There are different types of bonds available and there are some that can be appropriate in rising interest or rising inflation scenarios. So read on for the details in the next segment.
Bond Strategies for the Corporate Executive
So after giving you a tour of the major aspects of the world of bonds, let’s discuss some things that you should consider if you are going to make positive choices about adding bonds, again, debt securities to your portfolio. And let me just make three major points, which I think are going to be very important for your consideration. First, timing is everything when looking at the interest rate environment. If interest rates are high, perhaps high single-digit levels or possibly double digits (10 percent or higher), then buying fixed-interest bonds, such as treasury bonds or quality corporate bonds, is not a bad consideration because you’re locking in a good income stream. Secondly, and as long as you remember everything else, you want to focus on quality and choose bonds with ratings no lower than BBB. Lower than that, bonds are considered more speculative and very low rated bonds are derisively referred to as “junk bonds.” Thirdly, how you buy bonds matter as well—consider “laddering” your bond purchases. This means you don’t buy 100 percent of your bonds in one fell swoop and lock in a single rate. It is better to stagger the purchase and buy some now and some later to lock in various rates and maturities which can limit your risk. Having some bonds at 8 percent and others at 9 percent can serve you well and provide some diversification.
But what happens if, like in the year 2022, you’re talking about very low interest rates involved? Well, because of the conditions that could be hazardous—as I mentioned earlier, a low interest rate environment with the threat of inflation—long-term, fixed-interest rate bonds are really not a good consideration.
Adjustable Rate Considerations
Therefore, the best thing to consider if you are going to add bonds to your portfolio mix is to consider bonds that have an adjustable rate feature to them. They are certainly out there; just the way there are adjustable rate mortgages, there are adjustable rate investment bonds. And in this segment, I want to focus on at least two different types of bonds that are worth considering. They’re both issued by the U.S. Treasury. So, from a point of view of financial strength, again, they’re considered triple A and the highest reputation for quality in the world. But the bond that you want to consider to look at is the following. Number one, the “I bond.”
Now the I bond is, of course, a type of savings bond. And you could be able to purchase these for as little as $25. And what happens is that the interest rate that you will get will be between a fixed-interest rate at the time of purchase, but also a component, and interest will rise during periods of rising inflation as measured by the consumer price index. So, this is a way for you to have an adjustable rate mortgage issued by a triple A source, namely the federal government. So the I bond is a strong choice—and the fact that you can buy in a given year, an amount equal to a minimum of $25. And I’m talking about the electronic version; there’s also a paper version, but with the electronic version, you can make a purchase for as little as $25 at a minimum. And on top of that your maximum is 10,000 a year. In other words, the most you can bind given years is 10,000. All right. Now, that’s the I bond. And keep in mind that the interest is subject to federal income tax; however, it’s free from state and local taxes. And as an added feature, if you’re buying it for the purpose of financing education, then it’s possible at the time of purchase to see to it that this interest is tax-free as long as the interest is applied to the college tuition for yourself or a family member. All the treasury bonds mentioned in this section can be easily purchased through the Treasury Department’s “Treasury Direct” website at www.treasurydirect.gov (Figure 8.1).
Figure 8.1 Home page for Treasurydirect.gov
The site has full details and opening a Treasury Direct account is free and easy. The great thing is that making the bond purchase at this site is easy and there is usually no transaction fee or commission. Your initial purchase can be as low at $100 with some securities the minimum can be lower (such as with savings bonds for as little as $25).
The second investment that you may want to consider is TIPS which stands for “Treasury inflation protection securities.” TIPS can be bought for as little as $100. And the maximum is up to $5 million. So, you definitely have a range that is fine for most corporate executives. And when we talk about TIPs, they can be issued in terms of 5, 10, and 30 years. The great thing is that when they pay out the interest rate twice a year, it’s a fixed interest rate. But part of the interest will move with the inflation rate. As inflation rises, so does the interest payment to the bond-holder. And if inflation falls (such as in a period of disinflation or deflation), then your interest rates will head down. In inflationary times TIPS can be a solid addition to your portfolio.
You can buy TIPS directly from the federal government at Treasury Direct but you can also purchase them through many banks and broker firms (details at treasurydirect.gov). I like the adjustable rate feature to TIPS coupled with the strength of the federal government behind them. This helps to offset both financial risk and inflation or “purchasing power” with the same investment. Keep in mind that the Treasury has other securities, which are fixed in their interest rates, such as double EE savings bonds (details found at www.savingsbonds.gov). You can also acquire Treasury bills, Treasury notes, and Treasury bonds, which have a fixed interest rate but they have different timeframes. Treasury bills have maturities of under a year so they can be a suitable spot for your cash for short-term timeframes. Treasury notes are intermediate term up to 20 years while Treasury bonds are long term, that is, 20 to 30 years. Again, you can start buying these securities starting with as little as $100.
Again, as I mentioned earlier in this chapter, when interest rates are much higher and you want to be able to lock in a rate, it becomes a beneficial feature in terms of the fixed-interest aspects of it. So if you’re going to have bond securities in your portfolio, make sure again that they’re issued by the strongest issuers and in this case the federal government is triple A; make sure that if you’re going to be buying adjustable rate bonds with low interest rates, you don’t have the risk of being locked in at low rates. You want to have an adjustable rate feature to make it safer, especially when interest rates start to rise. And the fixed-interest rates will be better in separate environments down the road.
Main Takeaway Points
• Long-term, fixed-interest bonds can be a bad place for your investment money during a period of low interest and the near-term threat of rising interest rates along with rising inflation.
• When interest rates are rising, it is better to be in adjustable rate securities.
• If you have long-term, fixed-interest bonds, consider selling to avoid potential losses.
Resources
To get full details on the world of bonds, here are some resources:
• Investopedia (www.investopedia.com) has great information and tutorials on what bonds are and how to buy/see them.
• Savings bonds information (www.savingsbonds.gov)
• Buying Treasury securities (bonds, notes, etc.) at Treasury Direct (www.treasurydirect.gov).
• Learn about the bond market at Bond Buyer (www.bondbuyer.com).