Not All Bonds Are Created Equal

This week, Gail resumes her discussion on bond-investing strategy -- and reminds us not to assume that all bonds follow the same general rules.

Hi Gail,

I have a few thousand dollars in a high-yield bond fund that I've owned since late 1998. The fund did fairly well in 2002, although its overall performance since purchase has been nothing great. I know that bond funds take a big hit when interest rates rise. It seems likely that if interest rates go anywhere this year it will be up.

Should I get out of this fund now while its doing well, to avoid losing value this year?

Thanks,  Art

Dear Art -

One of the biggest mistakes investors make is to assume all bonds follow the same general rules. However, as a bond trader will tell you, debt instruments have as many nuances and complexities as stocks. In other words, not all bonds are created equal.

In the past three years, as nervous investors pulled out of the stock market, bonds have generally outperformed every other type of investment, racking up cumulative total returns of 30% or more over this period (source: Bloomberg). "Total return" includes both interest payments from the bonds plus any increase/decline in price. And because people perceive securities issued by the U.S. government to be the "safest" type of bond -- believing the government would never default on its debt -- that means the bonds most investors chose were U.S. Treasuries. In particular, Treasury bonds with 5 to 10-year maturities.

As with anything else, when demand increases for something in limited supply, it drives up the price. In fact, investors wanted these bonds so badly, they were willing to pay more than the bonds will be worth at maturity. That is, they paid a "premium" over and above the $1,000 "face value" of the bond.

Now here's where things get a bit complicated, so hang in here with me. One of the most important characteristics of a bond is its "yield." This is figured by dividing the interest income it pays each year by its price. A bond's annual interest is fixed. So, when demand for a certain bond pushes the price higher, its "yield" goes down. Conversely, when the price of a bond drops, its yield goes up.

To give you an idea of how strong demand has been for intermediate term Treasuries, consider this: on May 15, 2002, the yield on a 10-year Treasury was 5.25%. Today (May 2, 2003) it is 3.91% (source: Bloomberg). For a bond of this type, this represents a huge price move.

Strong demand isn't the only thing that affects a bond's price. As you point out, a change in interest rates can also have a positive or negative effect on the value of a bond by making it more or less desirable to own.

As a bond investor, it's important to understand that a bond's price typically moves in the opposite direction of interest rates. The reason is simple. Say, ten years ago you paid $1,000 for a bond that has an interest rate, or coupon, of 8%. This means it pays $80/year ($1,000 x 8%). Then, a couple of years later, interest rates go up and similar bonds are now paying 10% per year, or $100.

Clearly, the newer bond is more attractive because it pays a higher annual income. This means if you want to sell your old 8% bond, you've got to offer it at a lower price so that its yield will be equivalent to that of the newer bonds. In this case, you would have to drop the price from $1,000 to $800. ($80/$800 produces a yield of 10%.)

The opposite is true, as well. If interest rates go down, then the price of older bonds that carry higher coupons will go up. In the past three years, a combination of strong investor demand and falling interest rates resulted in dramatic gains in (some) bond prices. And since investors were particularly anxious to get their hands on "intermediate" term Treasury bonds (those with 5-10 year terms), these bonds have seen the biggest price increases.

Now, guess which bonds are likely to fall the hardest when interest rates eventually start to head higher? In fact, one bond guru told me, if interest rates go up by one percent (100 "basis points" in bond jargon), that would translate into a loss of 7% in the price of a 10-year Treasury. Even after counting the interest the bond pays, you would be left with a net loss. That's why a number of experts recommend avoiding this sector of the bond market right now.

However, not all bonds will decline in value when interest rates go up. In fact, high-yield bonds, such as those in your mutual fund, could very well see their prices increase.

High-yield or "junk" bonds get their name because they carry a lower credit rating (BB or lower) and offer a higher yield in return for more risk. This indicates that there is concern about the issuing company's ability to continue to pay the interest on its bonds. However, as the economy improves -- and everyone from Federal Reserve Board Chairman Alan Greenspan to most economists seems to think it will -- then business should also pick up for so-called junk bond issuers. Improving profits mean these companies should have an easier time paying their debt. As the risk of default diminishes, these bonds could see their ratings upgraded, which would cause their prices to go up.

I'm not surprised you think your fund had a lackluster run the past three years. High-yield bond funds didn't participate in the rally enjoyed by the much of the bond market. On average, high-yield mutual funds lost over 3% for this period (see footnote 1), far below the 33.88% posted by the Lehman Aggregate Bond Index, an unmanaged index used as a general measure of U.S. fixed income performance, for the 3 years ended April 30, 2003.

That's because the economic slowdown increased the chance that a company that issued high-yield debt might default. As a result, these bonds declined in price while others increased. However, starting last fall, we began to see signs that the economy was doing better. As a result, high-yield bonds started to go up in value.

Warren Buffett jumped on the high yield bandwagon back in March, buying more than $8 billion worth of high-yield bonds. So far this year, high- yield bonds are outperforming every other asset class, with a year-to-date total return of over 11%.( see footnote 2)

The fact that high-yield bonds have already enjoyed a significant return means an expected economic recovery is already somewhat built into their prices. As a result, much of the gain could be behind us. Nevertheless,these bonds are still yielding around 9.5% (source: Wall Street Journal, 5/1/03). With 1-year CDs paying less than 2% and 10-year treasury bonds yielding less than 5% as of May 2, 2003 (source: Bloomberg), 9.5% is darn attractive.

But don't forget that there's a reason these bonds have their lower ratings. In my opinion, the average investor should NEVER buy individual high-yield bonds. You're much better off in a diversified portfolio that's managed by professionals who understand and closely monitor the companies in this sector of the market.

Another thing, don't load up your portfolio with high-yield debt just because you like the yields these bonds are currently paying. Make sure you are diversified across the fixed income spectrum, which includes U.S. Treasuries, mortgage-backed, foreign, and high-grade corporates or municipal bonds, depending upon your tax bracket.

Or, consider investing in a broad, multi-sector mutual fund with the latitude to invest across the bond universe. This approach allows the fund managers to adjust maturities, credit ratings, and market sectors in order to take advantage of the best opportunities available.

Hope this helps,

Gail

1 Source: Lipper, Inc. For the 3 years ended 3/31/03, the average cumulative return for Lipper's High Current Yield Fund category was -3.87%.

2 Based on results for the JP Morgan (formerly Chase) Global High Yield Index, an unmanaged index that is designed to mirror the investable universe of the U.S. dollar global high yield corporate debt market, including domestic and international issues. It returned 11.89% year-to-date as of 4/30/03.

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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.