In this article, the Fixed Income Desk at BAM Advisor Services provides answers to some of the questions it most frequently receives.
Q: What are the hidden costs in municipal bonds?
A:
A markup is the difference between the price paid by a broker/dealer and the price a bond was sold to a client. Broker/dealers are permitted to charge fair and reasonable markups on bonds. These markups do not have to be disclosed to the client. Because of this, the nominal ticketing fee on the client's trade confirmation is often assumed to be the only cost, similar to a stock purchase. Bonds are traded in an over-the-counter market where broker/dealers trade with each other. By comparison, equity markets trade on an exchange (such as the New York Stock Exchange).
Because there is no centralized exchange for bonds, pricing is more difficult to determine. Bond dealers have an advantage over retail investors, and many exploit this by charging large markups without the client's knowledge. This is a common practice. A 2014 Wall Street Journal article cited a study that showed that individual investors trading $100,000 in bonds of a municipality paid brokers an average spread of 1.73 percent, or $1,730.
BAM's Fixed Income department functions as a Registered Investment Advisor and, as such, cannot legally charge markups on any bonds purchased for clients. This doesn't totally eliminate markups, because bonds still need to be purchased from other dealers in the market. What BAM's Fixed Income Desk can do, though, is drive down those markups as much as possible by putting dealers in competition.
Q: What are the risks associated with fixed income investing?
A:
Following is a brief overview of the primary risks associated with investing in fixed income:
Interest rate risk
is when your bonds' values fall as interest rates rise. This risk generally increases with maturity; longer-term bonds have substantially more interest rate risk than short-term bonds.
Reinvestment risk
occurs when future interest and principal payments will not be reinvested at the prevailing interest rate that the bond was initially purchased. This risk generally decreases as you extend maturities. Reinvestment risk is in direct conflict with interest rate risk, so eliminating one amplifies the other.
Inflation risk
happens when bond returns are eroded by inflation. Generally, inflation risk is higher as bond maturity increases. But short-term bonds can have exposure to inflation risk because their returns have barely outpaced inflation historically, and they are not a perfect inflation hedge. TIPS are the only securities that are generally guaranteed to outpace inflation (at least on a pretax basis).
Liquidity risk
is generally thought of as the cost of getting out of a position. All else equal, yields on illiquid bonds are generally higher than yields on liquid bonds. Treasuries are considered to be the most liquid securities. Agencies, municipals and brokered CDs are less liquid.
Historically, U.S. Treasury bonds have been viewed as the only fixed income security with no credit risk. A rule of thumb for the amount of default risk you are taking is the spread on the bond versus Treasury bonds. One popular yet simplistic model is to treat the spread as the one-year probability of that issuer defaulting, so a bond trading at a spread of 1 percent has a 1 percent probability of defaulting over the next year.
Q: Does currency risk add value in the fixed income markets?
A:
Interest rates on high-quality bonds have remained relatively low, so some investors continue to search for ways to achieve higher returns. One strategy that has been in the news frequently is the idea of purchasing non-U.S. dollar denominated bonds. The thought behind this is that taking on currency risk could potentially increase the return of a bond portfolio. BAM's Fixed Income Desk has looked into this strategy extensively, and when isolating for currency risk, returns do not increase. Volatility, however, does increase significantly.
The data below illustrates that a portfolio's risk-return profile does not improve when currency risk is introduced to fixed income. When examining 25 years of data (from January 1990-December 2014) on both the unhedged and hedged versions of the Barclays Global Aggregate Bond Index, returns were essentially the same, while volatility was 42 percent higher for the unhedged index due exclusively to the currency risk. This leads to a significantly lower Sharpe Ratio on the index that was exposed to currency risk.
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The Sharpe Ratio is a measure of the risk-adjusted return of an investment. A higher ratio indicates a greater return for a unit of risk. The Sharpe Ratio is calculated as the average annual portfolio return less the average annual risk-free rate (One-month T-bills) divided by the portfolio's annualized standard deviation.
