Steve McDonald Explains Bond Market Basics
Samuel Taube: Joining us today is Steve McDonald, Bond Strategist, and we are talking about the basics of bond investing today. Steve, thanks for joining us.
Steve McDonald: It’s my pleasure, Sam. Thank you for having me.
ST: So, when we’re talking about bonds, we usually mention two numbers: price and yield. Now, in basic terms, what do these two numbers actually represent? How are their values determined?
SM: One of the biggest misunderstandings about bonds is that bonds fluctuate in value – not as much as stocks do, but their market value will fluctuate based on fundamentals for corporates and interest rates for government bonds and municipal bonds. So the price is simply whatever price you pay for a bond at any given time.
Now when a bond is issued, it’s always at a thousand dollars. It can instantly trade down a little bit, but it’s usually $1,000 per bond. And we’ll work with that number of $1,000. The coupon is the second variable in this.
A coupon, unlike any other number in investing, is cast in stone. If you buy up a bond and you pay $1,000 for it, and it has a 7% coupon, that coupon cannot change. And that means for 7%, you get $70 a year.
So on your $1,000 investment, you get $70 a year, no matter what happens, short of a bankruptcy. The only way that can change is if the company or the government defaults or goes into bankruptcy.
SM: Now, this is where people get confused, and I’ve never understood it because it works exactly the same way with dividend stocks. If the market price of a bond drops from a thousand dollars to, say, $90, the percentage that you get in income, which is called the current yield, actually goes up, but it doesn’t change.
ST: Right, it has to be that $70 number, right?
SM: Yeah. But that $70 remains the same. So essentially, if you buy a bond for $900 and you get $70, you get a higher percentage than if you paid $1,000 for it, and the reverse is true.
If you paid [$1,110], you’re getting a lower percentage, but you still get the $70. It’s really pretty simple. But at the root of this problem, Sam, isn’t the numbers. The numbers are easy. Anybody can understand that. The problem, though, is that information in the money press and media about bonds is awful. I mean, it’s almost nonexistent. That’s the real problem.
ST: I see. Now, this next question might be a bit of a lengthy one, so if you just want to summarize, that’s fine.
ST: What is the basic difference between how investors treat a government bond versus a corporate bond or a municipal bond? How do their risks and returns differ?
SM: That’s a great question. In fact, I just did a little conversation about that in an article recently. Let’s start at the top. Government bonds, Treasurys, notes, bills and bonds. They’re absolutely guaranteed. But again, we’re back to this market price fluctuation.
What most people don’t understand about government bonds is they fluctuate in price too, even though they’re guaranteed. But their guarantee only applies if you hold them to maturity. That’s the first thing you have to understand about government bonds.
But, because they are backed by the full taxing power of the U.S. government – which you and I both know is pretty formidable – there is no risk. It’s a 100% guarantee you’re going to get paid your interest, and you get back your $1,000 per bond at maturity, so there is no risk there.
However, long term, nobody has ever made any real money on government bonds.
Well, I shouldn’t say that. Once in a while, you know, you’ll hit these freak markets where you get lucky on a buy… But by the time you pay your taxes – and U.S. government bonds are taxable – by the time you pay your taxes and inflation takes its bite, you’re always going to be in the hole a little bit. Same thing is true for CDs and savings.
Now, municipal bonds. So government bonds have a 100% guarantee. Now, municipal bonds, there are two types of municipal bonds. There are rated bonds and non-rated bonds. And I know I can’t give personal advice, and this isn’t personal, but never buy a non-rated municipal bond.*
The non-rated ones have the highest default rate, and it’s higher than corporate bonds, actually.
ST: Oh, wow.
SM: Rated municipal bonds, and only investment-grade municipal bonds are rated. So that’s BBB- and higher up to AAA. Those have a long-term track record of paying exactly as promised, somewhere in the 98% to 99% range. That’s just a regular investment-grade municipal bond.
Now, if you take that a step higher in municipal bonds, they’re called GO’s. Municipal GO’s: general obligations. They’re tax-free too.
They’re virtually as safe as – and I hate to use that word virtual, but it applies in this case – but they’re virtually as safe as government bonds. But, because they are not backed by the full taxing power of the U.S. government, they can’t get the 100% guarantee.
So that brings us to corporates, and this one’s going to surprise people. Investment-grade corporate bonds – that’s BBB- and higher-rated bonds – have a 98% to 99% success ratio.
ST: Oh, wow.
SM: There have been defaults in these occasionally, but in the investment-grade, the success ratio is so high. And when you look at how much more money you make, taxable or otherwise, in corporate bonds, they far outweigh the returns of Treasurys and municipals with just a tiny hair more risk than you get in those other two.
Then we get to the bad boys of the world, or at least they’ve been portrayed as the bad boys: junk bonds or high-yield bonds. These are BB+ and lower. These are probably the most misunderstood of all bonds.
The long-term success ratio of junk bonds – these are BB+ and lower – is around 94%.
Now, there have been periods of spikes where we’ve gone to 13% and 14% default rates, but they only last a couple months. And it doesn’t take a brain surgeon to be able to go through a bond inventory and pick out the ones that are going to default.
They’re the ones that are overleveraged, their businesses are falling apart, they’re not growing their earnings. I mean, all the same things that we look for in stocks, the exact same thing is true here.
So you go from a 100% in the Treasury to a 99.9% in general obligation municipals to about a 98% to 99% in regular munis. Those are rated munis. Never buy unrated munis or non-rated munis.
Then you’ve got investment-grade corporates with a 98% success ratio and junk bonds with a long-term success ratio of 94%. That was a little lengthy, and I apologize, but boy, it’s so nice to be able to get that information out.
ST: No, you were very thorough.
SM: It’s because nobody really understands the rating system or the success ratio of bonds. It’s really very oppressive.
ST: Yeah, certainly, no. I didn’t personally know those percentage success rates before now. So thank you for going into that.
Now, speaking of high-yield bonds, I hear that you and your research team have been tracking a set of what you call “super bonds,” which have the potential to generate triple-digit returns for investors.
So how do you find these bonds? And would you be comfortable giving us an example or two?
SM: Sure. I wish I could take credit for this, but I can’t.
One of the super-brains in our research department came up with this and he came to me… and I have to be honest with you, he said, “I’m seeing all these bonds that are paying 120% a year, 80% a year, 60% a year.”
And I said, “Oh, you’ve got to be joking.” And he sent me a list of 15 of them – it was Anthony down in our Florida office – and I started looking at these and I thought, “You know, as long as people know the risk here…”
And there’s risk in these things. Obviously, you’re not going to make 120% a year for five years and have no risk.
ST: Wow. Not bad!
SM: That’s an example of one. It’s ridiculous. But again, in these sorts of things, we’ve set very specific limits. You only want to buy one or two of these. You can’t take your whole retirement and just buy these bonds.*
I call these side bets on the rest of my portfolio. We’ve got investment-grade. We have high-yield… And these things down here, these speculative bonds, the super bonds, you’ve got to keep this in perspective.
You buy one or two of these things. Let’s suppose you commit $2,000 to the whole speculative portfolio and you own, let’s say, eight bonds. If only four make it to maturity, you’ve made money. You’ve made a lot of money.
ST: Right, but I see what you mean. It’s kind of something you want to do more so with your side money…
SM: Exactly. Exactly. Yeah, I am begging people: Don’t dump any big money into these. This is a side bet, as I said.
ST: Right. Well, that’s very cool. Steve, thanks so much for joining us.
SM: Sam, it was my pleasure. Thanks for having me on.
*The views and opinions expressed in this article are those of the author and do not necessarily reflect the official position of professional analysts.