Money markets (MM) are a form of very short term high quality securities such as Treasury bills, CDs, and commercial paper. They are valued at one dollar per share and are considered safe. Know that there is no FDIC backing on most of these instruments. However, it is possible to buy government bond MMs that have government backing. Consider using them to hold cash for either short term plans, or as a one year supply of cash held for safety.
Bond rating system There are several bond rating companies in business. S&P and Moodys are most recognized but they all do the same basic thing. They are telling us how safe they think the bonds are that are issued by individual corporations, and foreign governments. Each has a different letter/number system but they all work pretty much the same way. Levels vary from very safe to very risky. The safer the rating, the lower the rate of interest companies must pay to sell the bonds they are issuing. We will use the S&P rating system to introduce how they do that.
AAA is considered safest. This is how US Government bonds are rated as are some municipal and corporate bonds. Often, a corporation or municipality will buy insurance on its bonds to raise the rating to AAA in order to pay a lower interest rate. Theoretically, there is no risk of principal.
AA is next in the pecking order. They are obviously considered a little less secure, but still very safe.
A is somewhat more susceptible to adverse effects of financial changes but is still considered a very strong obligation.
BBB is also considered safe, but it is the lowest ranking in the category for bonds, some times called 'bank grade', which are rated as safe. 'Bank grade' comes from regulations that require banks and savings and loans to invest our money into 'safe' bonds. Banks can make a higher return on these bonds than they are paying out in savings accounts and CDs.
BB is next in the rating system and has 'adequate' protection parameters. But there is more doubt about the ability of the borrower to repay the loan. This rating may apply to a small company which is doing fine but may not have the resources to repay the bond several times over which is part of the rating criteria.
B reflects an increasing risk but currently has the capacity to repay the debt, even though there is a real possibility of default. The rate of yield return has become higher with each lower rating. Do you want to make 10 percent with risk or 5 percent and feel safer?
CCC and below to D have more and more questions about repayment and bankruptcy may be in the offing. But remember K-Mart?
AAA bonds, in theory, have no risk of loss of principal so there is no additional interest rate reward for the possible risk of loss. If there is a possibility of loss by default in your bond investment, you deserve to be paid for that risk, therefore the borrowing company must pay a higher rate to compensate you for that risk. See how that concept of fear and greed works?
The division between BBB and BB also brings forth another name for bonds. Above the line, BBB and up are as we said are 'bank grade' and known as "investment grade bonds". Below this imaginary line we move into 'junk bonds' or high-yield bonds. There are many mutual funds that specialize in the different categories of bonds. Within those choices are lots of pros and cons to consider. But, if you own a whole basket of junk bonds, for example, only a few may actually go bad so your risk is mitigated and they typically, are less effected by increasing inflation and pay a higher interest rate. They are more volatile.
Maturity is the date that the bond is redeemed. Generally two principles apply, the longer the time to maturity, the greater the rate of return, other things being equal. The longer maturity adds to the volatility in the value of the bond. Why? Because there is more time involved, more bad things can happen.
Bond traders are a nervous lot. Here is one mental picture for you to work with: Starting with a teeter- totter, let's put Alan Greenspan or the new Chairman and the Federal Reserve on one end (these are the guys that set the discount rate). On the other end put the 30 year maturities where you get the best up and down ride, in other words, volatility. As the maturities shorten, you start working your way towards the middle of the teeter-totter. When you get to 90 days, you are right next to the fulcrum and you experience almost no price volatility, but also a lower return.
What can happen? Why is it considered safer to have shorter maturities? One thing is called interest rate risk, if interest rates go up and you already own this bond that has a low rate of return and a maturity date sometime in the distant future, the selling price of your bond will fall. Bummer! Shorter returns mitigate this risk, because you have a shorter holding period until your investment matures and you are refunded the price of the bond. Example:
You buy a bond for $1,000 with a stated return of 4% and a 10 year maturity. Note that bonds traditionally trade in $1,000 units. It is normal for a minimum trade to be of at least 10 bonds, 10 bonds would represent a $10,000 investment. On the day you made the purchase, it was a good buy and you can now anticipate a return of $40 a year for 10 years (paid $20 twice a year). You are essentially locked into this rate, but there is an ongoing market in bonds so there is always someone out there who would buy your bond from you, but what would they offer? If interest rates go up and the 10 year bond is now being sold with a yield of 5%, that bond will pay out $50 a year until maturity, which is $10 more than you are getting. Now, who would give you par (the issue price of the bond) when they can spend their $1,000 on a bond paying 50 bucks? Obviously, not even your mother. So you can hold the bond and keep getting your $40 a year for ten years, or you can sell it at a 'discount'. This price of your bond is adjusted downward to reflect a comparable return to the new 5% bond. If however interest rates should go down, your bond would trade at a 'premium' equal to something more than the $1,000 you paid for it.
When bonds are priced the system uses the following: A $1,000 bond is said to be at 100. A $1010 bond is said to be at 101.
Inflation is the most diabolical problem. Your rate of return must exceed the rate of inflation and your tax rate for you to be able to make a nominal return. Here is how it might work:
Bank CD return for one year on $10,000 is 5% or $500
Inflation (purchasing power loss) 3.5% (350)
Federal tax @ 25% marginal rate (125)
State tax @ 7% (17.5)
How did we do? We lost $10 in purchasing power. Know your numbers!
Exchange rates, just like interest rate risks, can be your friend. If you have invested in the European Union and the EURO goes up in value relative to the dollar, you make the specified interest rate plus a little extra when the EURO exchanges to dollars. Of course, it could move the other way and you lose on the exchange. Be aware that most mutual funds 'hedge' the foreign bond which means they buy protection against the exchange rate. Which would you want? Know what you are getting.
We need to cover one more concept in bond purchasing before we conclude. Bonds are also rated with a priority within one issuer, because a company may have several separate issues out on the market at any given time. Therefore they must rate them as 'senior', meaning the first to be repaid, and 'junior' meaning to be repaid after the senior is repaid. You should know where your bond ranks in this hierarchy.
Conclusion
What percentage of your portfolio should be in bonds? Conventional wisdom often reflects a 60/40 split between stock and bonds, with stocks being 60 percent. As you approach retirement this conventional wisdom increases the bond percentage. In our opinion, this is not necessarily the right approach. Our life expectancy at retirement age is 20 years or more, and when you consider two people it is even longer. CFP planning articles are now suggesting that we should plan for young people to live more than 100 years. A respectable conservative stock portfolio along with bonds will help you keep up with inflation for that extended life expectancy. More on this topic will appear in our "focus" articles.
Note that we are not saying "no bonds", but keep in mind inflation and taxes. It also might be smart to keep bond investments in your retirement account which is sheltered from taxes until withdrawn. It was once thought that you should keep stocks in your IRA and bonds outside, but with the capital gains laws changing, that is no longer considered to be true. Bonds in an IRA can be traded free of taxes for stock if the time seems right. Bonds can be a great buy under certain circumstances. We had a client who back in the 70's, when inflation was out of control, bought 30 year Treasuries with the longest maturity he could get and received a 15% return for years. Not only that, if he had needed to sell them at some point, he would have enjoyed a large capital gain.
Remember that income tax is a factor when comparing tax free munis and taxable bonds. The following table can help you decide which is best for you. Taxable in an IRA, tax free out.
