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Investing in Fixed Income Securities

John Wiley & Sons

Chapter One

RECENT RISE IN POPULARITY OF BONDS

When the stock market was soaring through the 1980s and 1990s, bonds were frequently ignored as an investment alternative. However, in recent years, investors, rocked by falling equity prices, a shaky economy, and a series of corporate scandals, flocked to fixed income securities in droves. Some were attracted to the relative safety of income and principal; others were looking for a higher or more stable potential return in a period of declining equity prices; still others were merely looking for a safe haven until the storm in equities blew over. While the market turmoil in equities has at least temporarily subsided for now, many investors have learned a valuable lesson: Fixed income securities should be an integral part of virtually everyone's portfolio. For most investors, bonds should represent an essential segment of one's financial pyramid. (See Figure 1.1.)

Despite the increased popularity of bonds, there are still many advantages of debt instruments that are overlooked by investors. Some brokers and financial planners argue that bonds and other debt instruments don't have the potential for capital gain usually associated with equities. As a result, many investors are uneasy about the bond market. In fact, bonds and other debt instruments offer investors an effectiveand secure way to build a nest egg for retirement. Furthermore, bonds can help people gain financial independence without causing them to accept more risk than is necessary or that they can comfortably tolerate.

The purpose of this book is to give you an understanding of the risks and rewards of including fixed income securities in your investment portfolio. This book will help you:

* Take an active role in managing risk in your fixed income portfolio.

* Apply various valuation methods to a variety of fixed income instruments.

* Learn essential bond market concepts and terminology.

* Learn how to maximize after-tax earnings.

* Utilize economic statistics to forecast the direction of interest rates.

* Gain a better understanding of the primary debt instruments.

DEBT VERSUS EQUITY

Understanding how fixed income investments are best incorporated into your portfolio strategy requires knowing the basic differences between debt instruments (bonds) and equities (stocks). Simply stated, a debt instrument is a contractual or legal obligation of the issuer to pay you, the bondholder-investor, a predetermined rate of interest over the life of the security and, even more important, to repay the principal at the maturity date. Equities are not obligations of the issuer; rather they are ownership interests, which increase and decrease in value based on the issuer's business success or failure. Bond interest payments are contractual periodic payments, unlike stock dividends, which are paid when and if the company so chooses. As bond payments are legal obligations, any failure to meet those obligations can have dire financial consequences for the issuer. If a corporate borrower failed to meet scheduled interest or principal payments, such a default could potentially force the borrower into bankruptcy. Credit defaults resulting in a bankruptcy are not frequent occurrences. However, if a company were to go bankrupt, bondholders are at the top of the list of creditors who must be paid from corporate assets. (Secured creditors are first, unsecured creditors next, then preferred shareholders, and then equity holders, if there is anything left). (See Figure 1.2.) Dividend payments made to common stockholders may be made only after the issuer has satisfied its obligations to pay bondholders and preferred stockholders.

Key Characteristics of Bonds versus Stock

* Certain debt instruments, especially some corporate bonds and municipal revenue bonds, are often structured around covenants (maintenance of liquidity, debt, or revenue ratios). These covenants are rules by which a borrower must operate, thereby providing the primary level of protection to the bondholder, as compliance with a bond's covenants assures that there will be sufficient revenue to pay bondholders their interest and principal when due.

* Equity securities represent an ownership interest in a company. Payments of dividends are at the discretion and direction of the board of directors and the company's management rather than an obligatory payment required under a bond resolution or indenture.

* Bond prices are determined by the market, taking into account the issuer's credit ratings, the coupon payment rate, term to maturity, and market yields on other fixed income securities.

* Equity share prices reflect the perceived or expected value of the company's current and future earnings potential.

The scheduled automatic conversion of your bond investment into cash, no later than the maturity date, is an important distinction between debt and equities. As an investor, you can tailor bond maturities in your debt portfolio to meet your future cash needs as well as to achieve a balance between the risks and rewards offered by shorter-term cyclical trend and longer-term trend changes in market interest rates. As equities are perpetual securities, converting stocks to cash requires selling the shares at whatever the market will pay. Also, the risk of loss through corporate bankruptcy is substantially higher with equities than with debt instruments because, as stated earlier, the claim of debt holders on a company's assets is superior to that of equity holders in a bankruptcy. That may be one reason why, through much of our financial history, the market has generally demanded a higher dividend yield on equities than the yield on corporate bonds, though that is far from the case today. The fundamental truth is that, if chosen wisely, corporate bonds are inherently a safer investment than equities. And there is no counterpart in the equity markets to the inherent investment safety available with government debt, especially with U.S. Treasuries. Debt instruments, offer investors greater certainty of cash flow and security of principal than you have with most equity investments.

CHARACTERISTICS OF FIXED INCOME SECURITIES

The world of fixed income securities is diverse in many respects. In order to maximize the investment value of fixed income securities in your portfolio, it is necessary to understand the characteristics of these types of investments.

When you're considering investing in fixed income securities, you should first evaluate your income tax bracket, credit risk tolerance, market risk tolerance, and liquidity needs so that you can establish the right portfolio game plan.

Tax Bracket

Your tax status is one of the most important factors to consider in structuring a fixed income portfolio. Knowing your federal, state, and local tax brackets and whether you are subject to the Alternative Minimum Tax is necessary to assure that your investment choices will provide the maximum after-tax return. As many bonds enjoy some form of tax exemption or preferred treatment, which we examine in greater detail in later chapters, your tax status as well as the tax treatment of the account that you are investing for is central to maximizing the yield of your bond portfolio.

Municipal bonds are debt instruments whose interest payments are exempt from income taxes. The exemption from federal income taxes is based on the Doctrine of Reciprocal Immunity, initially established by the Supreme Court in 1895, which determined that the federal government and state and local governments shall not impose personal income taxes on the interest payments on debt instruments of each other. Therefore interest income received on municipal investments is not subject to federal taxation. Also, interest paid on U.S. Treasury debt instruments is exempt from state and local income taxes. In the vast majority of cases, states do not tax the interest income generated by bonds issued within that state or by any of its political subdivisions. In addition, the interest income received on debt issued by Puerto Rico, as well as Guam and other territories of the United States, is also generally exempt from state and local, as well as federal income taxes (each state has its own statutes with respect to local tax treatment of tax-exempt interest income).

Interest income may also be deferred from taxation, depending on the type of account in which the income is generated. To make this point more clearly, if you hold taxable fixed income securities, such as Treasuries, agencies, or corporates, in an individual retirement account (IRA), 401(k), or Keogh plan or similar tax-deferred account, income generated is taxed when the funds are withdrawn, rather than when earned. This will allow you to defer taxation to a period in the future (i.e., when you may be retiring and are presumably in a lower tax bracket).

Market Risk

Market risk is influenced by credit, maturity, and economic factors. The longer the term of the security, the greater the market risk, since there is more uncertainty as you invest farther out on the yield curve. Investors who want to make a market play, betting on falling long-term rates for example, could buy 20-year low coupon bonds, in the hope of capturing significant price appreciation as interest rates declined. Conversely, if you anticipate a rising interest rate period, you might buy shorter-term bonds, or bonds with a variable rate structure, such as auction rate securities or variable rate demand bonds (Chapter 8), to ride the rate rise. Investors wishing to minimize market risk could ladder their bond maturities, thereby creating a shorter overall average maturity yet capturing some additional yield from longer-term securities. Laddering a portfolio means buying bonds that mature over a range of time-short-term, medium-term, and long-term. For example, an investor could consider purchasing an equal amount of bonds due in 3, 5, 7, and 10 years, resulting in an average maturity of 6.25 years. This portfolio would have less market risk and a lower average yield than a portfolio made up exclusively of 10-year bonds.

Short-term debt obligations include those securities that mature or must be repaid in full relatively soon. Short-term securities have maturities that can be as short as one day, or maturities of weeks or months, but usually less than two years. Securities maturing within one year are often referred to as money market securities. These securities include commercial paper, Treasury bills (T-bills), repurchase agreements, certificates of deposit, Eurodollar deposits, variable rate demand bonds, and auction rate securities.

Fixed income securities may contain a call option, or an option for the issuer to redeem the obligation prior to maturity. Some bonds which contain embedded call options include a call premium, similar to a prepayment penalty, so the investor receives some compensation for being taken out of the investment earlier than the original term, presumably when interest rates are lower than at the time of purchase. On those bonds that are callable, the period prior to the call date is known as the no-call period. Redemption premiums may be stated as percentage over par, such as 102 percent (par plus 2 percent), or may be stated in the form of a formula usually referred to as a "make-whole" premium. The latter is more typical in the corporate bond market, whereas the simple premium concept is typical in the municipal bond and Treasury markets. Callable bonds tend to be slightly higher yielding than noncallable bonds due to the risk the investor takes in being called out of the investment prior to maturity. The benefit of the call feature to the issuer is the ability to redeem the issue if rates fall, enabling the issuer to refinance the debt at a lower rate.

Certain securities, especially variable rate securities, carry a put option, which entitles the bondholder to tender the securities at par, or a predetermined price, under certain circumstances. This is the structure that gives variable rate demand bonds their appeal in that the holder has the option to tender, or put, the bonds back to the issuer or trustee at any time with a certain number of days' notice, typically one to seven days. Some corporate-backed bonds carry a longer-term put option as well. The put option can work like this: Suppose you purchased a seven-year bond with a five-year put at 5 percent, and it is now five years later. Rates for similar investments are now at 6 percent, so you would be inclined to tender your bond and purchase the new bond at 6 percent. In another case, say the issuer of the bond was rated AA at the time of purchase and has now been downgraded to A. If you have a put option that is current, or active, you might put the bond and reinvest in another AA security. In both of these cases, you would receive 100 percent of the par amount with a par put instead of having to sell the bond, probably at a price less than par. This feature does provide added potential value, so put option bonds will generally be priced at a lower yield than a bond without a put option.

Liquidity

An investor's liquidity needs is another important consideration in assembling a portfolio of fixed income securities. What are your cash needs now and in the future? Will you have any particular obligations to fund over the next several years? What are your current and future income needs? When do you expect to retire? Investing in fixed income securities means tying up cash for a determined amount of time. By identifying specific cash needs in the future, you will be able to better time your bond maturities to meet those needs.

Credit Quality

Credit characteristics of fixed income securities are not homogeneous in structure or market performance. Any given investment grade corporate bond will have certain credit attributes that may cause it to have greater or lesser security than a similarly rated corporate bond, and may trade quite differently in the market due to factors unrelated to interest rates as a whole. For example, a secured single-A utility bond will tend to trade parallel to Treasuries, but an unsecured single-A telecommunications company bond may deviate from the fixed income market as a whole due to market concerns about the telecom industry. While credit ratings are an important diagnostic tool to help investors assess the risk and value of a bond, additional due diligence is required.

The credit market as a whole is divided into six segments determined by the type of debt issuer. These segments include (1) the U.S. Treasury market, (2) the U.S. government agency (GSE) market, (3) the state and local government debt market (municipal bonds and notes), (4) the U.S. corporate debt market, (5) the mortgage-backed and asset-backed markets, and (6) the foreign debt market. Each of these issuers of debt sells a wide range of debt obligations with varying maturities, from overnight to long-term, which in some cases may be as long as 100 years.

With the exception of U.S. Treasury obligations, issuers may issue debt that varies in credit quality. The difference in credit quality will depend on such factors as whether the debt has a first or subordinate claim on specific assets; what those assets are, if any; and how soon the debt must be repaid. Corporations, for example, can issue unsecured debt backed by the parent company or by an operating subsidiary. These are termed debentures, secured only by the general credit of the issuer. The corporation can also issue debt backed by a lien on, or a pledge of, specific assets. Assets that can be used as backing or collateral for the debt include real estate, equipment, credit card debt, car loans, and the like.

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Excerpted from Investing in Fixed Income Securities by Gary Strumeyer Excerpted by permission.
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