Taking the fear out of bonds

The recent rash of cities and counties falling-victim to bond market disasters has prompted widespread consideration of the appropriateness of bonds in municipal portfolios.

After the hit that derivatives took in 1994, public trustees are shying away from some speculative instruments. But investments in agencies, mortgage-backed instruments or collateralized mortgage obligations CMOS) are still viable as long as the trustee is knowledgeable about such securities and as long as the instruments can be cashed quickly, regardless of market conditions.

Most federal agency securities, mortgage backs and CMOs have at least some complicated features, and, for most investors, the problem with owning complicated bonds is the difficulty in establishing their status at any given time.

Bonds can be called from the owner, the coupon can change or both. Bond players refer to these “wrinkles” as options, but they are the agency’s options rather than the buyer’s. For example, it is the agency’s right to call the bond or to let the buyer continue to carry the market risk of ownership.

The Federal Home Loan Bank, the Federal Home Loan Mortgage Company and the Federal National Mortgage Association are examples of savvy borrowers; any option that could work to the investor’s benefit will be exercised against the investor. To compensate for these options and the risks they present to the buyer, non-treasury bonds carry higher yields than treasuries.

To determine adequate compensation for callable bonds, option-adjusted spread analysis should be performed. Virtually all bond dealers and dealer banks have access to the financials on which this analysis is based.

The basics are as follows. Assuming that a bond is callable at par (many issues are) and that interest rates fall, the investor loses virtually all of the bond’s upside appreciation above par. In exchange for the loss of upside price appreciation, a higher coupon is paid. The goal of the option-adjusted analysis is to measure whether the new coupon r presents adequate compensation for (1) the loss of appreciation and (2) the loss of an income stream if the bond is called.

Trustees also should be able to check the adequacy of non-treasury compensation by comparing it to current treasury yields. The Wall Street Journal’s daily “Treasury Bonds, Notes and Bills” section is perhaps the most convenient reference for such comparisons and is routinely reprinted in local newspapers.

With some homework and attention, the purchase of non-treasury bonds does not have to be unduly risky. In addition to compensation research, “stress testing” yield, price and rate changes for severe interest rate fluctuations prior to investment will reduce the probability of an unexpected outcome.

Trustees can further boost security by consulting at least three legitimate sources — for example, a bank and two dealers — during the decision-making process. These sources should be willing to speak honestly and compare investments without imposing an obligation to invest with them.

A thorough understanding of any investment is critical in determining its appropriateness for a portfolio, and trustees must be willing to ask questions and demand answers. Following a recent valuation of Maryville, Mo.’s, investment portfolio, Maury Bouas a member of the city’s Securities Advisory Committee, said, “We were confident that we had a thorough understanding of our position and had developed an intelligent plan for disposing of inappropriate investments.”