MARK RIEPE: In the mid-1980s, Americans were entranced by a new car hitting the commercial airwaves—and soon enough, our highways and byways. This compact foreign car could do something almost no other new car on the market could:
It could be sold for less than $4,000.
Now, if we account for inflation, that’s about $9,500 in today’s dollars. That’s remarkable, given that the least expensive base model car on the market right now sells for more than $14,000.
To many people, this seemed like a wonderful deal. Here was a brand new car—it got decent gas mileage, it had some nice features—and, sure, maybe it wasn’t exactly high performance, but the price was incredibly hard to resist.
The car I’m talking about is the Yugo—manufactured in communist Yugoslavia and marketed here in the United States as an inexpensive choice for first-time car buyers, people who might otherwise buy a used car, or families looking for a practical second vehicle. At its peak Yugo America was selling over a thousand cars in a single day.
But the shine quickly wore off. Drivers started to see that quality was sorely lacking. Not only that, it was kind of boxy and, you know, frankly, kind of ugly.
It became the butt of jokes on late-night TV and beyond. Here are some examples.
Why does the Yugo come standard with a defroster on the rear window? To keep your hands warm while you push it.
What’s printed on the last page of every Yugo owner’s manual? The bus schedule.
The company, Yugo America, was out of business by 1992—as war in the former Yugoslavia raged.
The final blow was an EPA-issued recall.
Now, there’s nothing inherently wrong with low prices of course as long as you take the time to investigate whether there are any tradeoffs involved.
In the world of investing, low-cost index funds have taken off in popularity because many investors have concluded that the extra fees charged by some funds aren’t worth it, and there’s a lot of data to support that decision.
However, in other areas of investing, the association with price and the other features of the investment—it just isn’t so clear cut.
Today we’re going to take a look at a phenomenon that we see a lot with bond investors. When faced with the decision of which bond to buy, should you pick the one with the higher yield?
This decision is especially pertinent right now, given the low level of interest rates.
I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab. It’s a show about financial decision-making and the cognitive and emotional biases that can cloud our judgment.
We’ve discussed saliency on the show before. It’s the tendency for people to make decisions based on the traits that are most prominent, or emotionally striking, and ignore those traits that are less conspicuous.
It’s a bias because the most salient traits aren’t always the most relevant for the decision at hand. In some cases the most salient traits are actually irrelevant. In other cases a salient trait is relevant, it is informative, but it doesn’t tell the whole story. In the Yugo example, the price of the car was salient. Price matters, of course, but so does quality. The price of the Yugo was so strikingly low that it blinded the buyers to its less desirable features. To see how this connects to investing, let’s think about the stock market for a second.
In the stock market, there are several thousand stocks that can be purchased. Which ones should you buy?
You don’t have time to conduct in-depth research on every single stock. You need a method to sort the wheat from the chaff.
One study of individual investors showed that investors were more likely to buy what are called “attention grabbing” stocks.
A stock was defined as attention grabbing if it met one of three criteria:
- First of all, it was in the news that day.
- Secondly, it was experiencing unusually high trading volume.
- Or thirdly, it had an extreme return (either high or low) the previous day.
What they found was that individuals were, indeed, net buyers of stocks that met any of these characteristics. Not only that, they were far more likely to buy these stocks than others that weren’t as attention grabbing.
What’s interesting to me is that there’s little evidence that paying attention to these variables by themselves is associated with better returns, but clearly investors were captivated by these salient traits.
Of course individual bonds could be attention grabbing as well.
The most salient feature of a bond is its yield to maturity. With the advent of so many analytical tools at the disposal of bond investors, it isn’t surprising that many investors would sort the bond universe by yield and focus on those with the highest yield.
Whether that’s a good decision—that’s the focus of this episode.
MARK RIEPE: I’m joined now by Collin Martin. Collin is a managing director and fixed income strategist for the Schwab Center for Financial Research. He’s also a Chartered Financial Analyst® and provides analysis and education about fixed income for Schwab clients. Collin, thanks for being on the show.
COLLIN MARTIN: Hi, Mark. Thanks for having me.
MARK: Collin, we started out this episode talking about the prices of cars and how attractive low prices are. Most people, when they think about buying individual bonds, they think about the yield instead of the price. What’s the relationship between the two?
COLLIN: Well, when we think about the basics of bond investing, the way a bond works is it has a fixed par value. And for most investors, they’re less concerned about potential price appreciation, and it’s really about the yield or income that they provide, because at the end of the day, you know, bonds are usually meant to provide income or stability to a broad portfolio. So when we talk about the relationship between its yield and its price, we have to figure out where these come from.
So a bond’s yield is a function of its price, its coupon rate, and its time to maturity. Now, like I said, most bonds have fixed par values. They’re usually $1,000 per bond. They usually have a set maturity date, and they generally make semi-annual interest payments on that par value. Now, while the coupon rate is usually fixed, the price of a bond can still fluctuate in the secondary market.
And this really brings us to one of the most basic principles of bond investing, that bond prices and yields move in opposite directions. Now, think about it this way. Let’s assume I bought a bond today and it had a coupon rate and yield of 2%. Now, let’s assume interest rates changed overnight, and tomorrow someone can buy a very similar bond but with an interest rate of 3%. My 2% bond won’t look very attractive anymore, so its price would probably drop to make it more attractive to potential investors.
So when you hold bonds, you really need to keep in mind that the prices of those bonds can be influenced by the current level of interest rates. It can mean higher prices if bond yields are falling, but the opposite is also true—it can mean lower bond prices if interest rates are rising.
MARK: If we stick with the car analogy, everyone listening realizes that prices differ across cars, and they understand, you know, why that happens. Why do yields differ across bonds?
COLLIN: Well, Mark, there isn’t just one type of bond out there. We get this a lot when we talk to our investors. There’s no one bond market, there’s a lot of different types of bonds out there. It’s really large. It’s really complex. You know, there are high quality bonds, like U.S. Treasuries that are backed by the full faith and credit of the U.S. government. But there are also riskier bonds, like those issued by emerging-market countries or those by lower-rated corporations.
And taking it one step further, bonds can have many different maturities. You know, if we just use the U.S. Treasury as an example, they issue Treasury bills with maturities as short as four weeks and bonds as long as 30 years. So Treasuries with different maturities can offer different yields, even though they’re all issued and backed by the U.S. government.
MARK: So the yield on a bond is a way of expressing the price of a bond, and just like you wouldn’t make a blanket rule that says you should always buy the cheapest car, you wouldn’t make a blanket rule to always buy the bond with the highest yield. Is that what it comes down to?
COLLIN: Yeah, if a certain bond has a very high yield, it likely comes with a lot of risk. You know, you probably hear this a lot, but there is no free lunch, and that’s especially true when we’re talking about bond investing. Now, for example, corporate bonds generally offer higher yields than U.S. Treasuries because they have more credit risk. Credit risk is the risk that the issuer might not be able to make timely interest and principal payments due to something like profit concerns or maybe some other type of financial or business risk. So riskier bonds might offer higher yields, since they have a higher risk of default, but that high yield you see doesn’t mean it’s necessarily the best bond to buy.
In reality, there is no best bond to buy. Everyone’s circumstances are different. Whether you’re using bonds to match a liability down the road or if you’re looking for income in retirement, you want to make sure that you invest in bonds that match both your risk tolerance and your investing time horizon.
MARK: Yeah, I like to think of it as bonds are just like anything else for sale—you need to shop around. You don’t want to overpay for a bond, but you need to make sure that the bond makes sense for your situation. Give us a sense as to the typical yield spread between, say, a Treasury bond and a corporate bond that is of high credit quality.
COLLIN: Well, for the past 30 years or so, the average spread between investment-grade corporate bond yields and U.S. Treasury yields is about 1.3%.
MARK: In other words, if a Treasury bond is yielding 2%, then an investment-grade bond of the same maturity would have a yield of 3.3%. In other words, 2% plus 1.3%. Did I get that right?
COLLIN: That’s right. When we’re talking about spread added onto a comparable Treasury yield, and then that’s how you get your corporate bond yield.
MARK: So why do corporate bonds offer that spread? What am I getting for my money?
COLLIN: Well, those spreads are meant to compensate you for the additional risk you’re taking. You know, if we look at U.S. Treasuries, they’re considered risk-free investments—they’re backed by the U.S. government. But a corporate bond is backed by a corporation, and that corporation’s financial prospects might ebb and flow. So the credit spread is that extra yield to compensate you for the risk of a non-Treasury security.
Now, when a corporation is looking to issue debt, the bonds they issue are usually priced off of comparable Treasury securities. So if you’re a corporation and you’re looking to issue a five-year bond, the pricing is usually the five-year Treasury yield, plus, say, 100 basis points. Now, that 100 basis point spread is just an example. Actual spreads depend on the risk of the company. If it’s a riskier company, maybe it’s 150 or 200 basis points. If it’s a very risky company, like a high-yield issuer, that spread could be even higher, maybe 500 basis points or more.
MARK: And 500 basis points, for those who don’t, you know, think about bond math, 500 basis points equals five percentage points.
So as we’re recording this, those spreads are higher than historical averages, and Collin, I’ve seen you give a million presentations, those spreads fluctuate all the time. So what’s driving that? Why are those spreads fluctuating?
COLLIN: Spreads ultimately fluctuate for any number of reasons, but it’s usually due to the outlook of a specific corporate issuer or it could be due to concerns about the overall economic outlook. Now, sometimes spreads can fluctuate due to company-specific reasons, like I just mentioned. You know, maybe a company lost a key customer, and now their revenues might decline. That would make it more difficult for them to repay their debts. But often, spreads all move in sympathy with each other. In other words, general concerns about the economy can lead to higher spreads for all corporate bonds, regardless of if it directly impacts a specific company. If there are concerns that corporations can’t make timely interest and principal payments, investors generally demand higher yields or higher spreads to compensate them for that risk, and that’s why you see spreads rise.
Now, of course, the opposite is also true, Mark. If the economy is strong, you know, that would lead to growing revenues and growing profits, and, in theory, that would make it easier for corporations to repay their debts. So that tends to pull spreads lower, since investors may be less worried about the risk of default.
MARK: So the spreads, you know, ebb and flow—sometimes they’re wide, sometimes they’re narrow. Why does that matter for investors? What do they do with that information?
COLLIN: Well, it matters, because spreads are a component of yield. And if we go back to that major principle before that I mentioned—that bond prices and yields move in opposite directions—if spreads rise, it means your price is likely to fall. So if you own a corporate bond, or if you own a fund that owns corporate bonds, and spreads start rising, the price of those investments could decline.
Now, keep in mind that those price fluctuations could just be temporary. If you own a corporate bond, an individual bond, and price movements happen in the secondary market, it might not necessarily matter if the bond is ultimately repaid at its maturity date.
MARK: So yields differ dramatically depending on the type of bond you’re looking to buy, and a lot of that difference is driven by different levels of risk. How is an investor supposed to decide on the right amount of risk to take with their portfolio of bonds?
COLLIN: We always think that time horizon and risk tolerance are probably the most important things to consider. If you have a short time horizon, you probably don’t want to take too much risk in case the price of a high-risk investment falls. You know, it could take some time before that price rebounds, if at all.
MARK: So I need to make a tuition payment for one of my kids this fall. I shouldn’t put that money in a bond with a long maturity, right?
COLLIN: That’s right, Mark. Even though bonds have fixed par values and you know what you’re going to get at maturity, those prices can fluctuate in the secondary market. So if you have a specific investing time horizon, or if you’re trying to match liabilities down the road, like a tuition payment, we don’t suggest you hold bonds with maturities that are longer than that investing time horizon or that are beyond that liability date, because you won’t know with certainty what price you’ll receive if you try to sell it before maturity.
MARK: So where does risk tolerance come into play?
COLLIN: Well, you want to consider how you would handle a steep or sharp plunge in prices. You know, for example, during the financial crisis, the average price of the high-yield bond index dropped by about 40% in just a few months. If that’s not something you can handle, you would probably want to limit the amount of high-yield bonds you hold.
MARK: When you say “financial crisis,” you’re actually referring to the 2008-2009 financial crisis. How have high-yield bonds held up during the COVID-19 crisis?
COLLIN: Well, high-yield bonds, initially, got hit pretty hard in the first few weeks of March. The economic impact of COVID-19 is likely to pull corporate profits down pretty sharply, and that makes it harder for corporations to make those timely interest and principal payments. But then the market modestly rebounded, and then it stabilized a bit in April, and that was likely due to new programs and facilities that the Federal Reserve launched. They announced a few new programs that were really meant to help support the corporate bond markets and make sure that they were functioning properly.
At the end of the day, though, even though we’ve seen those prices move a little bit higher because of the Fed’s actions, it will take some time to see how this eventually plays out. You know, the Fed is offering more support to the investment-grade market than it is for the high-yield market. So we still think it’s likely that the amount of corporate defaults will probably rise, as lower earnings will make it difficult for companies to repay those debts.
MARK: Collin, let’s imagine I go to a website, I screen for individual bonds with approximately the same maturity, the same credit quality, I’m looking for something to … looking for one of these to buy. If a bond has a higher yield … well, let’s say, if it has a yield that’s noticeably higher than the other bonds, is that automatically the bond I should be buying?
COLLIN: No, it’s not necessarily the bond you should be buying. And we’ll say this again: There is no free lunch. If we see a higher yield, higher than things that look pretty similar, there’s probably some more risk there. Sometimes why you see these differences in the bond market is that bond prices and the bond market tends to move a little bit faster than credit rating agencies. So if you see a yield of a given bond that’s higher than a very similar bond, it even has similar credit ratings, the assumption, or the risk is that that bond could actually be downgraded. In other words, you know, bond prices tend to fall even before the issuer gets downgraded by the credit rating agencies.
MARK: I’ve got a brokerage account. I own some individual bonds. Every so often I get an alert telling me that one of those bonds has been downgraded. First of all, what does that mean to be downgraded, and does a downgrade mean that I should be looking to sell that bond?
COLLIN: Yeah, a downgrade, Mark, is when a credit rating agency lowers its rating on a given bond or a given corporation. And what ratings really are, it’s an opinion of risk. It’s not a guarantee of performance or anything like that, but it’s the opinion of a given rating agency of how they view the risk of these corporations and what’s their ability to repay those debts.
So when a corporate bond or any bond really gets downgraded, you have to evaluate what that means and if you want to consider holding the bond. In short, if your bond gets downgraded, it doesn’t necessarily mean you need to go sell the bond. It might be worth considering, but there are a number of things you want to consider if your bond does get downgraded. You know, one thing to consider is that the lower a bond’s rating, the more volatile its price will probably be. So you want to ask yourself if you can handle that heightened volatility.
You also want to consider what rating a bond gets downgraded to. If a bond is downgraded from, say, double-A to single-A, that’s still a relatively high credit rating. But if you own a bond that gets downgraded to junk—now, a junk-rated bond or a high-yield-rated bond is one that’s below investment-grade and it’s below a triple-B rating—if that happens, that’s a different story, because junk bonds are significantly riskier than investment-grade corporate bonds, and historically, they’ve had higher rates of default than those with investment-grade ratings. So you really want to evaluate the situation if it does get downgraded to junk to make sure that it matches your risk tolerance.
Now, because bonds have set maturity dates and a promised amount to be repaid at that maturity date, you know, I think investors often tend to look at that like it’s a light at the end of the tunnel. You know, even if you hold a bond from an issuer that’s facing significant financial difficulties, you might still be tempted to hold onto that bond, just hoping that it can continue to make those coupon payments, and you might be reluctant to sell at a loss, because you anchor yourself to that $1,000 par value. We think it’s better to ask yourself, “Would I be buying this bond today?” If not, you might want to consider selling.
MARK: Collin, we’re framing this episode around this decision of: Should I invest in the bonds with the highest yields?” And we picked that decision because, as we’re recording this, interest rates are extremely low, and so many investors, frankly, they’re looking for higher yields. And a couple of other places that investors look for yield are preferred securities and bank loans. So let’s talk about each one of those. First of all, what are preferred securities, or sometimes they’re called preferred stocks.
COLLIN: Yeah, it can be a little bit confusing sometimes, because there’s a couple of terms out there. You know, “preferred stocks” is pretty common. They’re a type of hybrid security that shares characteristics of both stocks and bonds. But as you alluded to, preferred stocks are really just a type of what we call preferred securities. That covers a wide array of investments. But in short, when we’re talking about preferred securities, we’re talking about corporate investments. Like bonds, they have fixed par values, but they tend to be more targeted to individual investors, so the par values are usually $25, as opposed to the par value of most bonds, which is usually $1,000. And also like bonds, preferreds have, usually, fixed coupon rates, sometimes they have floating coupon rates.
Now, most bonds usually make semiannual coupon payments. Preferreds usually make quarterly payments. And here’s a really important characteristic, Mark—they have very, very long maturity dates, or they have no maturity date at all. So they should always be considered long-term investments.
Now let’s talk about how they relate to stocks. Like a stock, a preferred security ranks below an issuer’s traditional bond, but they do rank above the stock. And this is really where they get their name: The dividends on preferred securities need to be paid before the dividends on a common stock. So in other words, if an issuer has common stock outstanding and preferred securities outstanding, as long as they want to maintain their common stock dividends, they always need to pay the preferred dividends or preferred coupon payments first. And that’s how we get the name “preferred.”
MARK: So why are the dividends on the preferred stock so high, relative to a common stock, in most cases?
COLLIN: Well, with preferreds, you are taking more risk, and that’s why they offer higher yields than a lot of other things that are available in the fixed income market. You know, the key risks are that they rank below an issuer’s traditional bonds, and also, because of their long maturities. Another thing and another reason why they tend to offer higher yields is that depending on the structure of the specific preferred, the coupon payments or dividend payments may be discretionary, meaning they can be suspended without triggering a default the way a missed interest payment on a bond would. But when we’re looking at preferred securities, you are compensated with higher yields because you’re taking on those risks.
Now, another thing you want to consider with preferreds is that they tend to be correlated to both the stock market and to the bond market, and specifically, the long-term Treasury market. And the problem is you really don’t know which one it’s going to behave like. So, and I can’t stress this enough, Mark, when you’re considering preferred securities, you always want to make sure they’re long-term investments. They can be a good thing to add to your portfolio to help complement your core bond holdings, but you really need to be able to ride-out the potential volatility.
MARK: Let’s turn to bank loans. What are they, and what sorts of risks are associated with them?
COLLIN: Yeah, bank loans are … they’re very a niche investment, and they have a lot of other names. They’re often called senior loans or leveraged loans. So sometimes it’s even difficult to know what it is they are when you’re reading about them. But a bank loan is just a type of corporate debt. Despite the name, bank loans really aren’t issued by banks. They’re … banks lend to companies, and then they sell that loan to investors. So when you’re investing in a bank loan or a bank loan fund, again, you’re just investing in a type of corporate debt.
There’s three important things to know about bank loans. They have three defining characteristics. The first is that they have floating coupon rates, usually based on a short-term benchmark. Second, they are senior to an issuer’s traditional bonds. So in a worst-case scenario, like a bankruptcy, a senior loan would get paid before a traditional unsecured bond. And third, they are secured, or collateralized, by a pledge of the issuer’s assets. But what’s important is that even though they are senior and secured, they are still very risky. They generally have junk ratings, and it’s because of those junk ratings that they tend to offer higher yields.
But a final point on bank loans is that just because they are senior and secured, it does not mean safe. Bank loans are still risky investments, and they can and do default just like traditional bonds.
MARK: Collin, how do I go about investing in a bank loan if I’m interested? I mean, I can go on to Schwab.com, I can buy individual bonds. I can buy a stock. I can buy a preferred stock. I can’t really go out and buy a bank loan. So how do I get exposure to that type of investment if I think it makes sense for me?
COLLIN: Yeah, the easiest way to invest in bank loans is usually through a mutual fund or an exchanged-traded fund, because bank loans are usually targeted for large institutional investors, not necessarily individual investors like you and me. So if you are looking for them, they do have their own Morningstar classification. So if you’re searching for a type of fund, just look for bank loans, and you will see some options.
MARK: All right, Collin, one more question, then I’ll let you go. Cities, states, various governmental entities, they all issue bonds, as well. They tend to be called muni bonds, or municipal bonds. Does everything we’ve talked about so far apply to them, or are there wrinkles when it comes to munis that investors need to think about? I mean, their tax-exempt status, that tends to be a big one. Other things that people should be thinking about?
COLLIN: The points we’ve made generally apply to munis, as well, but there are wrinkles out there that investors should be aware of. But at the end of the day, like other bonds we’re talking about, municipal bonds offer varying degrees of risk, as well. You know, after all, some municipalities will be stronger than others. But municipal bonds do tend to be much safer than corporate bonds. Generally speaking, the credit ratings on municipal bonds tend to be higher than the credit ratings on corporations and corporate bonds, and historically, corporate bonds tend to default a lot more frequently than munis.
But at the end of the day, when you’re considering muni bonds, you always want to consider your risk tolerance and your time horizon, and just make sure that the investment matches up with those.
MARK: There are also some interesting tax implications and tax-advantaged treatment for certain types of munis, and people need to think about that, as well. Is that right?
COLLIN: That’s right.
MARK: Well, we could do a whole show on munis; maybe we will some time. But anyway, this has been great, Collin. Appreciate you coming by.
COLLIN: Thanks for having me on, Mark.
We started out this episode talking about the Yugo.
A car with an attractive low price is just like the bond with the high yield. But the allure of a great deal often has strings attached.
As Collin said, there are no free lunches. The risk involved with choosing a higher yield bond or a cheap car often ends up making them a bad deal in the long run.
The saliency of a higher yield is vivid—just like that low, low price tag on an ultra-cheap car.
But the other attributes, the so-called baggage that comes with it, are much less visible.
Several studies have shown that visualizing the negative consequences of ignoring less salient features can help people overcome the saliency bias.
Part of your job as a decision maker is to try to make those negative consequences and attributes a little more salient.
Here are some ways to do that.
If you see a bond with a higher yield that catches your eye, do some extra digging. Ask yourself these questions.
- First, what’s the credit rating on the bond? If the rating is below investment grade, be sure that level of risk is consistent with your risk tolerance. If the rating is investment grade, but it’s at the bottom rung of the investment grade tier, ask yourself if you’re comfortable with the possibility that the bond could get downgraded to junk status.
- Second, how long will it be before the bond matures? Longer-dated bonds tend to fluctuate more when interest rates change. While we don’t expect rates to go up soon (at least as of the time we’re recording this), if that were to happen, long-dated bonds would likely go down in price. Are you comfortable with that? If the answer is no, then maybe a shorter-maturity bond make more sense.
- Third, does the bond have any unusual call features? Some bonds give the bond issuer the right to call the bond back from bond holders before the stated maturity date. They typically do this when interest rates are low. They do that because they can issue lower-yielding bonds and use the proceeds to redeem the bonds with higher coupon payments. If a high-yielding bond is called away from you prior to maturity, it could ruin your chance of enjoying that yield.
Now, look, that’s not an exhaustive list of questions to ask, but I hope you get the idea that buying an individual bond is a lot like purchasing a consumer good. That bottom-line number—price or yield, in the case of an individual bond—it really matters, but it’s not the only thing that does.
To learn more about which bonds might be right for your portfolio, you can visit schwab.com/FixedIncome.
We mentioned municipal bonds, or munis, earlier, but if you’d like to hear a great discussion about what’s going on with munis lately, check out Mike Townsend’s interview with Cooper Howard on WashingtonWise Investor. You can hear it at schwab.com/WashingtonWise or in your podcast app of choice. Just search for WashingtonWise Investor.
Thanks for listening.
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For important disclosures, see the show notes and schwab.com/FinancialDecoder.