Are Your Bonds Leaking?

In a word: YES!

We’ll discuss this in view of long-term investment and portfolio management.

“Coupon-Bearing” Bonds don’t “compound” in line with initial projections

Okay…you walk into the office of your investment advisor and say:

“I have $10,000 to invest in bonds.”

She responds with “Well, this morning my trading desk sent out a list of available bonds. What are you looking for? Ten years? Let me tell you what I have.  Let’s look at the yields (Yield to Maturity, or YTM) to get a handle on value…”

Your advisor pulls out the list and rattles off “We have these 10-year bonds…AA ratings starting at a yield of 5.3% and A rated with a yield of 5.85%...” (these yields are just for the explanation, not realistic in today’s environment)

So, what is a “Yield to Maturity”?

Imagine you’re a real estate investor and considering buying a rental property. You have found a house with a price tag of $100,000. Your idea is to rent the house out at $1,000 per month for 10 years, then sell the house for $100,000.

You, as an investor, would like to firmly grasp the overall value of that approach, and how it compares to other properties/rentals. How does one calculate that?

Starting principal cost $100,000

Ending principal repayment $100,000

Income $1,000/month for 10 years

We’ll ignore maintenance, taxes, etc. for simplicity.

A computer would take that information and calculate the YTM or return on your money.

Bonds are handled similarly. You would input the purchase price, the “maturity” price. Maturity price what you get back when the bond matures…after all, bonds are simply loans to the issuer of the bond and have an end-date when you get your loan money back. You would also input the interest you expect to receive, and how often.

But…

The YTM calculation makes an enormous assumption. That assumption is that the interest received from the bond issuer (typically every 6 months in the USA) will be, in turn, invested at the original investment rate.

Let’s try this: your advisor suggests a 10-year bond with a Yield to Maturity of 5.3%. Implicit in that is you’ll get your money back in 10 years. Also implicit is that your investment will receive a YTM of 5.3% as the interest received over the 10 years will compound at 5.3%.

Factoid: a 10-year bond with a coupon (interest rate) of 5% would have a price of ~97.9, a discount from 100, to create the YTM of 5.3%.

Remember the “invested at the original investment rate” above? Let’s imagine a $1,000 bond. Let’s assume an interest rate of 5%, or $50/year per bond. Since we are dealing with semi-annual interest payments, that would be $25 every 6 months. The requirement to ultimately receive the YTM of 5.3% is that you must invest that $25 at 5.3%. Oh, and the interest on that piece, in 6 months, also at 5.3%.  And the interest on that, and so on…

Here’s the challenge, at today’s rates, or when interest rates hovered around 5%...where do you get the chance to invest small and smaller pieces of money at “the original investment rate”? Try nowhere. Certainly, you can’t buy additional bonds (same issuer) for true compounding…

So, what many assume the bonds to be doing, compounding as money grows at a constant rate providing a YTM as originally calculated, is at best a misunderstanding.

That $25 (here) goes to the money market account or to buy lunch.

Yield to Maturity is useful as a snapshot, for initial comparison purposes, only at time of purchase.

Those interest payments you received, making their way to money markets, is your “leakage.” More bonds or bond funds, you ask? All relative, but leakage still exists. Bonds are not as efficient or growth oriented as we’d like.

Is the YTM fictitious? Well, it provides a false long-term expectation. This all falls in line with the uncertainty (volatility) of economic factors. If interest rates were constant along the yield curve and long-lasting, YTM would have more validity.

One last point:  In today’s interest-rate environment, between lack of income (rates are very low) and lack of compounding, any volatility buffer expected in the portfolio from low (current) coupon bonds is…well, hard to see. And if rates rise, the bond prices will drop. Ouch.