Tips for Buying Bonds in Volatile Market Conditions

(Today’s guest post come to you from David Rosenstrock, who is a certified financial planner with an MBA and the Founder of Wharton Wealth Planning, LLC.)

Today’s economic and geopolitical conditions make it particularly important to safeguard your future. Because the risk of job loss is generally less economically sensitive and lower for a physician than that of many other professionals, more investment risk can generally be assumed and benefitted from over the long term. But it must be smart, calculated risk. That usually means being broadly diversified, so both bonds and stocks should have a role in the asset allocation of your portfolio investments. 

Bonds can include government, corporate, municipal, high-yield, and asset-backed bonds. There are generally no one-size-fits all answers in financial planning and there can be many shades of grey.  An individual’s circumstances will dictate what the correct course of action will be and what percentage of your portfolio bonds should comprise.

To simplify things a little, the relationship between bonds and stocks is generally inverse. They move in the opposite direction. This means that when bond prices increase, stock prices decrease; and vice versa. So, one role of bonds in your portfolio in addition to providing income is to smooth out and reduce the volatility of your portfolio.  

Are bonds for everyone?

There are many investment strategies available, from aggressive to conservative.  It’s important to find the right balance between safety and growth when assessing the role bonds, stocks, and other investments should play in your portfolio. Safety (such as investing in bonds and fixed income) often comes at the price of reduced return potential and erosion of value due to inflation. On the other hand, if you invest too heavily in growth investments (certain equity categories and strategies), you may be taking unnecessary risk.  Safety at the expense of growth can be a critical mistake for those trying to build an adequate retirement funding strategy. Choosing the wrong investment strategy is a common mistake that people fail to monitor correctly.  

It is important to note that there are categories of bonds that will fare better in an inflationary environment (like the environment we are currently in) than others. This includes floating rate debt (or debt instruments whose interest payments fluctuate with an underlying rate) and TIPS (or treasury inflation protected securities).  In general, investing heavily in bonds in an historically low interest rate environment with high inflation can prove to be a losing strategy (we’ve seen this over the last 10 years as interest rates went to historical lows after the financial crisis).  Since bond price levels typically have an inverse relationship with interest rates, rising inflation – and the higher interest rates it causes can make bond prices fall. Both bond funds and individual bonds can provide an additional stream of income in a portfolio, with less risk than individual stocks or stock mutual funds.

Generally, those who are younger are advised to invest more aggressively, tapering to more secure investments, such as bonds, as they grow older. As you near retirement and once you retire, you’ll have to rely on your accumulated assets for income. To ensure a consistent and reliable flow of income for the rest of your lifetime, you must provide some safety for your principal. It’s common for individuals approaching retirement to shift a portion of their investment portfolio to more secure income-producing investments, like bonds.

For some people, it can be better to accept lower returns so that they don’t lose sleep over the impact shorter term market moves can have on their savings.  There’s no one size or style of investing that will fit all. 

Factors investors should consider about bonds

There are many elements that investors should consider in assessing a bond issuers creditworthiness and whether a bond is right for their portfolio, including: credit rating (from credit agencies such as Moody’s, Standard & Poor’s, or Fitch), maturity, call structure (i.e. when can the bond be called and subject buyer to reinvestment risk), interest yield (including yield to maturity and yield to call), issuer sector (industry), credit metrics such as leverage ratio (Debt/EBITDA) and interest coverage (EBITDA/Interest Expense), liquidity (or current cash holdings of the issuer), the issuers management team (reputation and experience), and general industry and economic conditions. It may also be helpful to assess if the bond is trading at a premium or discount to par value.

Factors that should be considered in deciding if bonds are a good choice for one’s portfolio, include the purchasers, an investors personal circumstances, as well as his or her risk tolerance and risk capacity. Because everyone has a different situation you should determine what’s best for you based on your age, goals, life expectancy, liquidity, income, and other retirement/investment accounts. In general, over long periods of time, investors will make higher returns in diversified equity strategies versus bonds but this will come at the cost of increased volatility and ‘mark to market’ risk. 

Bonds are generally considered a conservative investment that can be suitable for individuals that have a low risk tolerance.  Many things can influence your risk tolerance: your age and stage of life, your personality, your overall financial goals, as well as your previous investing experiences.

Risk tolerance reflects the amount of risk that you want to take and involves your emotions as well. This involves how you’ll react emotionally when the value of your investment fluctuates.

Risk capacity reflects the amount of risk that you can take mathematically based on your financial situation and still reach your goals. So, it is how much risk you’re financially able to accept and how a change in your investment value will impact you.

Risk capacity and risk tolerance need to be considered together when assessing a bond strategy and bond allocation percentage.  Although you may have the financial capacity to deal with significant ups and downs in certain investments, you still need to consider if taking on that risk is going to cause you anxiety or have other negative effects on your sleep.

Buying new issue bonds vs. secondary market bonds

New bond issues are sold in the primary market. In a new issue, most of the terms are set, including the initial price and interest rate, and the bonds are sold to investors, with the issuer receiving the proceeds from the sale of the securities.

A secondary market transaction is a transaction between two investors, a buyer and a seller, and does not involve the issuer. Secondary market transactions typically involve a brokerage firm which acts either as an intermediary between the buyer and seller, or as a buyer or seller itself. Market conditions, such as prevailing interest rates, supply and demand, and credit quality, among other variables, determine the price in the secondary market (which may differ from the original new issue price).

Bonds that are just issued, especially in the municipal-bond arena, may often offer better pricing and yields, as well as potential ‘discounts’.

The secondary market for bonds is largely an over-the-counter (OTC) market where prices aren’t seen by all participants at the same time. It will be dependent on the broker-dealer network to get the best price if you are trading in the secondary market.

Bond funds vs. individual bonds

Just as you can invest in individual stocks or ETFs when investing in the stock market, you have a choice between individual bonds and bond funds when investing in bonds. When you buy and sell individual bonds, you will have to pay a spread, similar to a markup or mark-down. When you buy a bond fund, you will have to pay an annual management fee, known as an expense ratio. When you purchase a bond fund, you may also have to pay a transaction fee and there may also be a redemption fee when you sell your investment in the fund. 

There are many advantages to investing in bond mutual funds or ETFs including simplified diversification, lower minimum investment requirements, professional fund management, improved tax efficiency, and low expense ratios.

One large disadvantage of investing in bond mutual funds is the predictability of returns. If a bond fund declines in value you could lose money if you sell it for less than what you paid for it. Investment turnover in actively managed mutual funds can lead to short term and long-term capital gains.  Mutual funds may have significant embedded gains and in some instances you can pay taxes for economic gains you never realized based on the timing of your purchase and the structure of the mutual funds.

Investing in individual bonds also carries some advantages including reduced market risk (when bonds are held to maturity), lower risk of default (for higher rated bonds), consistent income from interest, and the ability to decide which bonds to invest in (including terms such as maturity, credit rating, issuer industry, etc.). 

If interest rates are rising, then individual bonds and bond ladders could be a good strategy, since bond prices are dropping while yields are on the rise.  A bond ladder strategy, or buying a portfolio of bonds with different maturities that are spread out, will often allow you to take better advantage of a rising interest rate environment. As shorter date bonds mature you can reinvest the proceeds in higher yielding bonds and capture higher interest rates.

Investing in individual bonds does, however, have some additional risks as well. For example, it’s important to understand the correlation between interest rates and bond prices and yields so you’re not buying or selling at the wrong time. 

Your credit exposure is generally higher when you invest in individual bonds since a greater portion of your portfolio is invested in just one or a few different bonds. When you invest in bonds, one of the biggest risks is that the issuing company or government will default. When you invest in a bond fund, your portfolio is often spread across dozens or hundreds of different bonds. If one issuer defaults, it will have less of a significant impact on your overall portfolio.

When you diversify with individual bonds, the burden of choosing bonds lies with the investor, rather than a fund manager. You may need to spend time researching different bond options to decide which ones are the best fit for your portfolio. In addition, you may need to invest larger amounts than you would with a bond fund to achieve the same level of diversification when choosing individual bonds.

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