The big rise in interest rates made bonds much more popular than they were during the years of near-zero interest rates. However, investors’ knowledge of how bonds work may not have improved very much. Perhaps this is because evaluating bonds properly often requires quite a bit of math, or because investors don’t often hear much about how stocks and bonds face different risks and tax rules. Here are three basic rules for investors who want to wade into the land of individual bonds.
1. Equity funds behave like an individual stock, but bond funds behave nothing like an individual bond.
Investors are familiar with equity mutual funds, which behave similarly to individual equities, but often think that bond mutual funds have a similar correspondence with individual bonds when in fact they do not.
A bond represents a debt security issued by a single issuer, such as a corporation or government entity. It has a fixed maturity date and pays a set interest rate (”coupons”) until then. The market price of a bond may fluctuate with interest rates, but those fluctuations decrease considerably as the bond approaches maturity. And those fluctuations are ultimately irrelevant for a bond buyer who keeps the bond until maturity, since there is no uncertainty as to what he or she will receive throughout the life of the bond (unless the company who issued the bond defaults).
On the other hand, a bond fund (a mutual fund, ETF or closed-end fund) is a collection of individual bonds managed by an investment company. Its value fluctuates with interest rates. Bond funds typically pay dividends, which can vary over time, rather than coupons, which are almost always fixed. They don’t have a set maturity, so their value never converges to a final value as an individual bond does. In fact, bond funds can be thought of assets that move inversely to interest rates (see graph). An investor may have to wait a very long time to just receive back the initial investment if interest rates rise too much above where the fund was initially purchased.
The practical implication of this is that investors may think that they can lower the volatility of their portfolios with bond funds, when in fact they may end up with even higher volatility. Choosing individual bonds and holding them to maturity is often a better way to lower the volatility of a portfolio.
2. The rate of return that you will get from a bond is very likely to be lower than its stated yield to maturity.
Yield to maturity (YTM) is a widely-used metric that represents the total expected return of a bond purchased at a certain price and held until its maturity date. However, the YTM calculation has several assumptions, and a crucial one is that all coupon payments received over the life of the bond will be reinvested at the same rate as the bond’s YTM, which is highly unlikely.
For example, an investor that buys a bond with a $10,000 face value typically receives the bond coupons in installments of a few hundred dollars each, well below the minimum amount usually required to purchase a bond through a broker. This means that the income generated by the bond will often be left uninvested, drastically reducing the bond’s actual return, or used to buy a money-market fund with lower rates than bonds, or simply withdrawn from the account.
Not reinvesting coupons or reinvesting it a rate lower than the bond’s original YTM has real investment implications, such as selecting the wrong bond.
Consider two 10-year bonds, one with a 6% coupon selling at par (i.e. at a price of $1,000 per $1,000 of face value) and a YTM of 6%, and another selling at $720 with a 2% coupon (a YTM of 5.7%). Many investors may think that the first bond is the better one because it has a higher YTM, but if coupons are not reinvested the return on the first bond will turn out to be 4.8%, compared to a much better 5.2% for the second bond (I will spare you the math). This makes sense, because the lower coupon of the latter means that the bond’s return depend much less on the rate at which the coupons are reinvested.
A practical implication is that investors who are unlikely to reinvest coupons efficiently may want to choose shorter-maturity or lower-coupon bonds.
3. Generally speaking, bonds should be held in tax-deferred accounts instead of taxable accounts
Bond coupons are subject to taxation at income tax rates each time they are paid to investors. But dividends are usually taxed at a lower rate than ordinary income, provided that the stock was held for 60 days or more within the 121-day period centered on the ex-dividend date. As a result, bonds are generally more tax-efficient in tax-deferred accounts, whereas dividend-paying stocks may be more appropriate for taxable accounts.
Moreover, any realized gain in stocks held more than one year in taxable accounts is taxed at the capital gains tax rate. However, withdrawals from tax-deferred accounts are always taxed at the investor’s income tax rate, which for most investors is higher than the capital gains rate. Therefore, holding stocks in taxable accounts and bonds in tax-deferred accounts may allow investors to keep more of their money (see example).
Taxation is a complex issue that involves numerous variables, such as the projected difference between marginal income tax rates before and after retirement. Also, while some investors prioritize maximizing returns, others may want to maximize current income. Therefore, the discussion above is only a general guideline for investors; they should always consult their tax professionals for advice that makes sense to their personal situation.
Nonetheless, the central point remains valid: Bonds and stocks are two different investment animals, and many investors overlook these distinctions.
Another issue is that many financial professionals are often knowledgeable about the stock market, but may lack the same level of proficiency in the mathematical complexities of bonds. Consequently, they might rely on professional bond mutual fund managers to handle their clients’ fixed-income allocations, which does nothing to resolve the issue addressed in the first point.
A practical solution to this problem is to select a financial advisor who genuinely understands how to analyze bonds and offer meaningful help to tackle these challenges.
Read the full article here