The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (43 page)

STRIPS are another kind of zero-coupon bond. Back when bonds were issued on paper, they would literally have their coupons “stripped” by brokers before sale. An example of this type of bond is U.S. Treasury STRIPS, which are not sold by the Treasury itself but through private brokers. The bond is separated from its coupon payments and sold by itself at a discount. As a result, taxes on reinvested interest are not an issue with these bonds. The difference between the amount paid on the market and received at maturity represents a capital gain.

The market value of zero-coupon bonds tends to be subject to more volatility than that of regular bonds. Be careful about purchasing zero-coupon bonds if you’re not planning on holding them until maturity.

TIPS are designed to keep the bondholder’s investment current based on inflation. TIPS come with fixed-interest payments just like other Treasurys, but the principal amount is adjusted twice a year, according to the current Consumer Price Index (CPI). For example, if you invested $10,000 in TIPS at a rate of 0.5 percent, you would continue to receive that 0.5 percent annual interest until maturity, but you might be earning 0.5 percent interest on $10,500 or $11,000 at some point, depending on current inflation.

The fixed rate of TIPS tends to be relatively low, and in fact we have even seen it effectively drop below zero recently. When fear of inflation is up, many investors are willing to take a small hit now in order to protect themselves from inflation later. (This doesn’t mean that bondholders will get a bill when the coupon payments are due. What happened is that bidders agreed to pay a small premium for these bonds at auction, and the premium effectively canceled out the even smaller coupon payments at the current rate and then some.) If inflation rises significantly, the par value of these bonds goes up and a bondholder can come out ahead. We will discuss inflation and its effect on bonds a little later.

Unlike other Treasury securities, U.S. savings bonds are not exchanged on the open market. They are tied to the bondholder’s Social Security number (or tax identification number), which means no one but the bondholder can redeem them. Savings bonds can be purchased in many different denominations ($25 and up), which, along with the fact that they can be owned by minors, has made them a favorite investment tool for parents and grandparents to give to children, often to save for education.

Savings bonds are zero-coupon bonds, so both principal and interest are paid in one sum when the bond is redeemed. Interest is accrued regularly, and the current value of any given savings bond can be calculated at
www.treasurydirect.gov
, though there is a small penalty if you redeem before five years have passed since issue. Current savings bonds offered are the Series EE (formerly Series E) and Series I bonds.

Series EE bonds have a maturity of 20 years, but continue to earn interest for another 10 years after maturity. Formerly, the interest rate on Series EE bonds was adjusted based on current rates, but bonds issued after April 2005 earn a fixed rate. Patriot bonds are a paper version of the Series EE bond. As of January 2012, these bonds (along with all paper Treasurys) are no longer available.

Series I bonds are savings bonds that are linked to inflation, much like TIPS. Series I bonds come with two different interest rates: a fixed rate that doesn’t change over the course of the bond’s term, and a variable rate that is adjusted twice a year based on the CPI. The adjustable rate might be negative during times of deflation, but the combined rate of the bond cannot fall below zero percent.

Mortgage-backed securities include those issued by government-sponsored agencies Ginnie Mae (Government National Mortgage Association), Fannie Mae (Federal National Mortgage Association), and Freddie Mac (Federal Home Loan Mortgage Corporation), as well as some securities issued by private corporations. Ginnie Maes are unique among the group in being backed by the full faith and credit of the federal government, just like Treasury securities.

Mortgage-backed securities are issued using a pool of home mortgages as collateral. Because most mortgages are paid monthly, most of these securities pay interest monthly as well. Because mortgage loan principal is prepaid in various ways and at various times (such as extra payments or paying it off all at once), the time to maturity varies widely.

Municipal bonds, or
munis
, are issued by state and local governments to finance new projects or to improve infrastructure. Munis have the advantage that interest paid is exempt from federal taxes, and in some cases from income taxes in the state in which the bonds are issued.

There are two principal types of municipal bonds.
General obligation
bonds are backed by the full faith and credit of the issuing government, based on its ability to raise revenue through taxes.
Revenue
bonds are backed by revenue to be raised from the specific project the bonds are funding—for example, if the bonds are being used to finance the building of a toll road or an airport.

The tax advantage is generally the key attraction for these bonds. The higher taxes you normally pay, the more attractive munis become. The way to assess the value of a tax-exempt interest rate is to calculate its
taxable-equivalent yield
. The formula is to take the yield of the tax-exempt bond and divide by 1 minus your tax bracket percentage. For a bond exempt from state taxes, you would combine federal and state tax percentages in the calculation.

Private corporations also issue bonds in order to finance and/or expand their business operations. Many companies that issue corporate bonds also have shares traded in public stock markets. But owning a corporate bond is very different than owning a share of a company.

When you buy stock in a company, you are buying ownership in the company, and the value of the share will rise or fall in accordance with the company’s market value. You might receive dividends from company earnings, but this is not at all guaranteed (especially if the company has no earnings), and dividend payments can be very low compared to the stock price. But when you purchase a corporate bond, you are making a loan to the company, which has an obligation to return your principal and make interest payments. If the company’s fortunes rise, you will still get only the amount that was agreed to in advance. You might lose your investment if the company goes bankrupt, but as a creditor you will be ahead of shareholders (even preferred shareholders) in line to receive money in a bankruptcy settlement. So while purchasing bonds has a speculative element to it, it is not nearly as speculative as purchasing stock.

Most corporate bonds are
unsecured
, meaning the debt is not tied to any collateral, and the bondholder is relying on the general credit and continued solvency of business. Secured bonds may be backed by claims on specific assets of the company, possibly including new equipment that the bonds were used to purchase. Other bonds may be backed with stocks and other securities, or can even be guaranteed by a company other than the bond issuer. Owners of secured bonds will take priority over owners of unsecured bonds in the event of bankruptcy.

Corporate bonds are available on the New York Stock Exchange or over the counter (directly from the issuing companies). The advantage of corporate bonds is that the coupons tend to be higher than government-issued bonds. But, of course, these higher yields come with higher credit risk. Some investors will take the higher risks along with the higher payments, even going after junk bonds issued by companies with poor credit ratings. But if capital preservation is your goal, corporate bonds are generally not your best bet unless you stick with rock-solid companies with great track records, and only if you get out well before the Aftershock hits.

Certificates of deposit (CDs) behave similarly to zero-coupon bonds, in that you deposit money for a certain amount of time, and receive principal and interest back at maturity. The differences are that CDs are offered specifically by financial institutions to their customers and that they are usually insured by the federal government. CDs fall under the category of
time deposits
, meaning you lock up your money for the specified period, and they cannot be sold on the open market or called by the issuing bank before maturity.

CDs tend to offer lower rates than comparable bonds, but interest rates can vary depending on a number of factors, including the size of the principal, the length to maturity, and the size and reputation of the financial institution, among other factors. On the plus side, interest is usually compounded monthly, which can be an advantage for deposits of longer time periods—as long as interest rates don’t rise. Unfortunately, both inflation and interest rates will rise, and CDs will not fare so well. Because they are guaranteed by the government, CDs have a reputation for being virtually risk free. That is not a reputation that will survive the coming Aftershock.

If you’ve ever had an account at a brokerage firm, you have probably had cash in a money market fund. Money market funds invest in a highly diversified pool of securities, with maturities usually no more than two or three months. These include government bonds, CDs, and commercial paper (short-term, unsecured debt obligations issued by corporations with rock-solid credit). The aim for a money market fund is to keep a constant share price of $1, with yields paid as dividends that can be reinvested.

The short terms of the investments and the solid credit ratings of the issuers make money markets very low risk, relatively speaking. If investments do fail and the share price of the fund falls below $1, it is referred to as
breaking the buck
, something that is never supposed to happen. It was an especially rare event before September 2008, when Lehman Brothers’ bankruptcy and the ensuing panic led to the Treasury Department’s setting up an insurance program for many money market funds.

Changes in interest rates impact some bonds more than others. Long-term bonds are much more reactive to interest changes than are short-term bonds. Long-term bonds can punish or reward the bondholder long after interest rates have changed. So it does not take much of an increase in interest rates to push the value of long-term bonds down significantly.

Changes in interest rates also have a greater impact on the value of bonds issued by less reputable companies than on high-grade bonds issued by solid corporations and agencies because of the combined concerns about both rising interest rate risk and credit risk. Bonds rated from AAA to BBB are considered investment grade. Anything below BBB–or Baa is considered to be speculative. Traditionally, most experts would advise sticking only with bonds among the A to AAA categories because they are considered the safest bets to get your money back, even if they don’t come with the highest interest rates. However, in this economic environment, it’s sometimes necessary to look past a good rating. Even very good ratings can drop very quickly and unexpectedly, as we’ll see later on.

To limit the risk of rising interest rates, many investors turn to inflation-protected or floating-rate bonds, such as TIPS. These are less sensitive to interest rate changes than fixed-interest-rate bonds because they adjust with prevailing rates. Therefore, rising interest rates are not expected to lower the value of inflation-protected or floating-rate bonds as much as they will lower the value of fixed-rate bonds. But do not be fooled into thinking that these floating-rate bonds will be risk free. As interest rates go up, credit risk will also go up significantly. Remember: It doesn’t matter how good your interest rate is if your bond issuer is unable to pay.

Under normal economic circumstances, bankruptcies are relatively rare, especially among larger corporations and banks, not to mention governments. And even when bankruptcies happen, even debtors holding unsecured bonds still usually end up getting back at least a portion of their principal from the settlement. So it is understandable that bonds, especially those issued by governments and blue-chip companies, have traditionally been viewed as safe from credit risk. But there is one circumstance that is always bad for bonds:
inflation
.

The conventional wisdom is somewhat divided when it comes to the impact of inflation on stocks. (Some say stock prices will rise with inflation, which is true to some extent, but it doesn’t account for the rising interest rates that can kill earnings and hurt stocks in the long term.) But pretty much everyone knows that inflation is poison to bonds. If money is losing value quickly, then tying it up for a considerable length of time at a fixed interest rate is a losing proposition. With inflation at 2 percent, a bond with a 3 percent coupon has a
real
interest rate of only 1 percent. But if inflation rises to 5 percent, suddenly your real rate of return is minus 2 percent. You may have more dollars in the end, but you are losing buying power; you are losing wealth. And the picture looks even worse if you spent your coupon payments along the way. The principal you get back when the bond matures will not be worth nearly as much as it was when you invested it. Now imagine inflation goes to 10 percent annually, or 20 percent, or higher, and you see how destructive inflation can be.

But it is even worse than that. Rising inflation, as we have said repeatedly in earlier chapters, eventually causes interest rates to rise. Rising interest rates only hurts the value of existing bonds even more. Now you have the double whammy of both falling value of your money due to inflation and falling value of your bonds due to rising interest rates.

And, unfortunately, the bad news doesn’t stop there. Not only is inflation making your money worth less and not only are rising interest rates making your bonds worth less, you also now have to face another rising menace:
increasing credit risk
. You see, the entities that issued your bonds may very well go out of business under these difficult conditions, or at least be unable to repay you. We saw in the last chapter what rising inflation and higher interest rates can do to company earnings. Unable to refinance their debt without paying high interest rates, and caught in a spiral of laying off workers to stay afloat, how will companies generate the new revenues to pay off their existing debt obligations? It is going to become harder and harder to do so.