Bond Market ABCs

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

In the media, we often hear that the stock market was up or down a certain amount of points. By “the stock market,” reporters are usually referring to the Dow Jones Industrial Average, an index of 30 very large companies that are supposed to represent the economy. I’ve never believed that was an accurate representation of the market since 30 mega cap stocks often don’t tell the story beneath the surface.

As a professional investment manager, we often compare our returns to the S&P 500, which represents the 500 largest companies in the U.S. and the most widely used benchmark in the industry. There are plenty of other indices that investors watch, from the small cap Russell 2000 to the large cap Russell 1000 to the all inclusive Wilshire 5000. Just remember that the Dow Jones Industrials may not always be the most accurate.

When we hear about the bond market, people are usually referring to the treasury bond market, those instruments issued by the U.S. treasury and backed by the full faith and credit of the U.S. government. And they come in all maturities from 3 month treasury bills all the way out to 30 year treasury bonds. Over the past decade or so, the benchmark bond has become the 10 treasury note. We often hear that the bond market lost a certain amount, like ¼ point, forcing yields higher. Remember, and this is the most confusing part to understand, when bond prices rise (good if you own bonds), bond yields fall and vice versa.

Unlike stocks, where most of the indices generally trend in the same direction, but to different magnitudes, bonds are all over the place. Besides treasuries, there is the government and agency bond market, which includes issues from Fannie Mae, Freddie Mac, Ginnie Mae, Federal Farm Credit and so on.

Next we have the municipal bond market, which acts much differently than treasuries and govies. The muni market is more economically sensitive than the previous two as it relies on the financial stability of the issuing entity. If tax receipts are on the rise, the price of those munis will likely rise as well. When the local economy falters or collapses, muni bond prices will as well since that local issuer may have trouble paying interest or repaying principal.

The last major muni bond crisis occurred during the fourth quarter of 1994, known as the Orange County Crisis. Orange County California began investing their money in non traditional instruments that took on significantly more risk than what was generally accepted to increase return. It worked without a hitch until some of their cutting edge strategies began to fail miserably. Once that little snowball rolled over the edge, it grew and grew rapidly, leading to an early December 1994 bankruptcy filing that sent shockwaves through not only the muni bond market, but the entire financial system.

Beyond the municipal market, you may have heard about the investment grade corporate bond market. These are bonds issued by companies, from IBM to GE to Microsoft, and carry a credit rating of BBB- or better. This market typically does not behave like any of three bond markets already mentioned, but does have some similarities with the stock market.

At the end of the food chain, there is the high yield or junk bond market, which is made up of companies with credit rating worse than BBB-. These usually have the highest risk of default, but also tend to offer the greatest reward. Legendary financier and former Drexel Burnham Lambert superstar, Michael Milken, is credited with really creating the modern day junk market from almost nothing into trillion dollar machine. If you know the story, he also was convicted of insider trading, securities fraud and racketeering as Drexel collapsed in early 1990. After being released from prison, he continued his philanthropy through the Milken Foundation and Milken Family Institute and remains a huge supporter of medical research. (Sorry for the digression)

Junk bonds usually behave more like stocks than any of their fixed-income counterparts. During massive bull market rallies in stocks, like we’ve been seeing since March and again during 2003, junk bonds offered comparable returns to stocks with much less volatility and downside movement. In fact, in 2009, many of the popular junk bond funds have outpaced their equity brethren!

When trying to determine if investment grade and junk bonds are cheap or expensive, many people turn to what’s called spreads. Analysts measure the difference in yield between the bond and a treasury instrument like the two year, five year and 10 year note. The smaller the spread, the less an investor is being compensated for taking on the risk of a non treasury issue.

In early 2007, the spread between treasuries and junk fell to an all-time low, meaning that investors were not worried about the companies defaulting and just wanted to reach for the most yield possible, forcing junk bond prices higher and higher. As we know, those bubble investors were severely punished with prices falling 30, 40, 50 and as much as 80% in less than two years!

Conversely, earlier this year and in early 2003, with the financial markets and economy in collapse, junk bonds spreads widened to levels never before seen. Astute investors picked up bonds yielding 15-20% and have been immediately rewarded with prices rallying as much as 50%!
If you have any questions or comments about any of the equity or fixed income indices or markets mentioned, feel free to email me at Paul@investfortomorrow.com