Until very recently (2018), bond brokers were not required to disclose the markup that they are charging for the bonds they sell to their clients. Even today, while the markup is disclosed on trade confirmations, brokers often dance around the explanation if questioned. Markups for typical bond transactions that originate from a bond broker range from 1-3%. Of course, the price for anything is only expensive in the absence of value. Value is defined differently for different people, but for me, value is defined as appropriate return for the risk taken, and cost should be factored into the return.
With bonds, people often get caught up in the “coupon” rate that the bond pays. For example, a municipal bond may pay an annual coupon rate of 5% which is the amount of interest that is received annually and paid generally on a semi-annual basis. But the price of the bond is also important and the rating of the bond, especially if the bond will not be held to maturity. Why? Because if the price of the bond goes down, and you need to liquidate the bond, you will take a loss.
Here are some common pitfalls to understand when purchasing bonds:
- If interest rates go up, then the value (or price) of your bond decreases. Why? Because bonds that pay a higher interest rate will be much more attractive to a buyer. There will be a lot less demand to purchase your bond if you wanted to sell, so the value of your bond goes down and you need to sell your bond (or it matures during a time like this), you will take a loss.
- Credit Quality of the bond issuer. Often a bond broker will sell bonds that are “Not Rated.” What does that mean? That means that we have no idea what the credit quality is of the issuer for that bond. The bond could be issued from a municipality that is not as solvent as you would like (think of the example of Detroit municipal bonds).
- Even if the bondholder does not default, when there is economic stress, lower quality bonds experience much more price volatility.For example, in 2008, lower quality corporate bonds experienced stock-like volatility with a 20-30% decline in price, and lower quality municipal bonds saw a decline of 10-15%. If the bonds are supposed to be your conservative asset class that balance out the stock portion of your portfolio, guess again! You are holding bonds that are highly correlated to the stock market with stock market risk, but that pay you less than stock-like returns. In other words, the return you are getting for the risk you are taking is not favorable. For investors looking to increase portfolio returns, taking on too much credit risk is not the optimal solution. Instead, consider increasing the overall allocation to equities.
- Your bonds are callable. What does this mean? The bond issuer will have a date on the bond that states that they are free to “call” the bonds, forcing you to sell them, on or after a certain date if they “call” them. At that time, the bond issuer will assess whether to exercise this right. The issuer has all the power. If interest rates have risen, they will very likely not call their bonds. If rates drop, your bonds will likely be called, and then you have “reinvestment risk,” as you embark on trying to find another suitable investment in a lower interest rate environment. If the bonds have a lower credit quality or are Not Rated, and interest rates have declined in an environment with some economic stress, they may not be called, but the price may very likely have declined.
- If your bonds have dropped in value within an environment of economic stress with stock market declines as described above, your entire portfolio has taken a much larger impact than a portfolio that holds high quality bonds which typically see price increases in a stock market decline. With high quality bonds whose prices increase when stock market prices decline, you can rebalance your portfolio (buy low and sell high back to the original asset allocation). If you have low credit quality bonds, you are forced to wait with a high impact to your portfolio.
- If you are buying bonds from a broker, you will want to understand the operation behind the scenes. A broker will purchase bonds to place in their “inventory,” that will be sold to a later customer. Then, those bonds are marked up and sold. Often, the bonds that are sold to the customer may not be the best of what is out there. A fiduciary who is putting together a bond portfolio for you will shop around for you, look at everything, and will never mark up a bond, because they can’t. A good rule of thumb: do not hold more than 35% of your bonds from a single state and no more than 10% of a portfolio from a single issuer.