Though today’s low interest rate environment has muted the relative allure of investing in bonds, one of the great things about looking at the fixed-income market is the flexibility that it affords. Investors have taxable and non-taxable options, the ability to take positions in short- and/or longer-term paper, and can tailor credit quality to suit individual risk tolerances.
To see a list of high yielding CDs go here.
If we look at the chart below with a random sampling of bond yields from both investment-grade and junk milieus, we see wide disparity in available payouts. The key for the beginning bond investor is to clearly understand the basis for yield variety and pick bonds that mesh with general goals. While a higher-yield may be an immediate attraction, it may pose much more risk and opportunity cost than one might first believe.
A Question of Credit Quality
If an investor has a roughly 5 year time horizon for their monies, they may be willing to consider the Safeway and Advance Micro Devices (AMD) bonds illustrated above. Both mature in August of 2020 but the AMD bond yields almost double the Safeway bond. Why? The answer is credit quality. An investment grade bond with similar maturity will almost always yield significantly less than a junk (high-yield) bond.
AMD’s financial position is considered far inferior to Safeway’s, thus investors are rewarded with a higher yield (7.2% vs. 3.7%) for taking on the elevated risk that AMD could default on its bond over the next five years. Thus, the bond investor has to make a decision whether they want to play it safe with a company involved in grocery retailing or take somewhat of a gamble on a ‘B’ rated technology company.
If the investor doesn’t like either choice, they may want to look for something “in the middle,” a BB rated bond that poses a bit less risk than AMD, but offers a more robust yield as compared to Safeway. So I actually conducted another search on Fidelity and found a number of options, but liked this bond the most:
With this bond from Frontier Communications, the investor increases credit quality by 2 notches compared to the AMD paper (B vs. BB-), but accepts roughly a 1.2% decrease in yield for having done so.
Bond investors must decide on an acceptable mix of yield and credit quality before taking positions. If you are prone to not sleeping well at night when you take more risk, it’s possible that the Safeway bond, in this case, would be the most prudent 5-year position to take. Those who can afford to take more risk may be comfortable with AMD.
A Question Of Maturity
In our next comparison, let’s consider the Darden Restaurants (Olive Garden, Longhorn Steakhouse) bond and the paper from Weyerhaeuser. Both are BBB-, investment grade rated by S&P. The Darden bond matures 10 years later, but offers almost 150 basis points (1.5%) more in yield for taking on the lengthier maturity.
For someone in need of the higher yield, the Darden bond may seem like a no-brainer. However, if the broken record of higher interest rates that we’ve been hearing for years now finally comes to fruition, there is a great deal of opportunity cost holding long-term paper. Frankly, both bonds could entail opportunity cost, but the longer the maturity you lock into, the longer the opportunity cost can be.
In any case, one has to decide how much maturity risk they wish to shoulder. Again, we could opt to dial back the maturity risk even further, which could lead us to the Safeway bond again, with 5 years less of maturity risk, but another 80 basis points less in yield as compared to Weyerhaeuser.
The flexibility of the bond market gives investors options. If you understand the risks associated specifically with both credit quality and maturity, you are well on your way to building a bond portfolio that you can sleep well at night with.
About the author: Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.