COVID-19 Diary Number 8 (July 14, 2020)

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It seems that many people have begun to see the market rally as an opportunity to get out whole, or nearly so, after the frightening losses of late March. They despaired three months ago when stock prices went off a cliff, and now that prices have regained much of the lost ground, they wonder if they should get out while the getting is good. They don’t have reason to forecast another plunge in values; they just want to avoid the pain of another March experience.

Such anxiety is understandable.  March’s stock price retreat was unnerving and no one wants to go through that again.  But before selling out, investors should consider two things:

  1. Do they have an immediate need for the money? If they do, then the recent price recovery is a wonderful opportunity for them to get out of stocks –– not because prices have risen, but because (as readers of these blogs should know well), they should not have been in stocks in the first place.  Equities are only for those who have no need for the money for at least five years.
  2. If they do not need the money now or for the foreseeable future, they should consider the investment alternatives. There are five choices, none particularly attractive compared with stocks.  Though some might offer less volatility than stocks, the cost to the investor is lower potential returns:

–Cash is one option.  Cash deposits and certificates of deposit (CDs), unlike stocks, offer assurances that you will get your money back no matter when you want it. But these “cash vehicles” pay extremely low returns.  Deposits — whether at commercial banks, savings banks, credit unions, or money market mutual funds — all pay less than one percent a year.  CDs pay a little more, but you must tie up the money for at least a year to get that higher rate of interest –– and you will pay a penalty if you take it out early.  This post will give you more detail.  In all cases, the returns on deposits are less than the rate of inflation.  The cost of living, in other words, is rising faster than what the investor can makes on deposits of any kind.  The real buying power of what you invest in these instruments will decline, even though the dollar amounts you get back will rise. 

–Quality bonds offer yields above the rate of inflation, but only slightly.  That might have an appeal, but the yields are still low.  What is more, the odds are good going forward that the yields will rise, which means that the bonds you buy today will lose value tomorrow.  For an explanation, see this post.

–You can get a higher rate of return if you are willing to invest in the issues of companies that are less credit-worthy.  But when you invest in these so-called junk bonds, you risk fluctuating prices or even the outright bankruptcy of the issuer, which makes this alternative as volatile and emotionally fraught as stocks.

–You could turn to commodities — precious metals, industrial metals, foods, etc.  If the economy does well, these prices will rise, as will stock prices.  But as with stocks, there is a significant downside on commodity prices should economic prospects deteriorate.

–You might take your investment funds overseas. Stocks and bonds in other developed markets — Europe, Japan, Australia, Taiwan — have all the same potentials and risks as those in the United States, so they hardly offer a haven for those wanting to flee volatility.  They do have a place in a portfolio, as explained in this post but they are not a hiding place for the frightened.  Emerging markets, as explained in this same post, have appealing long-term characteristics, but are actually more volatile than U.S. stocks.

If you want to be “cute” and take the risk, you might take some money out of equities and sit on it in the expectation that some future disappointment will bring a stock price retreat, and then you might redeploy that money effectively. I described this strategy here.  “Cute” is the best way to describe it, because it violates the basic principle that stocks are for the long term, and no investor, no matter how clever or well informed, can time market swings.

 

COVID-19 Diary Number 2 (April 6, 2020)

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Though no one can yet say how the virus will continue to develop in the U.S., and therefore how the markets will go, a review of the past few weeks can allow this conclusion (with apologies to Winston Churchill at the end of the Battle of Britain): This is not the end or even the beginning of the end, but it is the end of the beginning.

Whenever markets suffer a shock – a collapse somewhere in the economy, natural disaster, war – participants panic.  This happened in March as the extent and severity of the Covid-19 pandemic became apparent.  Such panic could of course return if markets were to suffer another terrible surprise, but their recent behavior suggests this beginning phase of the market correction seems to have ended:

  • Equity prices have clawed back some of the ground lost to March’s panic. Stock prices fell precipitously between February 21, and March 23, with the benchmark S&P 500 stock index sliding almost 35 percent in just some four weeks, wiping out all the impressive gains of the prior three years.  Since then, investors seem to have recovered the sense that perhaps pricing had anticipated the worst, especially since the Federal Reserve (Fed) and the government have initiated policies to mitigate if not erase the recessionary effects of the measures needed to fight the spread of the virus. Pricing has begun to improve.  Stocks have risen some 19 percent from those lows, still some 21 percent below the highs of February, but a sign that panic has passed for the moment. 
  • Bond markets, while still fearful, remain relatively stable. On the first news of pandemic, Treasury yields fell precipitously, with the yield on the 10-year note dropping from just under 2.0 percent at the end of January to just over 0.6 percent by mid-March. To a large extent, the move reflected the Fed’s efforts to drive down all interest rates and bond yields. A flight to quality also was an element here.  As investors sold off bonds issued by entities with lesser credit ratings and put the proceeds into presumably safer Treasury issues, the yields on all other bonds actually rose, widening the yield spread lesser credits offered over Treasuries from a little over 3.5 percentage points late in February to just over 10.5 percentage points late in March.  This was not as high as the 20 percentage point spread that prevailed for a while in the Great Recession of 2009, but it’s hardly a sign of confidence. (This post will brief you on how bond prices and yields interact.)  The past few weeks have seen only modest improvement.  these yield spreads have declined to some 9 percentage points –– hardly much improvement but nonetheless a tentative sign of relative calm.
  • Commodity markets tell a similar story to bonds.As the lockdowns and quarantines effectively shut down the economy, industrial materials prices dropped quickly. Copper prices illustrate the common story, falling by almost 20 percent from early to late March. Oil prices did worse, falling some 40 percent during this time, though extra pumping by Saudi Arabia (because of a dispute with Russia) exaggerated the general price retreat. Prices of oil, copper and most industrial materials have since risen slightly –– again, not a sign of confidence but at least a halt to the earlier panic.
  • Currency markets, in contrast, have all but corrected their earlier panic.  When the seriousness of the pandemic first became evident, money moved toward dollars, as it does in almost every emergency.  A global index of the dollar’s value rose some 5 percent, but has nearly returned to its level of early March.  Some might interpret this as a sign that Covid-19 infections in the U.S. have risen, but on a per-capita basis the American infection rate is no worse than in most developed countries and a good deal better than some.  The movement away from the dollar speaks to a lessening of panic.

All this could change if COVID-19 changes its course.  If it worsens, panic could reappear, and the markets would return to their levels of late March or even lose more value.  But if the effects of the disease ease and promise a return to more normal levels of economic activity, the relative calm of recent weeks suggests that markets could regain ground quickly.

Bonds: What Are They and How Do They Work?

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The Basics

 This post provides essential background on bonds.  A bond is simply a loan from the buyer of the bond to its issuer. When an established company or a government needs to borrow, it doesn’t go to a commercial bank, as an individual or small business would, it hires an investment bank to issue bonds on its behalf. Each piece of this “paper,” as the financial community calls it, binds the business or government to repay the face value of the bond plus interest at a designated date.  At one time, investment banks actually issued paper certificates with dollar amounts printed on their face, which is where the expression “face amount” comes from.  Now, of course, almost everything is electronic.

Because bonds are promises, they are sometimes called “promissory notes.”  Because they are the issuer’s debt, they are also often called “debentures.”  But whatever the name, they bind the issuer to make the designated payments to the holder on time, hence the use of the word “bond,”as in “their word is their bond.”

In addition to issuing this debt, the financial community makes an active market by buying outstanding paper from existing owners and re-selling it to others. Because this “secondary market”gives those who first bought the bonds a way to get their money out before the bonds’ due date, maturity date, as it is frequently called, its existence encourages people to buy bond issues in the first place.

Prices in this secondary market fluctuate, depending on changes in demand and supply for bonds generally and also for specific bonds.  When investors have a growing appetite for bonds, the secondary markets fills with buyers.  Their demand pushes up prices, and, according to the nature of bonds, pushes yields down.   (Prices and yields always go in opposite directions.  At the end of this post, a box on “bond math” explains how this works.)  When a flood of new bond issues overwhelms buyers’ appetites or when many existing holders want to sell in the secondary market, the supply of bonds for sale exceeds the demand and prices tend to fall.  Yields accordingly rise.  (Again, see the box on “bond math.”)

Making Money in Bonds

 There are three ways to make money in bonds:

  1. The primary way is through the regular payment of interest over the life of the bond.  Most bonds pay semi-annually, some quarterly.  Other bonds pay their accumulated interest in one lump at maturity.  (These are called “zeros,” because they pay nothing during the period from issuance to maturity.)
  2. Money is made and lost in bonds when they appreciate or depreciate at maturity, depending on whether the buyer in the secondary market purchased at a discount or premium to their face amont. (See box on “bond math.”)
  3. Because prices fluctuate over the life of the bond, you might also gain with a timely sale if you see the prevailing market price for the bond has risen above your purchase price.

The Roots of Price Fluctuations

Supply and demand fluctuate in the secondary market for a number of reasons, but four dominate:

Federal Reserve Policy

The Federal Reserve (Fed in financial jargon) is the government’s bank and the bankers’ bank, often referred to as the “central bank.”  Almost every nation has one to control flows of new money in their economies, mostly in order to smooth economic fluctuations.  When policy-makers want to raise economic activity, they increase the amount of money in circulation, and when they want to cool the economy, they decrease it.  These decisions affect bond prices.

When a central bank increases money flows it enlarges funds available for lending, heightening the demand for bonds, and thus lowering yields.  By reducing the cost of borrowing, the Fed encourages people and businesses to borrow and spend more, which speeds up the pace at which the economy’s wheels spin.  But when the Fed, needing to slow the economy, decreases the flow of money, the demand for bonds falls, their prices fall as well, and their yields rise.  Interest rates are so critical that the Fed announces its policy decisions in terms of short-term interest rates, specifically the rate that banks charge each other for overnight loans, the “federal funds rate.”  But while the Fed talks about a very short-term interest rate, its intent is to move the economy by affecting all rates and yields and thus bond prices.

Inflation

 Because bonds make all payments in fixed dollar amounts – both the repayment at maturity and the contracted rate of interest, called the coupon rate — they are especially vulnerable to the effects of inflation.  High rates of inflation quickly erode the real purchasing power of all these fixed dollar payments. In the early 1980s, when the United States suffered inflation rates higher than 10 percent, the real buying power of the fixed-dollar payments on bonds fell by half in less than seven years.  Needless to say, then, that investors shy away from bonds when they expect inflation to rise.  The resulting decline in demand depresses their prices and raises yields and continues to do so until investors believe that the yields bonds pay have risen high enough to compensate for the inflation-driven loss of purchasing power.  Of course, when investors expect less inflation, their interest in bonds intensifies, they buy, and all this happens in reverse.

Liquidity

Liquidity refers to how much money is readily available for the purchase and sale of securities – stocks and bonds.  In general, it affects prices in much the same way as does the Fed’s adjustments in the money supply.  Individual bonds have different liquidity considerations.

Bonds are said to be liquid when there is an abundance of potential buyers and sellers in the marketplace.  In this environment, traders can easily find buyers and sellers: in other words, they flow readily.  The most liquid issues in the world are US Treasury bonds.  Trillions of dollars of these bonds exist in the market and they are owned by millions of people and institutions.  There is a steady stream of new issues, while billions of dollars of bonds mature, that is come due for repayment every month.  Because the ease of trading makes investors feel more comfortable with US Treasuries, and similarly liquid bonds, they can pay a slightly lower yield than other, less liquid bonds.  Bonds that have unusual features or less active issuers or lower amounts circulating in markets are harder for traders to move and so tend to pay higher yields.  (This higher yield on illiquid bonds may appeal to investors who expect to hold them to maturity.)

Matters of Quality

 Supply, demand, and hence prices also vary according to what is called the “credit quality” of a bond.  Though the issuer is legally bound to fulfill its obligation, it cannot do so if it ceases to exist.  Companies sometimes go bankrupt, governments can be overthrown or go through something close to bankruptcy.  The greater the likelihood of such a mishap, the lower the bond’s price and accordingly the higher its yield, presumably to compensate investors for the potential of loss.  Some bonds, US Treasuries for instance, are all but certain to meet their obligations. They are considered to have the highest credit quality, and command relatively higher prices and offer lower yields than even the strongest corporation.

Three credit-rating agencies specialize in tracking the quality of bonds: Standard and Poor’s, www.standardandpoors.com; Moody’s,www.moodys.com; and Fitch, www.fitchratings.com.  They work for a fee, which issuers pay, hoping to get good ratings and so better prices for their bonds (and, accordingly, lower yields.)  Bond issuers also buy the ratings because a non-rated bond, as they are called, is suspect and thus harder to sell.

The ratings go from AAA, or some variation on this notation, for the most credit worthy issues down to CCC for the least.  The ratings are determined by the current financial health of the issuer, as well as future prospects, based on recent trends and likely potentials. Those rating the bonds also consider what are called bond covenants, which might put their owners first in line (or perhaps lower) for payment in the event of the issuer’s bankruptcy.  Because these agencies gave high ratings to undeserving bonds during the run-up to the severe 2008-09 financial crisis, governments, financial-professionals, investors, and others now rely less on their determinations.

How to Invest

 Whether an individual invests in bonds will depend heavily on what there other assets look like and a number of other considerations particular to them, their nearness to retirement and their comfort with risk just to name a couple of them. There are a great number of vehicles available for those who what to invest in bonds.  Buying them outright is sometimes difficult for the average investor because they are sold in large blocks.  But many mutual funds make bond investing straightforward and convenient for even small investors.  Future posts will go into these considerations in detail.

 

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Bond Math Made Simple

 Almost all bonds are issued with the interest indicated as a dollar payment at semi-annual intervals.  This amount is called the coupon, named after the tickets once attached to the old paper certificates that owners would clip off in order to claim their interest payment.  Say you bought $1,000 worth of a bond that paid $50 a year.  It would be referred to as a 5 percent bond because the indicated annual dollar payment would amount to 5 percent of the $1,000 purchase price.  This last figure is also often referred to as its “face amount” or “par”because that number once appeared on the face of the old paper certificates. It would pay you that $50 a year, $25 every six months, until the bond matures, when the issuer would return to you the $1,000 you paid for the bond.

Here is the relationship stated in a simple equation:

(semi-annual payment) × 2 = Annual payment                                                                                                                                        (annual payment in the secondary market ÷ face value) × 100 = annual percent interest.

In this example:

$25 every six months = $50 a year                                                                     ($50 ÷ $1000) × 100 = 5%

As supply and demand for bonds fluctuate in the secondary market, the changing price alters the calculation.  If a surge in demand drives up the price of a bond, an investor might have to pay $1,100 to buy the $1,000 face amount of this bond.  Financial jargon would describe the bond as selling at a 10 percent premium to par, because the $100 difference is 10 percent of the original $1,000 face, or par, amount.  Because the bond still pays $25 twice a year, that $50 a year is a smaller percent of the purchase price: to be exact, 4.5 percent.

(50 ÷ 1,100) × 100 = 4.5%

This rate is called the “current yield” — the fixed dollar amount paid each year as a percent of the purchase price.

Of course, the issuer will only repay $1,000 at maturity and not the $1,100 paid by the buyer in the secondary market.  To get a full picture of the bond’s return, the investor must also consider this $100 loss when the bond matures.  That means the overall percent return is really a little less than the 4.5 percent current yield.  Financial people use a complex formula to build this consideration into the percent return on the bond, what they call the “yield to maturity.”  There is no need here to go into the details of those calculations except to note that the more distant the maturity date, the less imposing the ultimate loss is and so the less significant is its impact on the calculation of yield to maturity.

This all works in reverse, if supply-demand fluctuations in the bond market reduce the price of the bond below par.  In this case, the fixed $50-a-year payment of our example would produce a current yield above the initial 5 percent.  If, for instance, a lack of demand drives down the price of our $1,000 face amount bond to, say, $900, a 10 percent “discount” in financial jargon, the “current yield” would come to 5.6 percent

 ($50 ÷ $900) x 100 = 5.6%

Because you bought the bond at a 10 percent discount, the $1,000 paid at maturity would also net you an extra $100 at that future date.  The “yield to maturity” would then exceed 5.6 percent.  How much would depend on the length of time from the purchase of the bond to its maturity date.

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