Dec 23, 2022
Bond Series 3
Losing Strategy #1: Dealing with Uncreditworthy Borrowers
The underlying premise for a lending arrangement is that you expect to get your money back. Thankfully, we have credit ratings issued by rating agencies, such as Moody’s and Standard & Poor’s (S&P), to help make informed decisions. The credit rating is akin to your FICO credit score: if you have bad credit, no loan for you. In a properly functioning market, poor credit means no loan, or else a loan at a punitive interest rate.
However, in a world of ravage risk-taking, unscrupulous investors are willing to dole out cash to speculative borrowers, known as “Junk” bonds, without requiring much in return via higher interest rates or lender provisions that provide a backstop when things go south. We’ve seen it repeatedly, greedy investors line up like pigs for the slaughter. If you like losing money, get in line. We focus primarily on building a portfolio with an average credit rating that is considered investment grade. It doesn’t mean you won’t have surprises, but these bonds historically hold up better when the economy weakens.
Losing Strategy #2: Selling a Bond at an Inopportune Time
As we have written, bonds do fluctuate in value after the purchase date. This is called “paper” gains and losses and it is a function of the constantly changing interest rate environment and the general supply and demand for bonds. Just like the stock market, the whims of “Mr. Market” can change quickly from positive to negative sentiment. So, a bond that you bought with a 5% yield-to-maturity (or the “estimated” total return), could be more or less attractive the next day depending on what mood investors are in and which direction they think rates will go. The temporary or paper losses would become permanent losses if the bond investor decided to sell on a day when the market is offering a lower price than the price at which it was bought – sometimes this happens out of necessity, but often selling early can be the result of fear or greed. Ultimately, however, if you hold the bond to maturity (or an earlier call date), you are going to get the anticipated rate of return that was calculated at the purchase date.
A quick technical note – we would be remiss not to mention the “opportunity” cost of owning fixed-rate bonds. Assuming you hold a bond to maturity or call date, it is true that you are giving up the opportunity for a higher return if rates go up; and therefore, you “could have” bought a higher rate bond if you had just waited until the right time. This is just a form of hindsight bias, and the reality is that we must build the best bond portfolio possible at the time the money is available for investment. However, our approach is to build bond portfolios that may have varying maturities/calls so you as an investor can benefit from rising rates by being able to reinvest principal repayments at the new higher rates.
This is certainly not an all-encompassing list of bond investment risks. There are other considerations such as liquidity risk, foreign currency risk, and frictional costs. Our goal is to inform, not to supply melatonin-releasing literature. Therefore, we will spare you…for now.
What we want you to take away from this is that stoking “general” fear about bonds that catches media attention, but the reality is that holding high-quality bonds to maturity (or call) will essentially give you the return that you expected when you purchased it.
While the “paper” value of the bond portfolio can bounce around during the holding period, it is fair to assume that you will have a positive net return, through interest payments and the eventual return of principal (as long as the bond doesn’t default).
While we simplify the nature of this topic of discussion, at NPF Investment Advisors, we stay diligent in selecting and monitoring bond investments for client portfolios; and when we lose comfort in a holding, we don’t hesitate to walk away when that is the safest choice. If you want to talk more about how NPF can help you with your bond investments, please call us.
Learn more in Part 4 of our bond series: Why We Prefer Individual Bonds.