Thursday, October 28, 2010

How will Republican House affect the Treasury yields?

Just as Bill Clinton was forced to abandon spending initiatives after Republicans took over the House and Senate in the 1994 elections, President Barack Obama's agenda may be constrained as voter concerns over the budget deficit grows. The latest Bloomberg News polls show likely voters favor Republicans.

With spending held in check, 10-year Treasury yields fell to 5.57 percent by the end of 1995 from 8.03 percent after the November 1994 election while stocks rallied and the Federal Reserve cut interest rates as the economy slowed. The Fed is now debating how to bolster growth after reducing benchmark rates to almost zero failed to lower the unemployment rate.

“There are parallels,” said Thomas di Galoma, head of U.S. rates trading at Guggenheim Capital Markets LLC, a New-York based brokerage for institutional investors. “The Republicans will draw a line in the sand about what money can be spent. That's very supportive of the bond market.”

Yields on Treasuries due in five years or less are already at record lows, providing less scope for a rally like in 1995 when they gained 18.5 percent as measured by Bank of America Merrill Lynch index data. Even so, yields are unlikely to rise to levels that restrict the economy as lawmakers tangle over spending. Treasuries have returned 8.45 percent this year.

“Gridlock is good,” said Mitchell Stapley, the Grand Rapids, Michigan-based chief fixed-income officer for Fifth Third Asset Management, which oversees $22 billion.

The median estimate of 59 economists, strategists and analysts surveyed by Bloomberg News is for the 10-year yield to rise to 3.25 percent by the end of 2011, from 2.56 percent on Oct. 15. A month ago, the median estimate was 3.5 percent.

The yield on the benchmark 2.625 percent note due in August 2020 rose 17 basis points last week. Two-year note yields dropped as low as 0.327 percent on Oct. 12 before finishing the week at 0.359 percent, while five-year yields, which closed at 1.19 percent on Oct. 15, touched 1.07 percent on Oct. 8.

Ten-year yields fell 6 basis points, or 0.06 percentage point, to 2.50 percent at 1:44 p.m. in New York. Five-year notes yielded 1.12 percent, while the two-year rate was 0.35 percent.

Democrats have controlled the House of Representatives and Senate since Obama was elected, as during the first two years of the Clinton administration. The Senate has 59 Democrats, while the House is divided 255 to 178, with two seats vacant.

The U.S. government posted its second straight federal budget deficit in excess of $1 trillion from costs associated with the bailout of the financial system. The $862 billion in fiscal stimulus spending passed by Congress in 2009 has helped push the total amount of marketable Treasury debt outstanding to $8.5 trillion from less than $6 trillion at the start of 2009.

The results of a Bloomberg National Poll released last week shows more than half of likely voters agreed the federal budget deficit is “dangerously out of control and threatens our economic future.” The poll interviewed 721 likely voters and has a margin of error of plus or minus 3.7 percentage points.

The most motivated voters -- those who say they will definitely vote and are extremely interested in the election -- lean Republican over Democrat, 51 percent to 37 percent.

Senator Orrin Hatch, who is line to chair the Senate Finance Committee if Republicans win control in the Nov. 2 elections, said he sees fewer prospects for bipartisanship in the next Congress. Democrats have created strains by expanding government the last two years, particularly taking power from states under a health-care program he helped establish for lower-income children, he said.

“I've got to say, that was almost the final straw to me,” the Utah senator said in an interview on “Political Capital with Al Hunt” on Bloomberg Television. “I'm certainly not going to let them keep spending and taxing us and building more government.”

From a deficit of $203.1 billion in 1994, Clinton worked with a Republican Congress to produce a $70.2 billion surplus by 1998, the first since 1969 when Republican Richard Nixon was President and Democrats controlled both houses. The surplus reached $236.9 billion in 2000.

Obama may veto efforts to block spending and make it more difficult for elected officials to reach agreements on extending the tax cuts enacted under the George W. Bush administration, continuing unemployment benefits and spending on infrastructure, said Priya Misra, head of U.S. rates strategy at Bank of America Merrill Lynch in New York. The firm is one of 18 primary dealers of U.S. securities that trade with the Fed and are obligated to bid at Treasury debt auctions.

“The problem is right now you actually need action to be taken,” said Misra, who predicts that 10-year note yields may fall as low as 2 percent. “It's a negative for the economy, but it will keep a bid in Treasuries.”

Fiscal stimulus can work with monetary policy to boost an economy. Christina Romer, the former chairman of Obama's Council of Economic Advisers, said the President pushed the largest possible stimulus bill, the American Recovery and Reinvestment Act, through Congress, though ideally it should have been larger.

“Given how we were just falling off the edge of a cliff, that act absolutely was crucially important to stopping the fall and helping us to turn the corner,” Romer said in an interview last week with Bloomberg Television. “Given where we were, we needed to do more.”

Chances for additional fiscal stimulus aren't good because people now “treat it like a dirty word,” Romer said. “We need some more of it. And it's something that would help put people back to work.”

Economists have slashed their GDP growth estimates for 2010, to 2.7 percent from 3.3 percent in May, based on the median of 83 economists surveyed by Bloomberg. For 2011, it's 2.45 percent. Fed Chairman Ben S. Bernanke said in an Oct. 15 speech that additional monetary stimulus may be warranted because inflation is too low and unemployment is too high.

“There would appear -- all else being equal -- to be a case for further action,” Bernanke said in remarks to a Federal Reserve Bank of Boston conference.

Gridlock in Congress also may be unable to reduce the deficit, potentially damping demand for Treasuries at a time when some parts of the market are signaling the securities are too expensive.

A Fed measure of risk in Treasuries that includes expectations for interest rates, growth and inflation shows the securities are the most overvalued since the financial crisis in December 2008, just before 10-year note yields almost doubled in the following six months.

Last week yields on 30-year bonds rose 23 basis points to 3.98 percent, or a record 1.42 percentage points more than 10- year rates in a sign that bond investors expect moves by the Fed to spark growth and inflation will work.

“The market is buying into the Fed mantra that it will work to get us out of this low inflationary environment,” said Michael Pond, an interest-rate strategist in New York at Barclays Plc, another primary dealer.

While spending cuts are usually good for bonds, they may hurt companies that count on federal contracts. A Goldman Sachs Group Inc. index of corporations getting 20 percent or more of revenue from government lagged behind the Standard & Poor's 500 index last quarter after beating it since September 2009.

Bethesda, Maryland-based Lockheed Martin Corp., which gets almost all its revenue from defense projects, has fallen 5 percent since July as the S&P 500 rallied 15 percent. Tenet Healthcare Corp., based in Dallas, depends on the U.S. for half its revenue and is trailing the market by 7 percentage points.

The September employment report, which showed state governments cutting positions for teachers and other workers, leading to a 95,000 drop in payrolls, is a sign that lack of federal spending to help municipal governments is hurting the recovery, said David Brownlee, head of fixed income at Sentinel Asset Management in Montpelier, Vermont.

“If they're going to play that game of chicken, it could be to the point where they throw cold water on the economy,” said Brownlee, whose firm manages $22 billion. “We've got more problems than answers.”

(ref: Bloomberg News, October 19, 2010)

Saturday, October 23, 2010

Gundlach's `No Normal' pressure cooker

Jeffrey Gundlach, the lone bond manager to beat Bill Gross in the past 5, 10 and 15 years, said there won’t be any “new normal” to guide investors until policy makers repair the damage caused by the financial crisis.

“I think ‘no normal’ is a good phrase, as opposed to ‘new normal,’ ” Gundlach, chief executive officer of DoubleLine Capital LP, said during an interview in his office in Los Angeles. “Some major policy shift has to happen that will turn everything on its ear. So this idea that we’ll go into some quasi-similar paradigm, some sort of new thing -- no way.”

Gross and Mohamed El-Erian, co-chief investment officers at Pacific Investment Management Co., use “new normal” as shorthand for their forecast that the U.S. will endure below- average economic growth of 2 percent or less for the next three to five years and unemployment peaking at 10.5 percent to 11 percent, from 9.6 percent in August. It’s entered the Wall Street lexicon to describe a post-crisis world in which the U.S. and Europe no longer offer the best investment prospects.

Gundlach, who until December managed the top-ranked TCW Total Return Bond Fund, doesn’t disagree with Pimco’s outlook. His point is that “new normal” fails to recognize that all previous economic and investment assumptions have been permanently altered by the financial crisis.

“Massive” policy changes will be required to bolster the economy and cut the U.S. budget deficit, projected to be at about $1.47 trillion, Gundlach said. The timing and nature of the potential regulatory changes are unpredictable, causing him to shorten the length of time he holds investments.

“You cannot go on with these policies for too very long,” said Gundlach, 50. “The problem is the debt burden is very high to begin with and it’s growing fast.”

The U.S. government will have to increase tax rates, now at historic lows, as it tries to reduce its budget deficit, Gundlach said. It will also have to wean itself from borrowing money to stimulate the economy, he said.

Pimco developed the concept of “new normal” about a year- and-a-half ago as an “attempt to move the general thinking beyond the notion that the crisis was a mere flesh wound, easily healed with time,” El-Erian, 52, said in an interview.

“The crisis cut to the bone, resulting from an extraordinary, multiyear period of debt and credit entitlement which was anything but normal,” he said.

New normal was less about what should happen than “what was likely to happen given our analysis of national and global factors,” El-Erian said.

In an April speech at Princeton University in New Jersey, Christina Romer, then head of the White House Council of Economic Advisers, said she found the fatalism of the new normal distressing. She said that shorter-term cyclical events such as the decline in demand for goods and services were the real drag on job creation.

“Unemployment is high fundamentally because the economy is producing dramatically below its capacity,” Romer said. “That is, far from being the new normal, it is the old cyclical.”

In September, as she exited the Obama administration, Romer said she had underestimated the severity of job cuts and that this “has not been a normal recession.”

Gundlach managed the TCW Total Return Bond Fund until Dec. 4, when he was ousted as chief investment officer of TCW Group Inc. after the company accused him of planning to start his own investment firm. Gundlach said he was fired to reduce expenses.

Co-manager Philip Barach and more than 40 members of Gundlach’s team followed him to DoubleLine, which started three fixed-income mutual funds and plans an exchange-traded fund focusing on emerging-market bonds. Assets in DoubleLine Total Return Bond Fund, run by Gundlach and Barach, have grown to $2.7 billion since its inception on April 6, according to data compiled by Bloomberg.

TCW Total Return under Gundlach averaged gains of 7.5 percent in the five years ended Dec. 4, topping Pimco Total Return Fund, which rose 7 percent in the same period. The TCW fund also beat Gross in the 10- and 15-year periods. He’s the only intermediate-term bond manager to post higher returns than Gross, 66, in each of the three periods, according to Chicago- based Morningstar Inc.

Pimco Total Return is the world’s largest mutual fund, with $252 billion in assets.

DoubleLine Total Return Bond Fund has increased 15 percent from inception through Oct. 4, compared with 7.3 percent by Pimco Total Return, Bloomberg data show.

Gundlach, who is known for his expertise in mortgage-backed securities, was early to spot signs of trouble in the U.S. property market, and by August 2006 he had started a distressed real-estate fund to take advantage of declining prices. He correctly called an end to the five-year property boom and said falling real-estate prices would weaken the U.S. economy.

“He is considered a wunderkind in the bond-fund world,” Jeff Tjornehoj, a senior research analyst at fund researcher Lipper in Denver, said in an interview. “He’s not as well-known as Gross, but he’s well-respected, and part of that reputation comes from being at the right place at the right time.”

Gundlach wasn’t immune to fallout from the subprime- mortgage collapse, investing in securities that lost value during the crisis. Under Gundlach, TCW became the biggest manager of collateralized-debt obligations, with $41.3 billion under management as of Sept. 30, 2007, according to data from Standard & Poor’s. Gundlach has said his CDOs got out of high- risk home loans early in the credit crisis and missed the worst of the losses from those securities.

Confidence in financial markets collapsed in 2008 after the debt securities derived from defaulted properties -- many of which were purchased with subprime loans -- became so toxic that credit dried up for companies and individuals. The bankruptcy of Lehman Brothers Holdings Inc. and ensuing panic-selling of all but the safest government bills and bonds prompted an unprecedented $1.49 trillion rescue of banks and the economy, now recovering from the worst recession since the Great Depression.

The economy grew at a 1.7 percent annual rate during the second quarter, compared with 3.7 percent in the first three months of the year, according to government data.

“The GDP isn’t really growing now, counting all this debt that is being used to prop up consumption over the short term,” Gundlach said.

That the stock market hasn’t declined this year amid predictions of a global economic slowdown and the debt crisis in Europe is “impressive” and signals demand from investors looking for higher returns as interest rates have hovered near zero for the last two years, Gundlach said.

The MSCI AC World Index has climbed 1.8 percent this year, while the Standard & Poor’s 500 Index has advanced 2 percent.

Gundlach said he is less bearish on the market than he was in 2006 and 2007, largely because he was worried about the solvency of the nation’s banks and because securities were “egregiously overvalued.” The S&P 500 peaked at 1,565.15 in October 2007, falling to a low of 676.53 in March 2009.

Investor demand for dividend-paying stocks bears the hallmarks of the next investment “disaster,” he said.

“People that think dividend-paying stocks are a good bond surrogate are greatly mismatching the risk,” he said. “This has the characteristics of something that could potentially be a debacle.”

Gundlach said equities haven’t declined enough to be attractive investments, especially shares of investment banks such as Goldman Sachs Group Inc. He compared bank stocks to those of airlines, as they haven’t made money for investors over the long term. In the past five years,airline stocks fell at an annual rate of 4.9 percent, compared with a decline of 11 percent for financial stocks.

“Banks and investment banks are horrible investments at the top of a debt cycle,” Gundlach said.

As concerns over regulation and the economy have increased, Gundlach said he’s investing in government bonds as well as mortgage-backed securities that will do well as they rebound from deeply discounted values. DoubleLine’s funds, including the Core Fixed Income Fund, haven’t completely sold holdings in 10- year Treasuries, which have the potential to do “reasonably well” in a weak economy where interest rates are low, Gundlach said. The securities can hold up in the event of deflation, which Gundlach said is a possibility.

The funds are also invested in non-guaranteed mortgage securities that Gundlach and his team believe are trading below what they are worth. These bonds, if purchased at the correct valuation, aren’t sensitive to interest-rate increases and inflation, or rising prices.

“It’s the ultimate inflation hedge,” Gundlach said.

In the past couple of months, DoubleLine also bought below investment-grade corporate bonds because they will be in favor for at least a year and yields are 7 percent to 8 percent. Gundlach doesn’t like junk bonds in the long term because there is risk of default, he said.

Gundlach, who joined TCW in 1985 as a quantitative analyst, later became a fund manager and was named chief investment officer of the Los Angeles-based company in 2005. TCW fired him last year, saying that Gundlach had threatened to leave and take key employees with him. Gundlach said he was dismissed so the company could cut costs.

TCW sued Gundlach and three other former employees in January, alleging they secretly downloaded proprietary information that was used to form DoubleLine. Gundlach has sued TCW, claiming he is owed as much as $1.25 billion in anticipated fee income, and said the allegations that he used information from TCW are untrue.

Assets in TCW Total Return, now managed by a team overseen by Tad Rivelle, have fallen by more than half to $5.3 billion since Gundlach’s departure. It has returned an average of 8.7 percent over the past five years.

DoubleLine started with backing from Howard Marks’s Oaktree Capital Management LP, a Los Angeles-based firm that focuses on high-yield and distressed debt. DoubleLine Total Return Fund had the fastest start for a mutual fund, according to Morningstar. It took 16 years for the TCW Total Return Bond Fund to reach $2 billion in assets under management, Gundlach said.

DoubleLine’s assets under management have risen to $5.5 billion, helping the firm turn profitable, according to Gundlach.

(Bloomberg, October 5, 2010)

Sunday, October 17, 2010

Reflection Series: Investing in Bonds

Bond investing should be easier than stock investing, but it’s not. The basic item you’re buying, the bond, represents a promise by a specified entity to make a well defined series of payments. Other than understanding the probability that the issuer will have the money to pay and an appreciation for any clauses that may allow early redemption, the bond can be mostly defined by an interest rate and a final date of repayment. Yet the bond market is less transparent than stock investing and even when you can get the data you need it often seems like bond investing is a maze of confusing jargon terms like “duration”, “roll-up”, “inversion”, and “call options.”

I think bond traders are secretly pleased to have such confusing words attached to their profession, it allows them to hold their own in conversations where commodities traders are talking about “contangoes” or stock traders are “shorting against the box.”

Most of those words can be explained in straightforward terms and I’ve tried to write this article for people who don’t know the jargon without skimping on discussions of advanced tactics and strategies. If you already are a bond whiz you can just skip the bits defining the terms and you’ll still probably find at least one neat tip here. If you haven’t tried to buy bonds before, or if you have but don’t have a full understanding of what is happening with those investments this article should clear up a lot of the confusing doublespeak that seems to surround bond trading.

Bond basics

A bond is basically debt. An issuer is the company or government who borrows the money by issuing the bonds – at which point the buyers pay for the bonds and the issuer gets the money. When originally sold the bonds will be sold in some fixed unit size (such as $1000) with a stated interest rate (let’s say 6% for this example). At 6% the issuer will pay the owner of the bond $60 per year (generally paid in parts every X months) until the “maturation date” at which point the borrower will give the bond owner his $1000 back and the bond will cease to exist. A bond is basically debt with interest. The difference between a bond and a direct loan is that a bond is easily traded in standard unit sizes and typically the bond has a standard contract form.

Bond types

The basic bond types that most people talk about are government and corporate.

The least risky government bond is the US Treasury bond. The US government has the amazing advantage of being able to borrow in its own currency, so the bonds will presumably always be repaid since the US can simply print any needed money. (As an interesting aside the Republican Congress actually threatened to stop payments on US bond obligations in the 1990s during a budget showdown with Democratic President Clinton, but everybody eventually realized that would be a horrible precedent and so to this day US treasuries have never missed a payment.) A few other countries have managed to borrow in local currencies, but most other countries and emerging economies wind up borrowing in bonds denominated in foreign currencies (usually dollars).

The result of this currency difference is that when the borrowing country’s economy has a slowdown their currency weakens and suddenly it becomes much more expensive (in local currency) to make debt payments at the same time as the local economy can least handle higher payments. This vicious cycle has shown up a number of times and has caused several recent bond market disasters such as the Argentinean, Russian, and Southeast Asian collapses of the last few years. Emerging nations have responded by building larger dollar currency reserves so that they can pay off their debts with dollars when difficulties arise, thus defending their currencies.

The second major bond type is corporate bonds. These bonds are issued by companies to raise money for business purposes. Some of these bonds have additional conditions that you don’t typically see in government bonds, such as “call rights” that allow a company to buy back the bonds at certain times (paying back the base debt amount, but depriving the owner of future interest) or “conversion rights” that allow the bond owner to convert it to company stock under certain conditions. Corporate bonds have more variations and are a somewhat wilder bunch than conventional government bonds.

This explanation has focused on the major categories and types. There are also government bonds issued within larger countries (including the US) by states and even by cities. These bonds carry various terms and exceptions and in many cases have different tax consequences.

Bond Price Changes

There is a basic relation between a bond price and the interest rate on that bond. When the interest rate goes up, the price goes down. When the paper says “bond prices strengthened today” you can tell without reading further that the interest rates available are lower. The simple reason for this is that the debt payments on a bond are based on the original issue price, so if Arnold buy a $100 bond from Bob for $105 for whatever reason, the interest the issuer is paying is still based on the issue value of $100. If the bond originally offered 5% on $100, that’s a $5 payment. The payment is still $5 but if you buy it for $105 you are making 5/105 = 4.76% because the price went up.

This price/interest rate relationship is clearest for US treasuries, where the price changes presumably do not reflect changing evaluations of risk (recall that the US treasury is largely considered “riskless”). These interest rates reflect the price the US government pays to borrow money, so it’s also an important value for economic forecasting. When the prices of treasury bonds change it is a relatively straightforward bit of math to calculate the accompanying interest rate change. The relationship between these two is called the “duration” for historical reasons. Don’t let the name fool you, the “duration” of a bond is not the amount of time between issue and maturation or the amount of time remaining on a bond before the capital is returned. The duration is the multiplier that is applied to an interest rate change to figure out the price change of a bond. If you own treasury bonds with a duration of 7 and you read that the interest rate on your bonds went up 0.25% you should expect the market price of those bonds to DROP by 7x0.25% = 1.75%. (This is a large jump, bonds move slowly most of the time.) The image below shows typical duration changes as maturity changes for different types of bonds. The “coupon rate” is the percentage yield payments the bond is making each year. (These used to take the form of coupons that were cut off the bond each year and cashed in.) You can see that for most reasonable coupon rates duration maxes out at about 10 (and yes, the standard units of duration are years – don’t let it confuse you). This means that for a bond of 30 year maturity (and thus duration of about 10) you would expect an interest rate change of 0.25% to result in a price change of -2.5%. One interesting exception to the duration calculation is that bonds which do not make payments (so called “Zero coupon bonds”) have a duration equal to their time to maturity.

Bond "duration" (the variable) versus bond "maturity" (number of years until the bond is finished and the principle is returned. The duration is a handy number that you multiply the interest rate change by in order to get the market price change of a bond. If duration is 10 and a bond yield drops 0.25%, the price on the market should go up about 2.5%

Duration is one of those jargon terms that make bond investing such a mess. I often see the term used in ambiguous ways in even the professional financial press. Some writers use the term duration in the sense of the price multiplier, above, and also in its conventional English meaning as a period of time – sometimes in the same paragraph! [Click here for more math on bond duration]

Bond yield and maturation

Bonds typically return a higher percentage rate (or yield) if they have more time until maturation. Another way of thinking of this is that people want a higher interest rate if they are going to lend money for longer. A longer term loan involves more risk that the borrower will default, or that interest rates will change, or that the lender will find a better potential use for their money. In our everyday lives this manifests as cheaper loan rates for a 15 year mortgage versus a 30 year mortgage, for example. A chart of these rates (known as yields) forms a curve and is known as a yield curve.

This would be a "normal" yield curve. Short term loans do not get paid as much interest as long term. The range (30 years) is set by the longest maturity common issue US Treasury bond, and is also the most common long term mortgage issue.

The relationship between bond maturation date and interest rate changes over time. It is influenced by the market demand for bonds and also by estimates of what the prevailing interest rates will do in the future (if you think interest rates are going to go up in a few years, you will want a higher rate on a loan that extends into that time). Sometimes, however, prices fluctuate such that interest rates on longer loans become LOWER than interest rates on shorter rates. This is known as an “inverted yield curve” because the relationship between the future and present yields is the inverse of the usual relationship. When the short term and long term yields are about equal we get what is known as a “flat yield curve”.

"Flat" and "Inverted" yield curves, made with recent data. Each of these leads to different short term strategies that hedge funds and banks engage in to profit from the shape. The cause of these is open for debate but some causes are traceable.

Advanced strategies
Bond Roll-Up

Take a moment to look back at the normal yield curve above. A 10 year bond normally trades at a higher interest rate than a 5 year bond, so what happens if you buy a 10 year bond and hold onto it for 5 years? You will collect the interest for 5 years, but you will now be holding a bond which will be paid off in 5 years which means that the market will value it as a 5 year bond. The interest payments remain the same, but since the market now values the bond as a 5 year bond it will probably trade at a lower effective interest rate and since prices of existing bonds move in the opposite direction of interest rates the price goes up. Another way of looking at that is that once a bond (any bond) has lived part of its life it becomes a shorter term loan and becomes more valuable since more people are willing to loan shorter term money. The increase in price of an aging bond is called “roll up.”

This strategy becomes more useful when the yield curve is steepest, because a larger change in interest rate leads to a larger increase in price. When the bond curve is flat you can buy long bonds and wait for them to age while the bond curve gets normal again and try to profit from both events.

The Carry Trade

When the yield curve is steep the bond roll up strategy above is widely practiced. The "carry trade" is the opposite strategy: it is widely practiced when the yield curve is inverted. When the curve is inverted an investor can borrow long-term money (by selling long term bonds short to generate cash for the strategy) and then loan short term money by buying short term bonds. The lower shield on the long term bonds means that more money is made from selling those bonds than by buying the short term bonds, resulting in profits. When the maneuver is completed the investor is left holding short term bonds and owing long term bonds, which is fine as long as the prices balance somewhat but can leave the investor owing money if the yield curve reverts to its normal shape. During the recent yield inversion a lot of hedge funds practiced this strategy, and some of them lost some money when they didn’t get out in time.

To further enhance the carry trade some market players also use different types of bonds for the two parts of the transaction. One recent example was that hedge funds were borrowing their money in Japan at nearly 0% and loaning it in Iceland and Turkey at 3-5%. It was possible to make a lot of money this way, but currency changes and bond market volatility make the strategy risky.

Bond risk

Each bond has some chance of default, which means that it will not be paid off. The US treasury bond is usually used as the “riskless” standard so you will often see comparisons of bond returns made to US treasury bonds or see the US treasury bond referred to as “the riskless asset”. Corporate and government bonds are usually given risk ratings by a number of rating agencies such as Standard & Poor or Fitch rating services. The rating names vary by agency but most are alphabetic and if you see something that starts with anything other than an “A” you should be very wary, the grades are not like school and a “B” is not very good.

The rating agencies use proprietary (and secret) grading methods and companies pay them for the ratings. This has led to some concerns about accuracy and conflicts of interest. The agents of the rating companies are essentially auditors who go into a company and give a credit score based on the books of the company. The rating companies argue that they have to keep their scoring methods secret in order to prevent people being able to reverse the rating to extract non-public information that rated clients have shared with them, but investor advocates have expressed a lot of concerns about the rating agencies keeping methods secret and accepting payment from their audit subjects. Academic studies have shown that the rating agencies are often 2-3 years late in spotting dangerous financial trends at their subject companies.

Fortunately there are alternatives.

I could fill pages and pages with academic debt rating methods, but the most widely used method is the “Altman Z-score” or simply “Z-score” introduced in an academic paper in 1968 by Altman [click for paper]. This score is calculated from publicly available numbers which can be extracted from the published financial statements, although it often requires quite a bit of accounting dexterity to get some of the numbers if the company is complex and has a conglomerated structure or joint endeavors with other companies. The resulting score is the corporate equivalent of a “consumer credit score” of the type that companies maintain on each of us individually. The Z-score has an advantage of being publicly reviewed and criticized so that a lot of people are constantly investigating the Z-score and looking for weaknesses or corrections that might be needed (a quick search found about 150 study papers using the Z-score for comparison or proposing extensions to the Z-score). This review makes the Z-score a very powerful method. Whenever I am concerned about the ability of a company to pay off its debt I calculate a Z-score for the company. [Link to an online Z-score calculator]

The availability of both the private rating agencies and the publicly reviewed Z-score raised a natural curiosity: how do they compare? Several studies have been done along these lines. If you go to this post you can see a chart of how Standard & Poor ratings have equated to Z-scores over time. As the financial system has changed both S& P and the Z-score users have slowly adapted their criteria to adjust for changes in how companies operate and how financial reporting works. The most interesting outcome from comparison studies is that the Z-score changes well before the rating companies adjust their scores, in fact the Z-score typically projects S & P downgrades almost 3 years in advance! To some degree this is understandable since the auditors at the rating companies only visit the company occasionally (remember they have to be paid), but I was surprised that the delay was so long. The next time you read about a bond declining in the market without any rating changes, keep in mind that rating changes are often delayed several years after company problems are visible in financial statements. If you invest in specific corporate bonds you may want to calculate a Z-score every time they release earnings.

Common stock typically becomes worthless during the bankruptcy process because stock represents ownership in the business. Bonds are a loan to the business so typically bondholders recover some value during a bankruptcy. There are a variety of levels of “seniority” of bonds, the more senior the bond the more firm a claim they represent on the assets of the company. I have reproduced a chart from a study showing the average value recovered during a bankruptcy by the various bond seniority levels.

Percentage of principle recovered after bankruptcy by corporate bond type. The different bond "priorities" in the left had column are different categories of bond a company can sell, with different priorities of claims on the company assets in bankruptcy. The safer ones are at the top and the worst ones at the bottom. If the company stays solvent it should pay of 100%, if it goes into bankruptcy this chart gives some average recovery numbers by category. N is the number of bankrupt bonds in that category that were found in the study and used for the calculation.

Bond Trading

Bonds are traded differently than stocks. For many years the market was hidden from investors and a broker would give a price without the investor knowing how much of a markup they were facing because there were not central quote interchanges available. Bonds were traded between the “bond desks” of large institutions and many times the markup on a bond purchase (versus the price the seller gets) could be several percent of the total price! Things are getting much better now with numerous bond supermarkets making some level of quotes available. An investor typically still pays more for a bond trade than a stock trade, but it isn’t nearly as bad as it used to be.

One thing to watch out for is expressed in the old saying that “stocks are bought and bonds are sold.” In many cases bonds (being debt) are pushed quite heavily by investment banks either to clear up their portfolio or to serve a corporate client (for some frightening stories about this see the book “Liar’s Poker”, linked below). If your money manager tries to SELL you a bond, you should become skeptical and carefully review the purchase (and consider changing money managers). The right way to BUY bonds is to come up with a fair idea of what qualities you want and have a look at the available bonds – and if you have enough capital to allot buy several different bonds for diversification. You should also be careful where you buy bonds and be aware of the specific compensation any intermediaries are collecting. I encourage you to click on some of the bond market ads that no doubt show up on this page, but be careful and make sure you are BUYING and not BEING SOLD.

Bond Expertise

Any investor who knows the material above is far ahead of the average bond investor. If you can look into a Z-score (and know how far behind S&P type credit ratings can be) and you know what duration is you will find even many bond articles in the financial press to be humorously ill-informed. The most complex math involved here is only multiplication so you can quickly do checks in your head when looking at the yield, maturation, and price of a bond to consider for investment.

There are still a lot of things that have not been mentioned here. Some corporate bonds have complex terms where the yields follow various indexes, for example. Some regional government bonds are “pre-refunded” where they have a pile of treasury bonds that are sufficient to pay off the bond sitting in a trust – those regional bonds cannot fail to pay unless the US treasury bonds fail. Other bonds may have “insurance” which means that even if the payer fails another company or bank will stand behind the bonds (although that payer may fail as well). There is plenty of room for further reading; the material here is designed to give you a solid foundation to start from.