“I’m not so much interested in the return on my money as I am the return of my money.” - Will Rogers
Last month’s letter discussed stocks. This month’s letter focuses on bonds, the typical counterpart to stocks in a balanced investment portfolio. If you agree with the above sentiment from Will Rogers, then you may find bonds of interest.
Think of bonds as loans or IOUs; one party is the lender (creditor), the other party is the borrower (debtor). The sum of money to be borrowed is decided, interest payments are scheduled, and a maturity date for the principal established. All mathematical and straightforward. However, some considerations:
- Credit Risk - The interest payment is typically based on the creditworthiness of the borrower. For example, if Uncle Sam owes you money, you can be confident the loan will be repaid. There is no credit risk. On the other hand, if your Cousin Jethro owes you money, perhaps the confidence level is a bit lower. To compensate for this risk, Cousin Jethro is required to pay a higher rate of interest since his credit risk is not zero. If folks have doubts about Cousin Jethro making good on his debt, his loan would probably be labeled ‘below investment grade’. The people on Wall Street name this type of debt ‘high yield’, to put a little lipstick on the pig.
- Price and Interest Rate Risk – If you own a fixed-income investment that pays 3% till maturity, and a few years down the road interest rates have risen to 6%, well, your 3% IOU is just not as attractive to a potential buyer. If you need to sell it, you will have to sell at a lower price to offer the new owner a 6% yield. In other words, you will lose money. However, if you hold the investment until maturity, and assuming the issuer doesn’t default, you will receive the full face value.
- Liquidity Risk – Most of the time markets function, and bonds trade in a timely manner. However, sometimes they don’t. During times of stress, sellers come out in numbers, and the buyers sit on their hands until the prices are discounted excessively. This phenomenon relates primarily to lower quality bonds, not U.S Treasuries.
If you find all this boring, and decide bonds are not for you, that’s fine. However, if you have an interest in stocks, you should still keep an eye on the bond market for the following reasons:
- The total US bond market is larger than the US stock market. The opinions of bond market participants matter.
- Bonds compete for dollars. When bond yields are greater than stock yields, people notice, and the dollars flow accordingly.
- The bond markets reflect expectations of future economic growth. When yields are high or rising, that has historically corresponded with economic growth. When yields are low or falling, that implies that economic growth may be questionable, which in turn raises concerns about corporate earnings.
Happy May Day. Get out on a patio and enjoy the weather!
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Any opinions are those of James Aldendifer and not necessarily those of RJFS or Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Investing involves risk and you may incur a profit or loss regardless of strategy selected.
Dividends are not guaranteed and must be authorized by the company’s board of directors.
