Chapter 15
HOW THE OTHER $30 TRILLION IS INVESTED
An Overview of the Bond Market
Some market analysts find little reason to invest in bonds. They point out that stocks have historically provided higher average returns and are therefore likely to be better long-term investments. For short-term needs, on the other hand, cash is just fine. And since many brokerage accounts are set up to pay interest on any cash in the account, there’s no need to concern oneself with the nuances of short-term investments like Treasury bills and commercial paper. Concentrate on picking good stocks and stock mutual funds, they say, and the rest will take care of itself.
Thirty trillion dollars thinks differently. That, according to the Securities Industry and Financial Market Association (
www.sifma.org), was the approximate value of the U.S. bond market as of June 30, 2008. This was more than double the total market value of all the stocks traded on the NYSE. Somebody obviously sees good reasons to allocate some of their assets to the bond market.
How is that $30 trillion divided? At first glance, Treasury securities would seem to make up about one-third, or approximately $10 trillion. According to the U.S. Bureau of the Public Debt, total public debt as of June 30, 2008, was $9.5 trillion. However, “only” $4.7 trillion is in marketable securities held by the public. What about the other $4.8 trillion? These are nonmarketable securities, mostly intragovernmental holdings, and they are not considered part of the bond market. Most of these securities represent money that the government has loaned to itself for various purposes. It also includes Savings Bonds and money loaned to state and local governments (nicknamed SLUGs).
So far, we’ve only identified $5 trillion out of the $30 trillion. Ten years ago, marketable treasury securities were the largest single component of the U.S. bond market. Today, they have been surpassed by the U.S. corporate bond market, with approximately $6.2 trillion outstanding. Even greater in size is the market for mortgage-backed securities (MBS), with $7.6 trillion.
Nearly $2.7 trillion more in municipal bonds brings the total for these four categories to about $21 trillion. The remaining $9 trillion is divided between the money market ($4 trillion), agency debt ($3 trillion), and other asset-backed securities ($2.5 trillion). (See
Table 15-1.)
Treasuries
U.S. Treasury securities are public debt securities issued by the Treasury Department of the United States. They make up the most liquid part of the U.S. fixed-income market, with a turnover greater than the market for corporates, agencies, or munis (tax-exempt municipal bonds). In 2008, the Treasury market had average dollar trading volume in excess of $500 billion per day, dwarfing all markets except for the global currency markets, which are even larger. More than half of this trading takes place among primary dealers, banks authorized to buy and sell securities with the Federal Reserve Bank of New York.
According to the U.S. Department of the Treasury, about $300 billion of marketable Treasury securities are held directly by individuals. This is roughly 5 percent of the $5.8 trillion in outstanding marketable Treasuries. In comparison, the total amount of U.S. savings bonds outstanding is $194 billion, one-third less than the amount of marketable Treasuries in individual hands.
Table 15-1 Overview of Public and Private Debt Outstanding
Sources: SIFMA, U.S. Department of the Treasury, Federal Agencies, Federal Reserve System, Bloomberg, Thomson Financial
Treasury securities are divided into three categories, depending on the length of time between date of issue and the maturity date. Securities with a maturity of between 10 and 30 years from issue date are called Treasury bonds. Securities with a maturity of more than 1 year but less than 10 years are called Treasury notes. Finally, securities with maturities ranging from 13 weeks to 1 year are called Treasury bills (or T-bills). Sometimes, however, Treasury securities are generically referred to as bonds.
Four Dimensions of Bond Risk
Traditionally, investors in bonds think about four kinds of risk to their investment: credit risk, interest rate risk, exchange rate risk, and reinvestment risk. Any of these risks can lower or even destroy the value of the bondholder’s investment.
Credit risk refers to the possibility that the issuer’s perceived creditworthiness may weaken, for reasons ranging from a general economic slowdown to an actual default on the part of the issuer. U.S. Treasury securities have the highest credit rating of any fixed-income security.
default
Failure to meet finncial obligations to a creditor.
Interest rate risk results from fluctuations in the supply of, and demand for, Treasury and other fixed-income securities. When demand for bonds falls, the government (or any other issuer) has to offer higher yields to attract investors. But current bondholders don’t see an increase in the amount of interest they are being paid. So what happens if you are holding a bond and interest rates go up? Nothing, unless you want to sell it. Now you are competing against new issues that pay greater interest. The only way you can attract a buyer is to lower the price of the bond you are trying to sell. This is why the market value of a bond falls when interest rates go up.
In general, interest rate risk is greater for longer maturities; also, it is greater for zero-coupon bonds than for coupon-paying bonds, and greater for premium bonds than for par or discount bonds.
Foreign investors have additional worries in the form of exchange rate risk. This can be a factor even if interest rates do not change in the currency in which a bond is denominated. If you are holding a foreign currency-denominated bond and the value of that currency falls relative to your home currency, you will receive smaller amounts of home currency after converting interest and principal payments.
Finally there is reinvestment risk: To understand it, recall that bond yields move in the opposite direction to bond prices. When the general level of yields increases, bondholders incur interest rate risk. But what if demand for bonds increases? The price of existing Treasury securities—those that have already been issued—increases. Because of this increased demand, the government doesn’t need to offer as high a rate of interest on new Treasuries. This is good for existing bondholders, but only if they wish to sell their bonds at a profit. If, on the other hand, they hold the bonds until maturity, they will find (assuming that yields remain low) that they cannot get as good a yield as they did last time around.
The federal government uses debt securities to finance its operations and to pay interest on the national debt. The national debt, or gross federal debt, which stood at approximately $10.7 trillion at the end of 2008, is the sum of all Treasury debt securities outstanding, whether 30-year bonds issued in the late 1980s or T-bills issued a few weeks ago.
gross federal debt
Federal debt, including interagency debt.
In any given year, the difference between outlays and receipts is usually referred to as the
budget deficit, although if receipts exceed outlays it is actually a
budget surplus (shown as a negative deficit). (See
Table 15-2.)
Table 15-2 Budget deficits versus gross federal debt
Sources: U.S. Treasury Department, Bureau of the Public Debt, and Office of Management and Budget *Estimate.
One of the most important decisions faced by buyers of Treasury bonds is how long a maturity date to choose. The maturity date is simply the date on which the bond comes due and the face value of the bond is given to you. If you purchased the bond at par value, the face value is simply the amount you paid. If you paid less than par, the bond is said to have been trading at a discount. If you paid more than par, it was trading at a premium.
face value
The amount of money due on a bond’s maturity date; also called principal amount.
Typically, the longer you lend out your money, the higher the interest rate you receive. But there are times when the reverse is true—at those times, you get higher interest rates for bonds with shorter maturities.
Using a Seesaw to Envision the Relationship between Price, Yield, and Maturity
As we have previously explained, the price and yield of fixed-income securities move in opposite directions. This is not merely a tendency or a correlation; it is simply a matter of how yield is defined. The relationship between yield and time to maturity is another matter. Here we can identify two tendencies:
• Yields of bonds with more time to maturity are usually higher. The graph showing the relationship between yield and time to maturity is called a yield curve. Its normal condition is to have a positive slope, although that slope can be fairly small. When its slope is positive but small, it is referred to as flat. When its slope is negative, it is referred to as inverted. This is considered abnormal.
• The sensitivity of a bond’s price (and yield) to a change in the overall level of interest rates is called its duration. In general, the longer the time to maturity, the greater its duration.
The relationship between price and yield can be envisioned as a seesaw, with prices on one side and yields on the other side. Longer maturities tend to be farther out on the seesaw, making them more sensitive to changes in the overall interest rate environment. The farther out you sit on the seesaw, the more you move when the seesaw moves. (See
Figure 15-1.)
Bond investors must decide the length of time they would like to put their money out on loan. A complementary decision is faced by issuers of bonds: How far out should they set the maturity date of the bonds they issue? Of course, forces of supply and demand come into play here. For example, if investors want more long-term debt than is readily available, they will bid up the price of such bonds, making them more attractive for issuers and thus eventually balancing the forces of supply and demand. The existence of a wide variety of maturity dates, each with its own yield and effective rate can be depicted in a graph of yields versus maturities. This graph, called the yield curve, provides a valuable reference point for understanding how yield varies with maturity.
Though yield curves can be drawn for any set of bonds of comparable quality, the most commonly depicted yield curve is the one for Treasury securities. Each day, as the yields of different Treasury bonds fluctuate in response to market forces of supply and demand, the yield curve changes its shape. Daily financial papers will often show the Treasury yield curve as it existed at yesterday’s market close, and one or two earlier curves, perhaps one week ago and one year ago.
Over time, a yield curve can undergo dramatic changes in shape, reflecting significant changes in market sentiment, especially related to inflationary expectations. The three basic shapes of the yield curve are steep and upward-sloping, flat, and inverted. (See
Figure 15-2.)
A steep and upward-sloping yield curve reflects an environment in which bond investors demand significantly more compensation for longer-term debt, reflecting concern that inflation may be on the increase.
Upward-sloping yield curves, whether or not they are considered steep, are also referred to as positive yield curves, because of the positive slope of the straight line that most nearly approximates the curve.
In recent years the yield curve has been nearly flat. A flat yield curve suggests an economic climate in which there is relatively little fear of inflation, and the government is able to obtain longer-term financing for roughly the same rate as for short-term financing like T-bills.
The term inverted suggests an abnormal situation, and inverted yield curves have been relatively uncommon. They typically occur in response to tight monetary policy on the part of the Fed, which is able to influence the market’s short-term rates by raising (or lowering) the discount rate, or by changing its target Fed funds rate. Higher short-term rates are a traditional means of cooling off an overheated economy, either to prevent inflation from increasing or to bring about an actual decrease in its rate.
discount rate
Rate charged by the Federal Reserve on loans to member banks.
Some analysts believe that a positive yield curve is normal, reflecting investors’ need to be compensated for the greater risk of a longer-term investment. This viewpoint is understandable, given the inflationary experience of the past several decades. Under deflationary market conditions, however, it would be desirable to be able to lock in a rate for as long as possible, so it may be wiser to keep an open mind on this subject.
Two Ways to Buy Treasuries: From a Broker/Dealer or Direct
Most brokers and many banks will be happy to sell you Treasury bonds, notes, or bills for a modest commission. Bills, notes, and bonds are sold in amounts beginning at $1,000.
There is a way to buy Treasuries without paying any commissions. Federal Reserve Banks and the Bureau of the Public Debt (
www.publicdebttreas.gov. ) offer what is called
Treasury Direct. Using Treasury Direct, you can arrange for your T-bills to be automatically reinvested when they mature. (See
Table 15-3.)
Savings Bonds
What about savings bonds? There’s a $5,000 per person per year limit for EE bonds, and a separate $5,000 limit for I bonds. For as little as $25, you can buy savings bonds, which can be purchased at many banks or even through a payroll deduction plan. EE Savings bonds, like other Treasury instruments, offer guaranteed rates of return if held until maturity. But they also offer the added protection of a guaranteed rate if held for a minimum of five years. This can be of value if interest rates move up sharply, sending the price of other long-term bonds sharply lower. EE Savings bonds have a built-in floor that adds protection to your capital investment. Of course, you pay for this protection in the form of a somewhat lower yield. The new I bonds are modeled after TIPS, to which we now turn. (See
Table 15-4 for a comparison of EE and I bonds.)
Table 15-4 What’s the Difference between EE Bonds and I Bonds?
Source: Bureau of the Public Debt
Inflation-Indexed Bonds
Since the mid-1990s, the U.S. Treasury has offered bonds whose interest and principal repayments are linked to a measure of consumer inflation. Treasury Inflation Protection Securities (TIPS) are designed to protect the bondholder against a loss of purchasing power due to inflation.
Corporates
Corporate bonds are securities representing debt obligations of U.S. corporations. After MBS, corporate bonds represent the second-largest segment of the U.S. bond market, with over $6 trillion in market value outstanding. Issuance of MBS and corporate bonds has surged in the last decade, unseating Treasuries from the spot at the top of the market value charts. Nonetheless, in terms of liquidity, Treasuries remain preeminent: the trading volume of corporate bonds (and MBS) remains far smaller than for Treasuries, and is likely to remain so, because there are thousands of different issuers of corporate bonds (and because of the complexities of MBS).
Corporate bonds offer greater returns than Treasuries. They are issued by a wide variety of U.S. corporations, including utilities, transportation companies, industrial companies, financial companies, and conglomerates. High-quality corporate bonds offer dependability of income and safety of principal. In addition, it is possible to diversify your holdings among many issuers while retaining marketability. Corporate bonds are available with a wide variety of terms. Maturity dates range from a few days to 100 years; interest earned can be fixed or floating. Zero-coupon bonds allow you to get all your money at maturity.
zero-coupon bond
Bond purchased at discount, paying par at maturity.
There is no free lunch in the financial markets. The greater returns of corporate bonds are accompanied by varying degrees of additional risk. In contrast to Treasuries, which are considered the most creditworthy of all securities, corporate bonds vary from AAA ratings all the way down to bonds that are in default. Another risk posed by many corporate bonds is the chance that they will be called if interest rates decline. This increases your reinvestment risk, because you may get back your principal before the maturity date and find that the yield you can get in the current market is substantially lower than what you were receiving. On the other hand, if you want to sell early, there is less liquidity in this market than in the market for treasuries. This means that it will cost you more to sell: Spreads are higher.
Foreign Bonds: Yankees and Beyond
Many foreign governments (and corporations) issue dollar-denominated bonds as a means of attracting investors who prefer a U.S. dollar-based investment. Collectively, these bonds are referred to as Yankee bonds. Unlike foreign currency bonds, they have no direct exchange rate risk, although a dramatic move in exchange rates might alter the credit rating of a Yankee issue, affecting its market value or, in the worst case, even leading to default. Other countries also have markets for foreign bonds denominated in their home currency. For example, the yen-denominated bonds issued by foreigners are referred to as Samurai bonds. In contrast to Yankees and Samurais, in which a foreign issuer sells bonds in a local currency, the Euromarket refers to the issuance of foreign bonds in foreign currencies. The lion’s share of this market is for dollar-denominated bonds, so-called Eurodollars.
Mortgage-Backed Securities and Other Asset-Backed Securities
Fueled by and fueling the boom/bubble in housing, issuance of mortgage-backed securities (MBS) surged during the decade leading up to the financial crisis of 2007-2008, making MBS the largest single category of debt outstanding in the United States. During the boom years, MBS were generally considered safe and liquid investments. In the aftermath of the financial crisis of 2007-2008, many investors exited this market causing great uncertainty about price, value, and liquidity.
MBS represent the lion’s share of all asset-backed securities (ABS). ABS are debt securities that are backed or “collateralized” by a pool of assets expected to generate cashflows. Besides mortgages, ABS may be backed by auto loans, credit card receivables, student loans, and so on.
ABS may be subdivided into several subcategories, including:
• Agency MBS (Government National Mortgage Association (GNMA or “Ginnie Mae”), Federal National Mortgage Association (FNMA or “Fannie Mae”), Federal Home Loan Mortgage Corporation (FHLMC or “Freddie Mac”). The financial crisis caused both FNMA and FHLMC to become insolvent.
• Non-agency MBS are issued by private companies including banks and other financial institutions. With the bailout of banks by the U.S. government, this distinction has become somewhat harder to make.
• Other ABS, i.e., debt backed by pools of assets other than mortgages.
With disappearing demand for new issues and loss estimates over $1 trillion (U.S), the relative size of the ABS market is likely to revert toward earlier levels.
Municipals
Tax-exempt municipal bonds (munis) have a long history of use by individuals in a high tax bracket. In the days when marginal income tax rates went as high as 90 percent, these bonds were an especially good way to generate additional current income. Lower taxes have been a boon to the stock market, making bonds less attractive on a relative basis. Lower tax rates have also meant that there is less reason to invest in munis, driving their yields closer to the yields on taxable instruments. Even though the decline in marginal rates (and the existence of the alternative minimum tax) has weakened their advantages over taxable investments, munis retain many adherents.
marginal income tax rate
Highest tax rate paid by an investor (i.e., tax paid on last dollar earned).
The name municipal is actually somewhat misleading; munis are bonds issued by many governmental entities, including states, cities, counties, and their agencies. They are put to many uses, from highways and hospitals to prisons and schools. Munis are interest-bearing loans, just like corporate bonds and Treasuries. As the owner of a muni, you are entitled to regular interest payments as well as the return of your principal on the bond’s maturity date. Most, but not all, munis are exempt from federal tax on the interest income they generate. Those that are not exempt from federal taxes are called taxable munis, even though they still offer state and local tax exemptions. We will focus on the larger and more important tax-exempt market.
Though it is the smallest of the four major markets in terms of market value outstanding, munis are still an enormous market, with more than $1.3 trillion outstanding. In addition, it remains of great importance to individual investors. This can be inferred from the fact that fully one-third of munis are held directly by individuals. This roughly $450 billion in municipals is more than double the amount of marketable Treasury securities directly held by individuals. Clearly, individual investors are attracted to munis.
Another third is owned by mutual funds, including tax-exempt money market funds and closed-end funds. This means that roughly two-thirds of the market value is fairly directly controlled by individual investors. The final third is spread among insurance companies, commercial banks, trusts, and others.
One of the major selling points of munis is that for many investors, they provide a higher
equivalent taxable yield than taxable bonds. This is the yield after adjusting for taxes. As an example, let’s compare a high-quality corporate bond paying 8 percent to a muni paying 6 percent. Which will put more money in your pocket after taxes? There is no universal answer to this question—it depends on where you live and your marginal tax rate for federal, state, and local taxes. If your marginal federal rate is above 25 percent, then you will keep more money with the muni—even without considering state or local taxes. If you can buy a muni that is double or triple exempt, you can do even better. (See
Table 15-5.)
equivalent taxable yield
The yield on a taxable bond that provides equal income to a particular municipal bond investor.
While all “tax-exempt” munis are free of federal taxes on income, state taxation rules vary for how individuals and corporations are taxed. Each state has its own rules to determine which munis are double exempt, and to whom this double exemption applies. Double exempt means that income from such munis is not subject to state income tax (as well as being exempt from federal income tax). For example, munis are not taxable for Utah residents, even if the bonds are issued by another state. On the other hand, Utah corporations are subject to tax on muni interest income, even for State of Utah bonds. A state-by-state guide for individuals and corporations is published by Commerce Clearing House.
Table 15-5 Equivalent Yields for Various Taxable Yields and Marginal Tax Rates
Until the credit crisis, many muni bonds were insured against default. In 2007 and 2008, it became apparent that the so-called monoline insurers had entered unrelated risky businesses that made their own credit-worthiness questionable at best. This led to a re-thinking of the vale of bond insurance that is just beginning.
Many issuers of munis, like corporate issuers, give themselves the right to redeem all or part of the issue before maturity. These call provisions are a way for the issuer to take advantage of falling interest rates by refunding the bonds with a new, lower interest-bearing issue. Of course, if your bonds are called, you are unlikely to be able to reinvest the proceeds to receive the same rate at the same credit quality. This is your reinvestment risk. In contrast to noncallable bonds, callable bonds should offer you something to compensate you for your reinvestment risk. That something can be a call premium.
An important point about tax-exempt bonds: The exemption applies only to interest income (or in the case of discount instruments, to the portion of capital appreciation that is equivalent to interest). Capital gains are still taxable. Taxable capital gains can occur if you sell a muni whose price has increased due to a decline in interest rates, tax rate changes, or an improvement in credit quality.
Money Market
Another market adversely affected by the financial crisis, money market funds were hit with losses following the September 2008 bankruptcy of Lehman Brothers. The Reserve Primary Fund, the oldest money market fund in the United States, “broke the buck.” This means that they sustained losses large enough so that the sponsoring firm was unwilling or unable to make up the difference, resulting in a loss of capital for shareholders. As the “raison d’etre” of money market funds is safety of principal, this was a true crisis for the global financial system, requiring dramatic action to prevent a run on the “shadow banking system.” The U.S. Treasury defused the problem by guaranteeing the assets of more than $3 trillion in money market funds against a loss of up to $50 billion. This “temporary guarantee program” only covers shareholders up to the amount invested as of September 19, 2008. Initially set to end on April 30, 2009, the program has been extended through September 18, 2009. Updates to this information should be accessible at
www.treas.gov.
Summary
Bonds offer many important advantages. High credit-quality bonds offer safety of principal and interest, while providing some diversification from stock market investments. Also, in contrast to stocks, bonds give you the ability to precisely match expected future liabilities. For this reason, insurance companies and pension funds make extensive use of bonds in their portfolios.
On the other hand, bonds are not without disadvantages. In general, they are harder to buy and sell. Outside of the Treasury market, they can bear a high markup. In addition, the bond market is not very transparent, especially to individuals. It can be hard to figure out your true cost of buying and selling. For these reasons, many individuals decide to hold bonds indirectly, in the form of mutual fund investments. It is important to understand, however, that such indirect holdings do not offer certainty of principal and interest income. Bond funds do not have a maturity date; bond fund shares are actually shares of stock in an investment company that buys bonds. The value of these shares fluctuates with the market forces that raise and lower bond prices and interest rates like a seesaw.
The financial crisis has added further uncertainties to bonds, especially bonds that are not backed by the “full faith and credit” of the U.S. government. Eventually, a new financial order will emerge from the ashes of the old. Bonds and the markets they trade in will be changed in many ways, but they are highly likely to remain an essential part of the new system.
