Suitability

Fixed income debt securities come in many shapes and forms. We’ve learned about corporate, US government, and municipal securities in this unit. Now, we’ll discuss the benefits, risks, and typical investors involved with these investments.

Benefits

The primary benefit associated with bonds is interest income. Most pay interest on a semi-annual basis, and the interest payments are legal obligations of the issuer. Unlike dividends from stock, there is no approval required by the Board of Directors (BOD) to make an interest payment. In fact, the bondholders will collectively file a lawsuit against the issuer and take them to bankruptcy court if an interest or principal payment is missed. This makes income from bonds generally more predictable and safe.

Capital appreciation could occur, especially if interest rates were to fall. However, interest rate fluctuations are not easily predictable, plus bonds always mature at par. If the investor holds the bond long enough, they’ll eventually receive the face (par) value back at maturity. Therefore, most bond investors don’t seek capital appreciation unless their bond is convertible.

While not always the case, bond market prices are less volatile than stock prices. With bond interest being a legal obligation of the issuer and not contingent on the company’s profitability, market price fluctuations are typically mild. Of course, there are exceptions. If interest rates fluctuate significantly or if the issuer is on the brink of bankruptcy, wild market fluctuations will occur.

Various benefits can be attributed to different issuer types. For example, US Government securities are considered some of the safest securities in the world, especially since the government can create its own currency to repay its debts. As we discussed earlier, municipal securities typically provide tax-free income if purchased by a resident. Corporate bonds offer a wide variety of choices, including debt securities issued by issuers ranging from large well-established companies to small start-ups.

Systematic risks

As a reminder, systematic risks negatively affect a large portion of the entire market. There are two systematic risks to know for bonds: interest rate risk and inflation (purchasing power) risk.

Earlier in this chapter, we discussed price volatility and duration, both relating to interest rate risk. We learned that bonds with long maturities and low coupons tend to move the furthest in price when things change in the market. Bond prices are most commonly influenced by interest rate changes.

Interest rate risk, sometimes referred to as market risk for bonds, is the risk that interest rates rise, which forces market prices of bonds down. As a reminder, market prices fall to make older bonds more marketable than newer bonds being issued at higher rates of interest. Interest rate risk applies to all fixed-income investments, which also includes preferred stock.

We discussed inflation (purchasing power) risk in the preferred stock suitability chapter, which occurs if higher levels of inflation reduce the value of an investment. Bonds are particularly susceptible to purchasing power risk due to their fixed coupons. Investors receive a fixed amount of interest over the life of the security. If prices of everything from milk to cars to real estate rise, the fixed amount of interest now has less purchasing power (buys less).

When inflation rises, the Federal Reserve (the central bank of the US) raises interest rates to drive down general economic demand (borrowing money is more expensive), typically resulting in prices of goods and services stabilizing. Purchasing power and interest rate risk are very closely tied together for this reason. When interest rates rise, bond market prices fall.

Just like interest rate risk, the longer the maturity of a bond, the more purchasing power risk a bond has. To avoid the risks of inflation, investors should seek short-term bonds. By doing so, they’ll be able to reinvest their proceeds into bonds with higher rates of interest when the bond matures instead of being stuck with a lower interest rate for a long period of time.

Non-systematic risks

Non-systematic risks negatively affect specific securities, not the entire market. There are several types of non-systematic bond risks to be aware of.

Default risk, sometimes referred to as credit or repayment risk, occurs when an issuer is unable to make required interest and/or principal payments to investors. The typical reason for default risk is bankruptcy.

Bankruptcy isn’t very common, but it does happen. Corporations and even governments default on their debts (although government defaults are rare). For example, the city of Detroit declared bankruptcy and defaulted on its bonds in 2013. It was (and still is) the largest default by a municipal (local government) issuer in the history of the United States. If you held a Detroit bond at the time, you probably ended up losing a substantial amount of money due to their bankruptcy.

Rating agencies help investors determine the default risk of specific bonds. Standard & Poors (S&P), Moody’s, and Fitch are the three rating agencies to know for the exam. While their ratings look slightly different, they all rate bonds based on their default risk. Here’s how their ratings appear:

It’s important to know the difference between investment grade and speculative bonds. Investment grade bonds have little to no default risk. Investment grade bonds have ratings of BBB (Baa for Moody’s) or higher.

Speculative bonds, sometimes referred to as junk bonds, are subject to considerable default risk. The lower the rating, the more default risk. Speculative grade bonds have ratings of BB (Ba for Moody’s) or lower.

Liquidity risk, sometimes referred to as marketability risk, occurs when a security cannot be sold or requires a deep discount to be sold. Generally speaking, the less desirable a bond, the more liquidity risk it has. Simply put, if investors don’t like what a bond has to offer, it might be tough to sell it. If you owned a bond from a company on the brink of bankruptcy, you might not be able to sell the bond without a drastic discount in price (or maybe not at all).

Certain investments come with higher levels of liquidity risk. For example, municipal bonds are notorious for their liquidity risk. This is the result of their tax status. Because residents gain tax-free income, investors tend to only trade these securities with others living in their municipalities. The smaller the municipality, the fewer opportunities to sell a municipal bond when necessary. On the other hand, US Government securities are traded globally, and are some of the most liquid investments in the world.

Legislative risk occurs when a law or regulation (usually domestic) negatively affects an investment. For example, the tariffs imposed by the Trump administration starting in 2018 increased the cost of doing business with foreign companies from certain countries. Investors holding securities involved with international trade experienced legislative risk when the financial markets responded negatively to the trade war.

Political risk occurs when there’s instability or a sudden change in government. For example, assume you own a Ukrainian bond. If an unexpected military coup completely replaces Ukraine’s old government, it’s possible that your bond will default. Unless the new government plans on paying off the old government’s debts, it’s likely you would lose a significant amount of money.

While political instability could happen anywhere, but it’s generally viewed as a foreign risk. The United States has its political disagreements, but we have a relatively stable political structure in place.

Reinvestment risk occurs when interest rates fall. While it could be argued that reinvestment risk is more of a systematic risk, this risk applies most to bonds with high coupons, frequent interest payments, and callable bonds.

Although bond prices rise when interest rates fall, reinvestment risk focuses on money reinvested back into the market. Long-term investors typically keep their money invested at all times. When an investment pays dividends or interest, that money could be used to purchase a new security (or buy more of the same security). When interest rates fall, bond investors reinvest their money into bonds with lower rates of return.

Earlier in this chapter, we reviewed callable bonds. Call risk, which occurs when a callable bond is likely to be called (or actually is called), is a type of reinvestment risk. Bonds are most likely called when interest rates fall, which allows issuers to reissue new bonds at lower interest rates (refinancing).

Call risk is the worst form of reinvestment risk. Instead of just reinvesting interest received at lower rates of return, the investor must reinvest interest plus the principal they receive when the bond is called. Because the investor is reinvesting a larger amount of capital, call risk is a very substantial risk.

The last risk to discuss relates to yield. We’ve already discussed the benefit of tax-free income from municipal bonds, but this benefit doesn’t exist for free. The drawback of tax-free income is low yields. Issuers know they can offer their bonds at low yields because of the lack of taxes investors pay on the interest. While it’s not the most devastating risk, an investor in a low tax bracket should avoid municipal investments. Otherwise, they’re experiencing opportunity cost when other investments could pay them a higher after-tax return.

Typical investor

There are a wide variety of bonds available to investors, which come with varying risks and benefits. The purpose of this section is to discuss the typical bond investor without being too specific.

Unlike stocks, bonds are usually sought out by older, more conservative investors. Because of the legally guaranteed interest payments, bonds experience lower levels of risk than stocks, leading to lower rates of return. Investors seeking safe, predictable income will most likely choose debt securities over equity (stock) securities.

Remember the Rule of 100? The older an investor is, they should generally invest more in fixed-income securities like bonds. Let’s take a look at a table from the suitability section of common stock:

The Rule of 100 is a little easier to utilize with bonds. Essentially, an investor’s age matches the percentage of bonds they should include in their portfolio. Keep in mind this is a generality and doesn’t always apply. There are some very aggressive older investors that have enough assets to take higher levels of risk. An 80-year-old billionaire could afford to put a large portion of their portfolio in more volatile investments like common stock. There are also younger investors that are more risk-averse (conservative). Bottom line - use the Rule of 100 as a generality, but know there are exceptions.

We’ll learn about the varying levels of risk unique types of bonds are subject to. While generally viewed as safe, there are plenty of risky bonds out there. Junk bonds and other securities involving high levels of risk offer high yields. Of course, the investor could lose a significant amount of money if a default occurs.

Interest income is the primary benefit that bonds provide. If an investor is not seeking income, they should probably invest in another asset class. The only exception is for zero coupon bonds, which pay interest only at maturity. If an investor seeks a predictable payout years later but doesn’t need income along the way, a long-term zero coupon bond could be suitable.