In my last post I wrote about about my desire to move my investment dollars to corporate bonds because of the deflationary period in which we currently find ourselves. For the sake of clarity, and for the gold bugs out there who believe we will be entering, or are presently in, a period of high inflation, let me say that – I agree! Well, which is it you ask? I believe it is, or will prove to be, both.
With regard to deflation, housing prices are still depressed, wages are still depressed and people (a vast majority of them anyway) are depressed and not spending money like they used to (i.e. consumer spending is down). As far as inflation is concerned, oil and fuel prices are still high, food prices are elevated and rising daily because of the drought conditions in the Midwest; plus, the costs of everyday living expenses (e.g. electricity, toilet paper etc.) are climbing. Thus, it would seem, that we currently find ourselves in an economic phenomenon most economists refer to as stagflation.
With stagflation, the economy does not grow (i.e. it stagnates) while the prices of those things consumers use most (think fuel, food, health care products etc.) rise. It is one of the most difficult economic dilemmas facing governments and central bankers. On one hand, if government officials attempt to fight inflation they end up killing any remaining growth in the economy; and, on the other hand, if they attempt to kick start the economy, they end-up fueling inflation – it’s a lose-lose scenario.
Fortunately, though, as with every other difficult situation that we have been dealt throughout the history of our collective existence, we will eventually get through these challenging times as well. Interestingly, on a recent NBC Evening News broadcast, there was a story about the Saturday Evening Post going digital. In the piece, Jeff Nilsson, one of the Archivist in charge of converting the print editions to digital, said: “If you think this country is teetering on the edge, you can come back here and read this and, after a couple of issues, you realize we’ve been through it before.”
So, this too shall pass, but what can we do in the meantime? Ultimately, the best way to survive and prosper during periods of uncertainty, in my humble opinion, is through a sensible and well thought-out approach. Investors will need to be very cognizant of their personal situations, their risk tolerance levels and the various opportunities that will present themselves. In other words, be patient, be smart and, most importantly, do your homework.
Okay, so where to begin once the decision is made to invest in corporate bonds? Well, the first place one will need to start is with his or her wallet; that is, how much disposable income is there to comfortably invest. Patience is a virtue and, when investing in bonds, it is a virtue than can be tested time and again. Given that, in many cases, bonds will need to be held until the maturity date in order to reap the benefits they offer, having the ability to invest funds that will not be needed in the short-term is critical.
Virtually all corporate bonds that trade on the secondary market (which is where individual investors can purchase them) have a par, or face, value of some denomination (many are $1,000.00). Depending on various conditions (e.g. current interest rates, company ratings and demand – or lack thereof ) bond prices will vary. A bond that trades at par trades for the face value of the bond. Bonds that fetch a premium sell for a price greater than the face value; and bonds that trade at a discount will trade at a price somewhere below the face value of the bond. If, for example, a particular bond is trading for a price of 108.989, it means that the bond is trading for 1.08989% of the face value ($1,000.00 in this case) of the bond or $1,089.89 per bond (1.08989 x 1,000.00 = 1,089.89). This figure represents an $89.89 premium for each bond purchased. If, on the other hand, the bond is trading for 99.515 per bond, then the bond would trade for a $4.85 discount per each bond with a par value of 1,000.00 (.99515 x 1,000.00 = 995.15).
When bonds mature, the original face value (provided the company does not go bankrupt) is returned to the investor. Because of this fact, there will be a capital loss on the bond when it matures if a premium was paid for the bond. This does not mean, however, that the bondholder will lose money over the life of the bond. The main reason a prospective buyer would be willing to pay a premium for a bond he or she wishes to purchase is because the Yield to Maturity (YTM) is greater than any other investment instrument (e.g. equities or a 10-year Treasury bond) that could be purchased at the same time and he or she is willing to hold the bond until the maturity date. This is where the “patience” part comes into play. Though, like any other investment, a bond can be sold at a later date for more than the price at which is was purchased, for retail investors the chances are greater that the bond will need to be held until maturity in order to make (and, more importantly, not lose) money.
RATINGS
There are three main ratings agencies that evaluate and grade the financial strength of corporations. They are: Standard & Poor’s (S&P), Fitch and Moody’s Investors Service or, simply, Moody’s. The agencies use a graduated alphabetic scale to rank corporate bonds based on the issuing company’s financial strengths (or weaknesses); and, though the reliability of the ratings agencies came into question following the recent housing collapse in the U.S., they are still the number one source for information on a a company’s financial stability. In my own, personal, opinion the embarrassment the agencies suffered following the housing collapse served individual investors well, given that the agencies appear to have sharpened their focus. If the agencies were to experience (at least in the near future) similar embarrassing episodes, it’s doubtful they would be able to continue as going concerns in their present form. Thus, I believe, they are going to do everything within their power to ensure they never again lead investors astray. For those interested in more information regarding how the ratings system works, a wealth of information can be found here.
MATURITIES
Bonds sold on the secondary market are offered in a wide variety of maturities ranging from one to thirty years. The time frame an investor chooses will depend on several factors, most of which revolve around a person’s time horizon (i.e. age, when he or she expects to be repaid, future interest rate change expectations etc.). With this last aspect in mind, one of the most common strategies utilized by bond investors is a technique known as laddering. With laddering, an investor will purchase bonds with varying maturities. As the bonds mature, the investor can then take the proceeds and invest them in other bonds with future maturities. With this method, investors reduce interest rate risks, given that funds become available for reinvestment at regular intervals.
PERSONAL PREFERENCE
When searching for bonds I will confine my search to investment grade bonds with a maturities ranging from five to twenty years, and with a YTM ranging from 2.5% to 4.0%. Essentially, I have been working to build a bond ladder that spans the time between now and when my young daughter will be entering college. The best yields, or YTMs, I have found, thus far, range from 2.996% to 4.50%, with maturities ranging from three to seventeen years. When performing my screens, I will enter ratings ranging from a high of AAA/Aaa (S&P & Fitch/Moody’s) to a low of A- (S&P & Fitch) or A3 (Moody’s). These grades represent “Prime” to “Upper medium grade” bonds and, though I could seek bonds with “B” ratings and still be within the “Investment Grade” category, at this point in time I only want to invest in the best companies I can find when it comes to buying individual corporate bonds.
Indeed, these are some very challenging times for investors but, the good news is that, there are measure that can be taken to preserve and build wealth. Individual investors should consider the benefits of adding bonds to their portfolios. Not only do they offer a steady stream of income, they dramatically reduce the volatility that comes with strictly investing in equities; and, though they may not be as exciting as owning equities, they offer something that many people may feel much more important at this point in time – stability!
