Quick Take on Fixed Income
November 2015
Question: What are corporate bonds?
Answer: Corporate bonds are debt securities issued by corporations. The bonds have a maturity greater than one year, and interest income is taxable at local, state and federal levels. These bonds are the obligation of the issuing company, which can issue many bonds with different maturities and characteristics to finance its operations. The bonds are backed by the company’s ability to make interest and principal payments or hard assets used as collateral. The Securities Industry and Financial Markets Association reported that corporations issued almost $1.5 trillion in bonds in 2014.
Credit Quality
Credit rating agencies give companies letter grades based on their financial strength. Each agency has a different approach to rating companies and municipalities to determine credit worthiness. As shown below, corporate bond issuers do not compare favorably to municipal issuers when viewed within the strict buying parameters (Aa3 or higher) of BAM’s Fixed Income Desk, with whom we work to build our clients’ bond portfolios. Municipal bonds also hold their credit rating better than corporate bonds. For example, according to Moody’s data covering 1970–2014, Aa rated municipal bonds hold their rating 95 percent of the time, while similarly rated corporates bonds retain their rating roughly 84 percent of the time. Corporate bonds tend to have lower credit ratings on average and get downgraded more frequently than their municipal counterparts.
Returns
From 1927–2014, corporate bonds on average returned only 0.3 percent more than their Treasury equivalents. High-quality corporate bonds also tend to yield less than brokered CDs to the tune of 10–30 basis points depending on maturity. The small premium for taking on corporate risk, coupled with the lower yields compared with brokered CDs, leads BAM’s Fixed Income Desk to not recommend purchasing corporate bonds. For clients that might require additional return, the equity markets have historically rewarded that risk much better.
Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.
Quick Take on Fixed Income
November, 2015
Question: What qualifications are required for a municipal bond to meet our buying parameters?
Answer: While there have been few defaults in the municipal market, it’s important to note that not all muni bonds are created equal. The market offers many different types of bonds backed by varying legal pledges and revenue sources to repay the debt. The following are some of the qualifications it takes for a muni offering to meet our strict parameters to be considered for purchase.
Rating: We buy only high-quality fixed income. We recommend only bonds rated Aa3/AA- or higher at the time of purchase. This rating is solely based on the issuer’s underlying rating and ability to repay its debts. We do not buy based on a separate bond insurer’s credit rating. There are benefits to buying highly rated bonds. First, nonrated bonds have historically defaulted at much higher frequencies than rated bonds. A Moody’s study covering municipal bonds from 1970 to 2014 found issuers rated Aa and above had a default rate of only 0.01 percent over a 10-year period. Second, the diversification benefit of fixed income tends to decrease as you move from Aaa down to lower ratings. Further, if an issuer’s credit quality begins to deteriorate, there will be far more available research and notification, allowing an investor to consider swapping into a higher-quality position. Rated bonds also tend to have better liquidity if they need to be sold.
Sector: We require that a bond comes from either the general obligation or essential service revenue sector of the municipal market. General obligation bonds are backed by the full faith and credit of the municipality. Essential service bonds include water, sewer, highway and transportation, public college and universities, and electric power revenues. These projects are considered essential services because municipalities cannot afford to default on these programs because they are vital to the community. These sectors have historically had much lower default rates than non-essential revenue projects such as housing and health care. There have been 95 defaults on bonds that Moody’s rated from 1970–2014. Only eight were general obligations. The housing and health care sectors accounted for more than 70 percent of the defaults.
Size: General obligation issuers must have annual revenues of at least $50 million. Larger municipalities typically have more flexibility to maneuver through difficult times or increase revenue. Their sources of revenue may also be more diverse and less concentrated within certain taxpayers. There also is far more information available regarding the finances of larger issuers.
Financial Analysis: The Bloomberg data system allows us to access financial information on municipalities including balance sheets and income statements over multiple years. This allows us to look for trends within a municipality’s finances and answer questions such as: Are revenues increasing? Are expenses under control? How much is the municipality keeping in reserves for unexpected shortfalls? If a municipality’s revenues are shrinking or its expenses seem to be getting out of control, we will bypass these credits even if other buying parameters are met.
Pensions: Going forward, unfunded pension liabilities pose the biggest risk by far to the municipal bond market. Over the past 10–15 years, unfunded pension liabilities have skyrocketed for many states and local municipalities. Some issuers are having difficulty keeping up with the annual required contributions, which are becoming a more significant part of their annual budget. These large payments, which are effectively debt of the municipality, could compete for resources with municipal bondholders. To mitigate this risk, we have chosen to eliminate the purchases of bonds where the unfunded pension liability exceeds 125 percent of the issuer’s general fund revenue.
Summary
Our evidence-based philosophy does not believe in taking unjustified risks with fixed income. We focus on high-credit-quality bonds in the strongest sectors with short- to intermediate-term maturities. A municipal bond will only be considered for purchase after it has met the criteria outlined above.
Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.
“It was totally worth it.” In this case, “it” referred to a Vitamix blender that a friend recently had purchased. He wasn’t the first. Indeed, I don’t know anyone who has purchased a Vitamix blender and didn’t share my friend’s effusive sentiment, even after spending between $429 and $719 (for the new line of G-Series models). For a blender.
But despite my appreciation for these friends and their opinions, I can’t help but notice their errors in judgment, explained by behavioral science, that, if followed, could lead to an unwise purchase for you or me.
To be clear, it’s not their purchase of the blender that I’m questioning. Rather, it’s their insistence that said purchase is a universal must. Worth, you see, is relative. What is “worth it” for you may not be “worth it” for me. Ultimately, determining the worthiness of your next purchase depends on many factors, but chief among them are 1) the joy you receive from using the product, 2) your personal cash flow, 3) how much you will use the product, and 4) the cost of available alternatives.
Utility
In economics parlance, the benefit you derive from using a particular product is called “utility.” And the concept of utility does range beyond mere pleasure. One person, for example, might want to buy a new Tesla Model S because of the inherent thrill he receives in being transported from “zero to 60 mph in as little as 2.8 seconds.” Another person might be motivated to buy the same electric sports car because of the perceived satisfaction derived from not (directly) using fossil fuels to power it. Most of the time when one of our friends lauds the worth of a recent purchase, it’s the utility talking—but of course this will be different for every person.
Personal Cash Flow
While I hate to be a spoilsport, I’d be irresponsible not to address what might be the most important factor in determining whether or not a purchase is worth it for you: your personal cash flow (or how much disposable income you have). If you’re Kam Chancellor, the Seattle Seahawks defensive back who was willing to forfeit $2 million in pay (and fines) to sit out the first two games of the season in a failed bid to force the renegotiation of his contract, you’ll not likely miss $719 spent on a blender. If, however, you’re a recent college grad with only $500 left over each month after paying rent and utilities, spending the entirety of your discretionary cash—intended for food and clothing—on a food prep device might not be worth it.
Frequency of Use
Assuming you do have sufficient cash flow and you’d derive a meaningful benefit from using a product, the next issue to consider is how frequently you’d use it. The best example, I believe, in determining worth through the frequency lens is that of a boat. If you only get on the water a couple of times a year, the cost of buying, maintaining, storing and conveying a watercraft is exorbitant, at least relative to the boater who is able to compound his utility by shoving off 50 times each year.
Alternative Options
I found myself especially susceptible to the siren’s song of the Vitamix, the blender to beat all blenders, because my wife and I use the appliance three times a day making meal replacement smoothies. That’s more than 1,000 uses per year—certainly enough to justify the expense of a top-flight blender when considering the compounded utility!
But shouldn’t the worth of the $700 blender be considered in relation to other less costly alternatives? The Ninja Professional Blender, often billed as a Vitamix killer, may not carry the cache of the chef’s first choice, but it’s available on Amazon for $80. Now, instead of simply asking, “Is the Vitamix worth it?” we must ask, “Is the Vitamix worth 8.75 times the Ninja?”
And it very well may be, because no one can question the total utility that you, individually, receive from your blender—or your car, your phone or your shoes. But the reverse is also true. Just because it’s worth it for someone else, doesn’t mean it’s worth it for you.
This commentary originally appeared October 10 on Forbes.com
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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2015, The BAM ALLIANCE