The Bond Trap

Date of publication: February 2, 2020

First, I’ve been buying bonds in this low rate environment not because of sexy yields, as there are none, but to begin to allocate more appropriately from a heavy, but happy, equity exposure. Bonds may not be appropriate for everybody and there are significant risks associated with buying and owning bonds.

The bond “trap” for individual investors as I call it includes a number of risk factors. Yes, interest rate and credit risks are the primary concerns, as rates go up bond prices go down and defaults do happen. But other risks are top of mind as well.

To avoid the trap consider these other risks:

Knowing your bond. Its hard for non-professionals to be completely sure the bond they have bought or are considering buying has the risk profile that fits in their risk tolerance and investing goals. With one exception1, for each bond I have bought I’ve spent time reviewing the prospectus and in particular, the security and redemption provisions within those documents. I do still refer to the ratings provided by a Nationally Recognize Statistical Ratings Organization such as Moody’s, S&P, Fitch and Kroll but also like to understand the security provisions myself. The willingness for the issuer to pay their debt in full and on time is unmeasurable and “stuff” happens over time. “Stuff” being a broad term for unhappiness and pain for bondholders. For example, the bondholders (lenders) to a large utility in California that had a decent history of paying its obligations are currently having a miserable experience due in large part to environmental changes impacting that utility.

Position size. In this low rate environment, odd lots or bond positions of less than $100k can be expensive to buy and very expensive to sell. Markups by dealers can quickly erode the yield to be earned on a bond.  I’ve called this “transactional friction” in the past and believe this is even truer in today’s market environment. Efficient markets like equities and U.S. Treasury bonds have less transaction cost friction than corporate bonds and municipal bonds are, in general, less liquid than corporate bonds. The less liquid a bond is the higher transaction friction can be.

Liquidation risk. As mentioned above, selling a bond before maturity can have costs and those costs can be significant. Be wary of valuations of bonds in your account statement. For many bonds, those valuations may not be reflective of the price your bond might fetch when and if you decide to sell it. In most cases, the valuations you see in your account statement are for institutional size lots of bonds which can be significantly higher than what a retail size lot may be worth. Many of the investors I speak with have the mind set that they are buying a bond to hold it until maturity. A wonderful mindset to have. I encourage investors to incorporate liquidity risk into their thought process when considering individual bonds as life happens. You can get hit by a car or you can get married or divorced, become a grandfather or a new mother. So many things can change in your life over time. Being prepared like a boy scout to sell a bond before maturity is critical.

Avoiding the bond trap. If you are not willing and able to research, understand and buy individual bonds and sleep at night as a result, don’t. Bond allocations can easily and efficiently be obtained by buying mutual funds or low-cost exchange traded funds (ETFs).

Best practices from my perspective.

  • If you don’t have the time and ability to research individual bonds, and you still would prefer to own individual bonds, do so with an advisor who understands your whole financial picture, risk tolerance and investment objectives fully.
  • Check the bond prices/yields with the on-line data sets available such as for municipal bonds.
  • Review the prospectus and or official statement of that bond issue carefully. With one painful exception(1), I print out the cover page, maturity schedule, security redemption provisions of each bond I buy. I highlight the bond issue I bought and the provisions impacting that particular bond. I don’t need to print the entire document as those documents are readily available on-line.
  • Stick to the script. Set your objectives and risk tolerance. Review your objectives and risk tolerance periodically but stick to it. Collectors know this risk well as they can at times buy things that are related to their collection, somewhat related to their collection or not even close to their collection. The result is they end up with a disparate collection. Don’t let that happen to you with bonds, stay with the script.
  • Review your trade confirmation carefully.
  • Pay little attention to the values of bonds provided in your account statement. Alternatively, if you are really worried about the prices of the bonds you hold, I recommend periodically testing the market from time to time by offering bonds for sale to see the real value of your position(s). Note: your broker may not like this but it’s your money, not his or hers.

(1) My painful experience. I bought a bond issue while I was really busy going from conference to conference and in airport using my smart phone. I know the issuer well, the price and yield appeared right. But I went outside of my normal process, pulled the trigger and bought the bonds without reviewing the security provisions. No excuses, my fault entirely. I ended up with a bond I don’t want and had a hell of a time selling. Embarrassing and costly. Don’t fall into the bond trap.

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