To fight inflation, the Federal Reserve has been raising interest rates in what’s referred to as a tightening cycle. Rates have climbed steadily by 75 basis points (3/4 of 1%) until the most recent Federal Open Market Committee meeting when the tightening was reduced to 50 basis points or a ½ of 1% increase. The cycle will go on until the Fed believes that interest rates are high enough to cool down inflation in the economy back to its former target of 2% annually. It’s not clear how long the tightening cycle will continue, but evidence is beginning to appear that inflation is starting to cool down. As it continues to cool, interest rates should hold steady for a time to insure that inflation doesn’t re-ignite anywhere. This is not good news for consumers and borrowers, but it could be good news for bond investors. Higher interest rates are already turning up in the corporate bond markets, and the time to buy may be coming soon.
Price: Bond prices are referred to in terms of percentages with par being 100 (or 100%). If a bond is paying a higher rate of interest, the price could be bid up to 105, 110, or 120. The price is a major component of the yield and prices are bid upon in the market place like stock prices. The investor is paying a premium by investing in bonds with a price higher than par, therefore caution is warranted. Prices that fall below par can be an indicator of a decline in the credit worthiness of the issuer.
Yield To Maturity: If you bought a 6% bond at par and held it to maturity, it would have a yield of 6%. But seldom will good bonds be sold at par—the price will typically be bid up by other bond investors. Therefore, the yield (what the bond pays you in interest on your investment in the bond) is always based upon the fixed interest amount divided by the price actually paid for the bonds including any premium. The interest rate of a bond will never change, but the yield will change as the value of the bond changes thereby creating a statistic known as the current yield. The current yield is what yield the bond has to any investor at any point in time. However, if you buy bonds with the intent of holding them to maturity, then the yield at the time of purchase will be what your bonds will yield. For over a decade corporate bond yields have been very low as market rates of interest have been held down by the Federal Reserve. Now that interest rates are rising to fight inflation, bond yields are also rising making them better investments.
Credit Rating: Moody’s, Standard and Poor’s, and Fitch’s all rate bonds as to their issuer’s credit worthiness. This is significant because many investors follow these ratings carefully, and that can affect the value of the bond. However, some fundamental analysis of the corporate bond issuer will provide most of the information that the investor needs. The issuers balance sheet will show how much debt it has versus equity. The ratios of debt to equity will vary widely, but a high degree of debt will show that the bond borrower has already taken on a big debt responsibility and therefore has a weaker credit worthiness. Any bond rating below investment grade (BBB-) is not recommendable for the average private investor. To take advantage of higher yields, a good high-yield bond fund would be advisable, as an experienced manager would be making the decisions.
Callable?: Callable bonds have a provision for the issuer to call in the bond at a certain price when the issuer so desires. When interest rates rise, corporate bonds are more likely to be callable as the issuer would want to reserve the right to call in the bonds before maturity to reissue them when interest rates are lower. Very often this callable provision will be “make whole,” whereby the issuer will pay a price at or very near the current price of the bond at the time the bonds are called. This feature is important as it protects most of the premium the bond has earned. As interest rates currently are going up, the risk of bonds being called is reduced; and if par is the call price, the value of the bond will have this priced in.
Bond Ladder: A good portfolio will not have all the bond investments maturing at the same time. The investor does not know for sure what the market rate of interest will be when the bonds mature. A recommended strategy is to have all the bonds mature at different times thereby creating a ladder of maturity dates. The value of the bond typically will revert to par the closer the bond gets to its maturity date. When bonds mature, they will only return the par value. The investor runs the risk of having large portions of the bonds mature at once with interest rates low, thereby diminishing future returns when they are rolled over.
Coupon Frequency: Most bonds pay semiannually, but some pay quarterly, annually or even monthly depending on the bond’s covenants. The interest is earned on a daily basis and gets paid to the investor up to date whenever the bond is sold. Similarly, when buying bonds the investor buys interest that is accrued from the last pay date to the date of purchase. A good bond ladder will also stagger the interest payout dates to create a more even monthly cash flow.
Risks: Corporate bonds have two major risks: risk of default by the issuer, and risk of an unfavorable change in interest rates. The investor must keep in mind that in the final analysis the purchase of a bond means that the investor is making a loan to the issuer. Laws and market place standards and protocols apply, but in the event of default by the issuer, the investor will face certain losses upon liquidation.
Conclusion: The ideal parameters for the above paradigm that I try to use when making a bond purchase are as follows: Price: about 103-107; Interest rate: 5-7%; Yield: 6-6.5%; Credit rating: never below BBB-; Callable: always make whole call; Coupon frequency: semiannually; Debt to equity ratio: no worse than 3 to 1; Maturity: long-term, at least 10 years. However, a great deal of good bonds might be acquired with less favorable parameters than these.