My Favorite Books on Bonds

If you have ever considered investing in bonds, or maybe you already own some bonds but just want to learn more about this investment, whether treasury bonds, corporate bonds, or municipal bonds, you may want to check out a few of these books. These are some of my favorites.

The Bond Book, Third Edition: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More by Annette Thau

Bonds: The Unbeaten Path to Secure Investment Growth by Hildy Richelson and Stan Richelson

Why Bother With Bonds: A Guide To Build All-Weather Portfolio Including CDs, Bonds, and Bond Funds--Even During Low Interest Rates by Rick Van Ness and Carl Richards

The Handbook of Fixed Income Securities, Eighth Edition by Frank J. Fabozzi and Steven V. Mann

Get Tax Free Income from Municipal Bonds: High Yield Tax Exempt Interest Full Disclosure: I wrote this book

Rising Interest Rates: The Big Picture: How rising interest rates can be beneficial for investors

Written by Alexander Hart; Director, Equity and Fixed Income Research

Federal Street Advisors

Intro:

While macroeconomic news out of China, and the price of oil has dominated the most recent financial market headlines, the U.S. Federal Reserve policy has been a subject of debate and intense focus for years.  Investors, bankers, economists and reporters alike are fixated on every word the Federal Reserve and its board of Governors releases.  The examination of, and some might argue obsession with, Fed statements has reached a point where the market can rapidly change direction based on just an alteration of word choice, even when the overall message remains the same.  These statements garner so much attention because traders and investors are trying to gain an edge in predicting when interest rates will rise.  Setting aside the debate on when the exact date of an interest rate hike might be, this paper examines what rising rates mean for your investment portfolio and argues that the long-term benefits are something investors should welcome not fear.  In order to examine this in detail, we first must have a good understanding of how the Federal Reserve works and why its policy affects interest rates.

What is the US Federal Reserve and why does it matter?

The U.S. Federal Reserve Bank (commonly referred to as the Fed) is the central bank of the U.S. financial system and its primary function is to enact monetary policy that helps to stabilize and improve the U.S. economy.  The Fed’s three main objectives are: to maximize employment, keep prices of goods stable, and moderate long-term interest rates.  As the economy goes through cycles from economic booms to recessions, the Fed takes action to moderate the booms and minimize the probability and depth of recessions.  One of the key tools the Fed uses to keep the economy stable is interest rates. In this case, interest rates reflect the yield paid to buyers of U.S. Treasury bonds.  The Fed can influence the level of interest rates by buying large quantities of Treasury bonds on the open market, thereby pushing prices of the bonds up and yields down and vice versa.  In general, the Fed will increase interest rates in order to slow down the economy and decrease them to stimulate growth.

Why do investors fear rate increases?

Investors have feared the prospect of rising interest rates for two main reasons: the potential for slower economic growth and negative returns for bonds.  The Federal Reserve uses higher interest rates to slow the economy by increasing the cost of doing business and buying a house.  Companies looking to build a new factory or invest in new technologies often raise funds for these projects by issuing bonds.  As interest rates rise on Treasury bonds they rise correspondingly on corporate bonds, increasing the cost of financing for companies.  As the cost of financing increases, companies are less likely to invest in new projects, slowing the economic growth rate of the economy.  Similarly as interest rates rise on Treasury bonds, the interest rates for mortgages on homes also rise.  This increases the monthly payment required to build or own a home, subsequently slowing the pace of growth in the housing market.  While we think this is a legitimate concern in the long run because slowing economic growth can act as an impediment to earnings growth and stock prices, at this point in the interest rate cycle the effects should be limited.

Interest rate changes don’t just affect the economy; they can also have sudden and material impacts on performance of investment products.  Interest rates and the prices of bonds have an inverse relationship, as rates rise bond prices fall and vice versa.  During the past 30 years, investors have enjoyed a long cycle of declining interest rates.  In September of 1981 the 10-year Treasury Bond peaked at an interest rate of over 15%.  Since then, interest rates have been steadily declining, producing an environment of sustained strong performance as bond prices rise.  The U.S. Barclays Aggregate Index has delivered an annualized return of nearly 8% over that time span, with only a few short periods of mild negative returns, conditioning investors to expect strong consistent positive returns in fixed income.  Many fear that when the Fed changes its policy and begins to raise interest rates, negative bond returns will cause widespread selling of fixed income products causing further declines in bond prices.  This concern is certainly warranted and we have positioned our clients’ portfolios to protect against this risk, however, we continue to believe that higher interest rates is a healthy outcome for investors and the market in the long-run.

What are the benefits?

At Federal Street Advisors, we believe that rising interest rates do present real near-term risks that investors should be prepared for but recognize that higher interest rates will also bring long-term benefits to those who are well positioned.  Higher interest rates are an indication of economic strength, improve income available for investment products, and promote rational capital markets.

While the Federal Reserve does use higher interest rates to slow economic growth late in a business cycle, it is important to understand that the potential upcoming interest rate hike is not an attempt to slow growth but rather to return interest rates rate to a normalized level.  During the financial crisis of 2008/2009, the Federal Reserve lowered their interest rate policy target effectively to zero where it has remained since then.  This was a historically extreme measure designed to promote business investment, stabilize the housing market, restore confidence in the stock market and stimulate economic growth.  The Federal Funds target interest rate (the interest rate that the Fed targets for monetary policy) has been 0%-0.25% since December 16^th, 2008, well below its long run average of 7.4%¹.  An increase in the Fed’s target interest rate today would be indicative of their confidence in the economic strength and stability as they seek to bring interest rates to a normalized level, and not an attempt to slow the growth rate of the economy.

While a declining interest rate market has resulted in strong performance from bonds, low absolute levels of interest actually significantly reduce the potential for future returns.  One of the primary goals of a zero interest rate policy is to reduce the cost of financing for companies.  Companies have been able to issue bonds to investors at all-time low interest rates.  While this is a good deal for companies, it’s not a great outcome for investors, who are forced to take increasingly lower compensation for the risk of lending this money.  The yield on the Barclays U.S. Aggregate Index was just 2.3% as of September 30^th, compared to 6.6% twenty years ago.  Low coupon rates generally mean poor opportunities for returns and more recent results have reflected that as the Barclays Agg has returned just 1.7% in the last three years.  

While an increase in interest rates will likely result in negative returns for bonds in the near-term, it greatly improves the long-term return potential by allowing investors to reinvest coupons at higher interest rates. In our estimation, investors in the Barclays U.S. Aggregate Bond Index might experience a drawdown of as much as 7.5% if interest rates were to rise by 2%, but would still be expected to achieve a 10-year annualized return 0.7% higher than a scenario in which interest rates remained unchanged and no drawdown occurred².  This scenario analysis highlights both the importance of protecting against the near-term risks of an interest rate increase but also the improvements to long-term total return opportunities.

Low interest rates can cause investors to take on more risk:

Sustained low interest rates also have significant impacts on investor behavior, which can cause imbalances in the capital markets.  Low interest rates means the retiring baby boomer generation in particular are not able to depend on the same level of income from their municipal bonds portfolios. Due to the lack of income in bonds, these investors have been forced to buy areas of the equity market that pay dividends, such as the utilities sector, but may expose themselves to more risk than is appropriate as a result. Increases in interest rates will bring increases in income from bond portfolios, and allow investors with lower risk profiles to return to more suitable asset allocations.

Pension funds will also benefit from a rising rate environment.  These funds are required to report an estimate of the value of their future obligations to pay benefits to retirees.  Since the bulk of these payments will occur in the future, they use a “discount rate” to calculate the value of the future payments in present terms.  This discount rate is tied to the prevailing interest rates in the market. Lower interest rates means a lower discount rate, which results in larger future obligations.  As interest rates fall, the pension fund’s financial health deteriorates and they are also forced to adopt a more aggressive or risky asset allocation to achieve the returns needed to pay retirees.  Conversely, if interest rates rise, pension funds should regain healthier financial conditions, the risk levels of their investments can be reduced, and payments to the beneficiaries will ultimately be more secure.

Active management will benefit:

Sustained low interest rates have also presented challenges to the performance of active managers through the encouragement of irrational investor behavior and unsustainable low financing costs.  While influencing the equity markets is not a stated goal of the Federal Reserve, it is an outcome of their zero interest rate policy.  As described previously, low income and poor total return expectations in bonds have pushed fixed income investors into buying stocks in the utilities sector.  In 2014, as interest rates fell, this sector returned 29%, outpacing every other sector in the market.  Active managers were broadly underweight the sector on fundamental concerns that high relative valuations and chronically low growth rates posed significantly greater risk than the promise of 3-4% of income.  In this environment, active managers posted one of the worst years of relative performance on record.

In addition to changing investor behavior, low interest rates offer greater support to companies in poor financial condition making it more difficult to separate good investments from bad ones.  Low interest rates mean low financing costs for companies raising money through the issuance of bonds.  This low cost financing benefits companies in poor financial condition or those that have been mismanaged disproportionately to high quality, well-run business.  The best-run companies are typically rewarded with low financing costs in all market environments, or in many cases do not need to rely on debt financing at all because they are able to fund new projects and investment from cash flow from their existing business.  A decrease in interest rates has little effect on the cost structure of these companies. 

Conversely, when interest rates are low, low quality companies that need to raise cash from the debt markets are able to do so at lower costs than ever before.  The stocks of these low quality companies can be rewarded in low interest rate environments as their fundamentals appear improved, but as interest rates rise and the costs of financing increase, these results will be unsustainable.  While the style of active managers can vary, most look to buy companies with superior business models and strong management teams, which should benefit on a relative basis as interest rates rise leading to active manager outperformance.

Conclusion:

Given the attention the media gives the topic it is easy to get caught up in the intense debate of when the Fed might raise interest rates, but as recent history has shown it is difficult to predict.  In the beginning of 2014, 46 economists polled by the Wall Street Journal expected the Federal Funds rate to be an average of 1% by the end of 2015 and yet today the effective rate remains roughly 0.1%.  At Federal Street Advisors, we believe the game of attempting to time an unpredictable interest rate rise is not one that our clients will benefit from playing.  While we recognize that there are near-term risks to bond portfolios associated with an interest rate increase, it is increasingly important to keep the big picture in mind: a higher interest rate environment is both inevitable and healthy for the market, and investors who are well prepared will benefit.

Author Bio:

Alexander J. Hart, CFA, CAIA
Director, Equity and Fixed Income Research 

5 Years Experience As the Director of Equity and Fixed Income Research, Alex is responsible for identifying and evaluating long-only equity and fixed income managers. His primary responsibility is monitoring client investments and making sure our fund managers' performance is in line with our expectations. He also evaluates potential new managers.

Alex earned his Bachelor's degree in Economics from Colgate University. Alex is a CFA charterholder, holds the CAIA designation, and is a member of the Boston Security Analysts Society. 

¹ "Historical Changes of the Target Federal Funds and Discount Rates."  Federal Reserve Bank of New York, n.d. Web. 30 Oct. 2015. http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html

² Analysis assumes a parallel shift in the yield curve occurring evenly over the first 12 months with income being reinvested at higher rates. Full scenario analysis is available upon request.

The President Barack Obama Stock Portfolio

There haven't been many of the political ads on TV yet, but of course they will start appearing shortly. The OGE Form 278, also known as the Executive Branch Personnel Public Financial Disclosure Form, is a required form for presidential candidates. It provides for the disclosure of the stocks, bonds, and other investments that are owned by the candidate. These forms can be found at the OpenSecrets website.

Yesterday, we published an article on the Mitt Romney stock portfolio. Now, let's look at the Democratic candidate, President Barack Obama. According to publicly filed records, he owns the following along with the estimated values of the holdings.

Vanguard 500 Index Fund (VFINX) [incl. S] between $200,000 and $450,000

Calvert Equity (CSIEX) [529 Plan] between $100,000 and $200,000

PIMCO Total Return (PTTAX) [529 Plan] between $100,000 and $200,000

US Treasury Bills between $600,000 and $1,250,000

US Treasury Bills between $1,000,000 and $5,000,000

JP Morgan Chase Private Client Asset Mgmt Checking Account between $500,000 to $1,000,000

If you like interesting stock lists like this, check out the various stock lists, most of which are free, at WallStreetNewsNetwork.com. The Mitt Romney stock portfolio can be found here.

Disclosure: Author didn't own any of the above at the time the article was written.

By Stockerblog.com

Stock ticker symbols for the funds assume A shares, as type of shares not specified in the OGE Form 278.

US Now Has a Lower Bond Rating than France

American's worst fears have taken place. The rating agency Standard & Poors has just dropped the rating for United States Government bonds from AAA to AA+, for the first time in history. Yes France still has a AAA rating even though France has a much higher debt per capital ratio than the United States.

What is happening to this country?

Treasuries May Crash But Shorting Them Isn’t Worth the Risk

Treasuries May Crash, But Shorting Them Isn’t Worth the Risk
By: J. Tyler Matuella

Chasing the Next Treasure-y

Everyone has heard about the famed handful of investors—Michael Burry and John Paulson, amongst others—who saw the real estate bubble forming in the early 2000’s and purchased the lucrative credit default swaps to cash-in when the system collapsed. A couple of those investors made billions in a few months from essentially shorting mortgage-backed securities. Now it seems like there’s a new fad on the Street to discover the next bubble and short it, in hope of making record returns. Many of these hungry investors have turned their beady eyes to the U.S. Treasury market.

Record deficits, the European PIGS, and the Greek debt bailout have put sovereign solvency on the short list of investor concerns since the 2008-2009 financial crisis. Even as the world has seemingly recovered from the dark trenches of the crisis with the resurgence of the equity markets, many investors are still waiting for the real bang.

But they’re not just referring to the Eurozone debt turmoil across the pond. There has been a lot of talk recently about shorting U.S. Treasuries right here at home as sentiment about the unsustainability of the debt has reached a fever pitch.

Real Concerns, Real Consequences

The concerns are valid. Some people are worried that the U.S. government’s ballooning debt, coupled with a decreasing demand for Treasuries as the equity markets heat back up, will force the U.S. government’s borrowing rate to rise.

On a more pessimistic note, other investment analysts think that gridlock in the nation’s political system will prevent the government from passing tax hikes and spending cuts that are needed for the government to rein in the debt—the eventual implication is a Greek-like debt crisis. As Treasury Secretary Timothy Geithner warned in early January, "Even a short-term or limited default would have catastrophic economic consequences that would last for decades."

Perhaps the best case scenario (for the United States, at least) for the fall of Treasury prices is that there’s a compelling argument for significant inflation in the near future. Massive amounts of increased government spending, tax cut extensions, and record low interest rates indicate that the economic system is flooded with cheap, pent-up money that will have to be spent at some point. When that happens, inflation will take charge and Treasury yields will have to jump to continue attracting investors. But at least the inflation will eat away the value of the U.S. national debt.


Small Upside, Large Downside

Short positions are already risky. Such is the case with any investment that has a finite upside and an unlimited downside—(although the downside of shorting Treasuries is not unlimited since most investors won’t accept large negative yields). Treasuries take the risk to a different level, however, and I will explain why it’s nearly impossible to earn a huge profit from simply shorting a bond or using a credit default swap on U.S. debt.

If bond prices fall, theoretically the return from shorting a U.S. Treasury could be anything from a few cents, to the entire value of the bond if the government defaults. To those who are convinced that Treasuries will tank because the insolvency threat is real and coming, then it doesn’t sound like a bad investment.

But there’s a key problem with that logic. Even though it may seem obvious, U.S. debt is denoted in dollars. That’s a critical distinction from Greek or Portuguese debt, which is denoted in a supranational currency—the Euro—rather that their own national currency. If investors are looking to earn landslide profits from a steep fall of Treasury prices because of rampant inflation or government default, then that very situation will correspondingly come with a huge decrease in the purchasing power of the U.S. dollar. Since U.S. debt is denoted in dollars, the purchasing power of that windfall profit from the Treasury short could drastically reduce the real return, depending on the severity of the price drop. There won’t be an opportunity to protect the profit by converting it to a foreign currency because the dollar value will simultaneously drop as the winnings are earned.

Some investors have bought credit default swaps on U.S. debt that pays in Euros. However, the exact same problem occurs in that situation as well. Large per-trade profit margins for retail investors are restricted because foreign banks will charge a premium, around the time of the crash in Treasury prices, to insure U.S. debt because they’re not only dealing with the chance of default, but also the foreign exchange risk. CDS are even more risky since they only pay out in the event of an actual default, and it’s very difficult to imagine that the U.S. government would choose to default instead of just running the printing presses more.

The chart below shows the nature of the restriction of real return per bond if an investor does a “simple” short on a 10-yr bond purchased at $100 face-value (Real return numbers are not exact at each bond price increment.):

Is It Still Worth It?

Now that we can see there’s inherently only a small to medium upside to shorting the U.S. Treasuries, the question remains, is that limited potential for gains still worth the risk?

The easy answer is that it depends on investors’ risk tolerance. If you’re a big risk taker or someone with lots of cash like a hedge fund, and if you can afford short term losses and don’t mind earning smaller margins per trade, then go for it. The potential for large absolute gains from making high-volume, small-margin trades still exists on a day-to-day basis without harm to the currency. Investors take advantage of small bond price movements every day. However, as I argued before, any large drop in bond prices will be self-defeating and inherently restricting. The “big bang” of profits that investors found in shorting the real estate market in 2008 simply doesn’t exist in the bond market, in part because of the different nature of the financial instruments used.

To more risk-averse investors, trying to profit by day-trading in the bond market may prove particularly difficult, given the current state of world affairs. If the events in Tunisia and Egypt have taught us anything in the past weeks, it’s that the prices of equities and Treasuries are not governed by purely market forces. Between January 25th and January 30th, investors exited equity positions and fled to the security of U.S. Treasuries amidst fears that turmoil in the Arab world could roil economic growth and pressure oil supplies.

Even with all of the convincing economic evidence for why bond prices should have been falling, bond prices rose for almost a full week while equities fell. Once investors realized their fears had no economic grounding, bond prices fell back and equities returned to normal. If someone shorted bonds that week, they would have lost a lot of money—the problem is that every economic model in the world couldn’t predict what happened in Egypt.

A Riskier Way to Short the Treasury Market

For small-cap retail investors who are certain that bond prices will fall in the coming months, there’s an alternative to take advantage of the fall in bond prices and still earn a huge return without the currency risk. Some inverse U.S. Treasury ETFs, such as the Horizons BetaPro U.S. 30-Year Bond Bear Plus ETF (HTD), allow investors to use leverage to short the U.S. bond market. This ETF is denominated in Canadian dollars, and it hedges against exposure to the U.S. dollar every day. As long as the investor considers the denominated currency’s home country to be “debt-stable,” then this investment avenue effectively reduces the currency risk.

However, there are some salient problems with investing in inverse ETFs—especially levered ones—from a risk-return standpoint. The returns on a daily basis of HTD, for example, range from +200% to -200% because of the leverage. As a result, holding onto these types of funds for more than a few days can be deadly. Treasury prices may fall for four straight days, earning the inverse ETF investors massive returns with leverage, but only one or two days of small to medium-sized losses later can negate multiple days’ gains, even to the point where the net return on investment is negative. While market fundamentals exhibit compelling evidence for why Treasuries should consistently fall, a little political turmoil around the world could cause Treasuries to rise again short-term and severely hamper the returns from inverse ETFs. Since investors really shouldn’t hold onto these levered inverse ETFs for more than a few days at a time because of the compounding high risk of doing so, investors will have to keenly get into them just before the debt crisis in order to earn massive returns—that is, if a U.S. debt crisis occurs at all.

If You Do It, Do It Right

Going short on bonds probably isn’t the best way to take advantage of a debt downgrade or rising inflation in the U.S. vis-à-vis going long on metals. But for investors who insist on taking the risk, the best way that I have heard to do so is to short the bond, take the money gained from the sale of the borrowed bond, and immediately put it in a forex Euro futures contract. That way, the investor locks in the exchange rate and preserves the purchasing power of the initial investment. Even if the dollar greatly depreciates in the meantime, the investor will still walk away with a solid gain. Depending on how far the bond price falls, the investor could still earn 60-70% per trade, though that size return is highly unlikely. In addition, the risk of betting against the world’s reserve currency over the course of an entire yearlong contract makes it an even riskier position, and perhaps more apparent why shorting Treasuries may not be worth the risk.

Playing the Game Requires Knowing the Risks

The dollar still holds strong as the world’s reserve currency, which could prove an obstacle in the future to investors who short bonds amidst political turmoil in the Middle East. And since large profits (per trade) from shorting bonds are very unlikely even in the event of a debt crisis, it doesn’t make sense for most small-cap, retail investors to play the high risk, low return game that characterizes the bond market. However, for those who insist on profiting from shorting the potential debt crisis in the United States, doing a regular short and putting the initial payout in a forex Euro futures contract may be the best way to produce solid returns with minimal currency risk.


J. Tyler Matuella is a guest writer for Stockerblog.com