Monday, December 27, 2010

Bonding With Bonds: Value and Risk

In my previous article about bonds, I introduced to the concept of a bond:  what it is, how it works, and some of the different flavors of bonds.  In this article, I will delve into my original question of whether or not bonds are truly the risk-free investment that some people think they are.  Before I get to that, I want to discuss how bonds are valued as this is central to understanding why bonds may not be completely risk free.

If you remember, a bond is just a loan.  I loan you some money in return for a piece of paper which says that you will pay me back at some future date.  How is the deal actually structured?  Let's take a simple example of a one year zero coupon bond.  This bond agrees to pay the person who holds the bond $100 one year from now.  If I am selling the bond to you, how much would you agree to pay me in return for a promise to receive $100 one year from now?  Maybe you will pay me $100 today for the promise of $100 a year from now.  In that case, you are earning 0% interest on your money.  You are giving me $100 now, and I am giving you back $100 a year from now.  Considering that you can probably earn at least some interest just by depositing your money in the bank, nobody would take this deal.

Most likely you would want to pay me something less than $100 for this bond.  Let's say that we strike a deal where you will pay me $97 for this bond.  At this price, you will be earning about 3.1% interest on the transaction ($3 gain divided by $97 investment equals 0.0309 or 3.1%).  Now we're talking!  In this example, 3.1% is the bond's yield, which is the annual interest rate that the buyer of the bond earns.  Note that because the bond is a one year bond, the calculation is simplified somewhat.  If this had been a two year bond, we would have to take the 3.1% (the interest earned over two years) and annualize it by taking the square root.  Generally speaking the yield on a bond that doesn't have coupon payments is:

i = nth root (F / P) - 1

i = annual yield
F = bond face amount
P = bond price
n = length of the bond in years

If the bond were a two year bond, solving for i would produce an annual yield of 0.0153 or 1.53%.

There are a couple of points to take away from this example.  First, there is a rule of thumb when it comes to bonds:

The lower the price, the higher the yield.

The example makes this pretty obvious.  The less money that you pay for the bond, the more interest you will earn on your money.  Just to hammer home the point, let's say that you bought the bond for $95 instead of $97, now you've earned 5.2% on your money.  You've invested $95 and earned $5.

Second, when a government or corporate issues a bond, it is up to the buyer to set the price of the bond.  Obviously, the seller would love to maximize the selling price, because this means that they get to borrow more money, and they have to pay back less interest.  On the other hand, the buyer would love to minimize the selling price.  They arrive at the price through simple economics:  supply and demand.

Let's say that I offer the bond not just to you, but to anybody willing to buy the bond.  You might offer me $97, but if somebody else comes along and offers me $98, I am going to sell the bond to that person and not you.  Generally, there are two factors that determine the price of a bond:

1. The interest rate that you can earn on the next best alternative.

2. The creditworthiness of the person selling the bond.

If you remember the example, we saw that nobody would be willing to pay $100 for a $100 bond that matures in one year because then you aren't earning anything on your money.  You would be more likely to put your money into a savings account, since you'll get a better return.  Let's say that a savings account would earn you 0.5%.  If that's the case, then you would want to buy the bond for a price that would earn you at least a 0.5% return.

The second factor is just as important to the price of a bond.  If there is a chance that the person issuing the bond is going to renege on the deal, you are not going to pay as much for their bonds.  This is because there is a chance that you will get nothing when the bond matures.  U.S. Government bonds generally seen as being safe because the United States has never failed to pay when a bond matures.  On the other hand, there are plenty of other governments and corporations which have failed to pay because of bad finances.  One notable example is Argentina, which defaulted on its bonds in 2002.  If a lender feels that you are a bad credit risk, they will demand a higher yield on the bond to compensate for the additional risk.

During the height of the financial crisis, people clamored to buy bonds, especially U.S. Government bonds.  Prior to the crisis, real estate investments were all the rage.  It seemed as if you could put money in property and earn a guaranteed 10%, 15%, or even 20%.  However, when that bubble burst, Government bonds were seen as a safe haven from the volatility of real estate and the stock market.  This flight to safety drove up the price of U.S issued bonds.  As a result, yields on these bonds fell.  People were willing to accept small returns because the return was guaranteed and safe. 

This brings us to the central question of whether or not bonds truly are risk free.  The answer, of course, is no.  So what are the risks of holding a bond?

The first risk obviously is the risk that the issuer is going to default.  If that happens, you might get something from the bankruptcy court, but then again you might get nothing.  That is the ultimate doomsday scenario.  To buy an investment and get nothing in return is the worse thing that could happen.  The good news is that some bonds are safer than others.  As I mentioned before, U.S. bonds are considered to be among the safest.  The perception is that only a disaster of biblical proportions would cause the United States to default on its bonds.  In addition, corporations on strong financial footing also are considered to be pretty safe.  However, that perception has changed with the recent economic crisis.  Some companies are such a bad credit risk that their bonds are considered to be very risky.  These bonds are called high-yield bonds because investors demand such a low price for buying them.  Some people refer to them as junk bonds for obvious reasons.

There is a second risk which is not quite as apparent:  interest rate risk.  This is the risk that interest rates rise after you purchase the bond.  To illustrate this risk, let's revisit our example.  Let's say that you decided to buy the one year zero coupon bond for $97 for a yield of 3.1%.  Now let's say that the next day some event occurs which causes people to demand a higher yield on this type of bond.  Instead of accepting 3.1% for this type of bond, people demand to earn 5%.  You are now stuck with an investment that only earns 3.1%.  You have two choices:

1. You can continue to hold onto the bond for the next year and earn 3.1% on your original investment.

2. You can resell the bond you bought yesterday to another willing buyer and use the proceeds to buy another bond at 5%.

Let's say that you decide to pursue option #2.  In order to entice a willing buyer, you will have to sell them the bond at a price which will yield the buyer at least 5%.  Otherwise, the buyer will just buy a similar bond from somebody else.  In order to yield 5%, you would have to sell the bond for $95.24.  This means that you would be losing $1.76 on the bond.  This a percentage loss of -1.81%!  Because interest rates rose, your bond has become less valuable.

Let's say that you decide just to hold onto your bond until maturity.  Now you are earning a return of 3.1% for the next year which still isn't that bad, right?  Maybe, maybe not.  It is possible that interest rates on this type of bond rose because inflation jumped higher, in which case your after inflation return might be negative.  It is possible that the risk of default has gone up because of some external event, in which case you aren't being compensated for the additional risk.  It is possible that six months from now you will need to sell your bond in order to pay some bill, in which case you will sell for a loss.  In any case, earning less than market returns for an investment is never a good thing.

As you can see, interest rates affect the price of a bond in an inverse fashion.  There are a couple other facts to consider that affect the magnitude of the interest rate risk:

- The longer the maturity of the bond, the more the price of the bond moves in response to a change in interest rates.

- Bonds which have a coupon payment feature are less affected by a change in interest rates than a zero coupon bond.

When you buy a bond, you essentially are locking in an investment at a particular interest rate.  If you have a one year bond, you can always wait one year until maturity, take your payment, and reinvest at a higher rate.  However, with a 30 year bond, you have to wait 30 years before you can reinvest at a higher rate.  Therefore, when rates rise, a 30 year bond's price will fall more than a one year bond's price.

Likewise, a bond that has coupon payments will allow you to reinvest the periodic payments at a higher rate of interest.  If a bond doesn't have any coupons, you cannot reinvest your money until the final maturity date.  Thus, a zero coupon bond's price is affected more than a coupon bond by a change in interest rates.

The bottom line is that bond prices fluctuate just like stock prices.  If interest rates rise, the value of the bond falls, and you lose money.  To say that any bond is risk-free is wrong, plain and simple.

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