A Bond Primer

Robert T. Hennes

We are often asked by our clients how we can generate more income from their bond portfolios. The question is not surprising given current painfully low interest rates. Before I answer this question, let’s review briefly why we own bonds at all in a balanced investment portfolio. Sure, we like the income, which is especially miserly in the current environment, but there is a more important reason. The bonds are in your portfolio to protect your principal by softening the blow from lower stock prices in your portfolio during times of economic contraction. Now let me address a couple bond issues that come up frequently.

  1. Higher income is only earned by taking more risk. There is no “free lunch”. There are two principle ways to increase risk, and therefore generate more income. First, we could buy bonds with longer maturities. Generally, investors demand a higher interest rate to invest for a longer periods of time. The longer the period, the higher the interest rate. This makes sense. Wouldn’t you want a higher interest rate to commit to a fixed interest rate for a long period of time?A second way to increase income is to buy bonds with lower credit ratings. Bonds are rated according to their safety; that is, the likelihood that you will get your principal back at maturity. A company with a low credit rating must attract investors with a higher interest rate.Neither the risk from a longer maturity nor credit quality risk is black or white. There are gradations and middle ground. It is our job to find the right mix of maturity and credit quality, and because our philosophy is not to take too much risk with your bond portfolio, we are conservative in striking the balance.
  2. We don’t always buy bonds at the time they are issued (“the primary market”). We often buy them in the secondary market at prices either higher or lower than their face value. The stated interest rate on a bond (the “coupon rate”) does not necessarily equate to the amount of income (“the yield” or return) you will earn for holding that bond. Older bonds with higher coupon rates than new current bonds do make larger interest payments. But the purchase price for these bonds is above the face value that will be paid at maturity. They “trade at a premium” as the saying goes. The resulting loss (purchase prices less the maturity price) will reduce and offset the higher coupon rate received. The result will be that the return for the premium bond will be about equivalent to the return for the lower coupon current new bond.

As we said above, “There’s no free lunch.” The high coupon seems great, but it gets offset because the price of the bond declines as it approaches maturity.

After dispelling the notion that one can somehow “beat the market” by buying bonds with higher interest rates, the key decision comes down to a simple trade off: risk versus safety/stability. We take safety very seriously in our client balanced portfolios because we are driven to protect your principal. However, no two investors are alike, and we stand ready to talk to you about reasonable risks that will raise income without taking on more risk than you are comfortable with or significantly compromising the important “windward anchor” purpose of your bonds.

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