Understanding Bond Risk

Feb 2, 2022

Understanding Bond Risk

Don’t let reading a long and complex investment book stop you from understand bonds and how they can be affected. Steve Wolff (Founder and Managing Partner) and Greg Carroll, CFP® discuss their experiences during the 2008 Market Collapse and how not just the stock market and housing markets were affected but also the bond market.

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DISCLAIMER:

WWM Financial is an SEC- Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where WWM Financial and its representatives are properly licensed or exempt from licensure. Investing involves risk and possible loss of principal capital. No advice may be rendered by WWM Financial unless a client service agreement is in place.

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Full transcription below:

Steve Wolff:

Hello, once again, this is Steve Wolff. And we’re ready for another episode of Steve Stock Stories, which are becoming pretty popular these days, surprisingly. Anyway today, we’re going to deviate a little bit from what we normally do. Normally we talk a little bit about stocks, hence Steve Stock Stories. However, we’re actually going to talk a little bit about bonds today because I’ve got Greg Carroll with me, who someone I’ve known for quite a number of years. We worked together, I think we started … what was it? Shearson Lehman or something.

Greg Carroll, CFP®:

Yeah, something like that.

Steve Wolff:

You’ve been in the business since, what? 1994.

Greg Carroll, CFP®:

Yes, sir.

Steve Wolff:

I’ve been in the business since 1986. So we’ve seen a lot of things happen. We’re going to talk a little bit about what happened in the 08 timeframe. Because everyone talks about how stocks are really risky and everything else. And people never really realize the risk that you can have in a bond. Before we get to the story and before we get to you, Greg, I have to have a little disclaimer here, otherwise the lawyers will chop my you know what’s off. And we don’t want that to happen.

Steve Wolff:

This whole Steve Stock Stories is just for informational purposes only. It’s not meant from one specific person or what they have in their portfolio. If you’ve got something that … any questions about what we’re saying, talk to your financial advisor or talk to your tax person or whoever it might be, who you talk with. Before you buy anything that we’re talking about. All right? So now that we got that out of the way, Greg Carroll, it’s nice to see you.

Greg Carroll, CFP®:

Good to see you, Steve.

Steve Wolff:

Yeah, I mean, we worked together at Shearson Lehman for, I don’t know how many years. Before you went off on your own.

Greg Carroll, CFP®:

Yes. I think about seven years.

Steve Wolff:

Seven years. Wow.

Greg Carroll, CFP®:

Yeah.

Steve Wolff:

Then Greg came back to us, what? Two years ago now?

Greg Carroll, CFP®:

Two and a half years ago.

Steve Wolff:

All right. So we’ve been working together for quite a number of years. At any rate, Greg, I know when you and I talked about what happened in the 08, 09 timeframe, 07. When they look like the banks were going to collapse. Talk a little bit about what happened to some of the bonds that you … or just tell us the story.

Greg Carroll, CFP®:

Okay. The good thing here, as far as your disclaimer goes, you can’t buy what we’re going to talk about because it’s no longer in existence. What we’re going to talk about is bonds that we purchased for our clients back in 2007 timeframe and they were the Lehman Brother bonds. They were A-rated, high quality bonds that you really wouldn’t expect to ever lose any money with.

Steve Wolff:

A rated, basically, for those who don’t know means what?

Greg Carroll, CFP®:

Well, you’ve got a bond rating scale, which starts at AAA rated. Government bonds would be considered AAA rated, all the way down to A, B and even C and below is junk bonds. These are pretty high on the ladder there.

Steve Wolff:

They’re pretty high quality.

Greg Carroll, CFP®:

Yeah. Anything with an A, A plus, double A rate is high investment grade bonds.

Steve Wolff:

Okay.

Greg Carroll, CFP®:

You’re just going to buy those, collect your coupon, your semi-annual interest payments, until it matures and you get your money back. But we ran into this thing called a great financial crisis. A lot of things happened in the financial services industry. One of which was the bond rating services, Moody, Standard & Poor’s. I can’t remember if Duff & Phelps does bonds or if it’s more real estate. But they’re the ones that actually give these ratings to certain bonds.

Greg Carroll, CFP®:

Apparently they weren’t doing their homework well enough to actually understand what some of the bonds; what the real risk was in those bonds. The way the financial services industry was evolving, they didn’t understand how intertwined globally some of these banks and financial services companies were with different aspects all around the globe. There was a kind of a kink in the armor early that year in February, I think when Bear Stearns ran into some trouble. Didn’t raise a lot of red flags, but a few people started to notice. Then later that summer … what was the treasury secretary’s name back then?

Steve Wolff:

You’re trying my-

Greg Carroll, CFP®:

Geithner? Anyway-

Steve Wolff:

I don’t know.

Greg Carroll, CFP®:

Very smart young fellow.

Steve Wolff:

It was Geithner, actually.

Greg Carroll, CFP®:

Something like that. He was a very smart individual.

Steve Wolff:

I can’t remember what I had for breakfast this morning. You asked me about 20 years ago or however long it was.

Greg Carroll, CFP®:

That was a long time ago. Anyway, he realized there was some serious issues with a lot of the big banks and they had to call an emergency meeting with the treasury, the heads of all the banks, JP Morgan, Bank of America, Merrill Lynch, all of them.

Greg Carroll, CFP®:

But apparently Lehman Brothers was the one bank that may have been the most leveraged and the most in trouble during a financial Blacks Swan event.

Steve Wolff:

And by leverage…

Greg Carroll, CFP®:

Well, it means that for every dollar of assets they took in, they were investing 40 times that.

Steve Wolff:

I heard it was even higher than that.

Greg Carroll, CFP®:

Yeah.

Steve Wolff:

I heard it was something like 80 times.

Greg Carroll, CFP®:

Yeah. It was astronomical.

Steve Wolff:

Right.

Greg Carroll, CFP®:

It should never have been that high. I don’t know if it was public knowledge how levered they were.

Steve Wolff:

Right.

Greg Carroll, CFP®:

So they were kind of the sacrificial lamb at one point in September. I remember talking to one of the large wire-house firms that my partners and I worked at. I called them early, about a week out from them going bankrupt, Lehman Brothers-

Steve Wolff:

When you’re talking about the wire-house firms, you’re talking about the well known companies, I don’t know specifically. But the Merrill Lynches, the UBS’s, the Morgan Stanley’s et cetera, et cetera.

Greg Carroll, CFP®:

Correct, correct.

Steve Wolff:

Okay.

Greg Carroll, CFP®:

I started noticing the prices come down on these bonds, that bonds are priced at a hundred is par value. That’s what you buy them at when they’re issued and that’s what they mature at. Based on a hundred, sometimes they go down to the mid nineties, maybe, up to 105 based on the interest rate environment. But these things were going down big.

Steve Wolff:

The bonds really are priced much like a certificate of deposit is, CD at a bank. You buy X amount of dollars worth, and let’s say you buy $10,000 worth of a CD. You get your interest payments along the timeframe that the CD lasts. When it matures, you get your $10,000 back or whatever that amount is.

Greg Carroll, CFP®:

Right.

Steve Wolff:

So supposedly it’s similar to a bond. Isn’t that how it works?

Greg Carroll, CFP®:

Very similar. Yes.

Steve Wolff:

Okay. So, go ahead.

Greg Carroll, CFP®:

So I noticed these bonds, the price was falling dramatically. I mean, they were at like 70 cents on the dollar a week out from the actual bankruptcy. I didn’t know how to call my clients tell them I have an A-rated bond that seems to be in trouble, but we can maybe get 70 cents on the dollar. I was calling for advice back to New York, the people that are supposed to be helping us kind of collaborate on these types of issues.

Steve Wolff:

This is with the firm you’re with.

Greg Carroll, CFP®:

This is with the firm. And they told me, “No, Lehman Brothers is going to be okay, it’s going to be okay.” I said, “All right.” They get paid a lot of money to tell me that kind of advice. Later in the week, though, the price was down to 60 cents on the dollar. I didn’t know what to do, so I called New York again. They told me the same thing and I said, “I am hearing that Lehman could go bankrupt.”

Greg Carroll, CFP®:

With a bond holder, it works a little different than a stock where dependent on … there’s a lot of different levels of bonds in every corporation. There’s senior secured, senior unsecured, and then a bunch of subordinated debt. So depending where you’re at on that hierarchy in a bankruptcy, you might get 10 cents on the dollar, 20 cents, 30 cents in a bankruptcy scenario. These were senior unsecured debt. I was saying, I just didn’t know that I want to hold onto these. They talked me into holding on. And the news came out over the weekend, that Lehman was going to go bankrupt. So on Monday morning that caused a major onslaught in the stock market. I mean, just the ramifications were far and wide. I mean, it was-

Steve Wolff:

And of course, all this was precipitated by what happened in the real estate market.

Greg Carroll, CFP®:

Yes. That was a big catalyst to it. Yes.

Steve Wolff:

Yeah. I mean, this was that movie, I don’t know what the name of the movie was.

Greg Carroll, CFP®:

The Big Short.

Steve Wolff:

Yeah. It was that at The Big Short where this one particular person at … I don’t remember what institution he was at. But, he actually did some research into what was going on because everybody seemed to be getting a loan, no matter how much you made. I mean-

Greg Carroll, CFP®:

Right.

Steve Wolff:

A guy was making $30,000 a year and he was getting a $600,000 house. He knew something had to be wrong. So when he went out to investigate all of that, he realized that these places where they couldn’t afford them.

Greg Carroll, CFP®:

Right.

Steve Wolff:

Okay. And all these mortgages, they were underwater.

Greg Carroll, CFP®:

And a lot of those houses were just empty.

Steve Wolff:

Absolutely. So that caused all these people … especially the ones who were leveraged. And leveraged, let’s go back to stocks for just a minute. Leverage is the thing that really can kill you.

Greg Carroll, CFP®:

Yes.

Steve Wolff:

In the 1929 stock market crash, it’s exactly what happened. Individuals were buying three and four and five times and maybe more of what they actually had the cash to buy. It was legal. Well, when things went down, they had to come up with money because they were borrowing it and they had to come up to pay off the debt. Well, to pay off five times what you had when you didn’t have that to begin with and everything’s crashing around you, that’s what happens in stocks. Well, the same thing can happen in bonds. And that’s exactly what was happening right?

Greg Carroll, CFP®:

Right. Yes. So, I think one thing that the financial crisis did do, it did kind of clean up the system a lot, the bond rating agencies are doing a much better job. The banks are in much stronger position, I think-

Steve Wolff:

Today.

Greg Carroll, CFP®:

Today. So when you buy an A rated bond today, again, you can feel very confident that that bond should come to maturity and get all your money back. You should have a lot more confidence, but you got to know that things can happen with a company. Not necessarily with the market or the economy as a whole, but a company could have their own Black Swan event. Which could cause it to be downgraded and then you do lose price.

Steve Wolff:

Any company can have an issue. If they do have an issue, then your bond … let’s say they’re going bankrupt, like you said. It can happen to any company. Then your bonds are not going to be worth a whole lot. I mean, I don’t think a Sears bond was worth a whole lot at the end.

Greg Carroll, CFP®:

Right

Steve Wolff:

So, that can happen. I guess the point, again, is that it can happen in stocks or bonds. So you have to really know what it is that you own.

Greg Carroll, CFP®:

Right.

Steve Wolff:

There’s a big difference between buying a company, like, let’s just say Johnson and Johnson. By the way, you can buy that today, but don’t buy it just what we’re saying. But there’s a big difference between a Johnson and Johnson and XYC biotech company.

Greg Carroll, CFP®:

Right. Yeah.

Steve Wolff:

But back then, it’s funny, I had a very similar experience to what you’re talking about when I had the Lehman bonds. Fortunately, I didn’t have it for a lot of people. But I had the Lehman bonds and it looked like things were going bad. Of course, I called our big wigs in New York and they said, “Oh, no, no, no. Everything’s going to be just fine.” Well, I listened to them, unfortunately. Unfortunately it was a learning experience for me and for my clients. But it was not easy to tell a client, “Hey, you’ve got a bond here that you’re pretty sure is going to be okay till maturity, that’s going broke.”

Greg Carroll, CFP®:

Yeah, that’s a tough conversation. It’s not like with stocks, it can move around a lot in price and always do. Bonds are supposed to be pretty steady. On the statement, they don’t move very much.

Steve Wolff:

Right.

Greg Carroll, CFP®:

But they do move, but they do move.

Steve Wolff:

We’re at a timeframe right now, we’ve actually been in a bull market for bonds almost my whole career, since 1986. And actually probably started during 82 or 83-

Greg Carroll, CFP®:

Right.

Steve Wolff:

Where the interest rates were extremely high and coming down. Well, why is that a bull market? Because as interest rates come down, prices on a bond goes up. We’ve talked about this before and some other things. So I’m not going to explain why, but that’s what happens.

Greg Carroll, CFP®:

Yes.

Steve Wolff:

Okay. Now we’re on the other side of that, where interest rates were almost at zero. Now it looks like because of what’s going on here with inflation, the fed is now talking about raising interest rates. Now you’ve got a little bit of a headwind for bonds. So those existing bonds could drop in price again. But they should last to maturity, where you’re going to get your money back.

Greg Carroll, CFP®:

Yes, exactly. So it’s not the same as the company going bankrupt. But yeah, you could see depressed prices for a while until they get close to maturity. So you just want to be aware of that. I mean, if they’re paying a good interest rate and you’re comfortable with that. The bonds highly rated and you’re still going to get it at maturity or your value back, you can hold onto those.

Steve Wolff:

Right. And it always comes down to know what you own.

Greg Carroll, CFP®:

Know what you own.

Steve Wolff:

Know what you own. If you do that, you’ll probably be okay. Look, there’s always something that can happen. All right. There’s not a person I know who’s honest who hasn’t lost money in stocks, for sure, and probably in a bond, too, if they’ve been in there long enough. It happens. You just got to make sure that you know what you own and that’s a good case for diversification.

Greg Carroll, CFP®:

Absolutely.

Steve Wolff:

You wouldn’t want to have everything you own in a Lehman Brothers bond at the time.

Greg Carroll, CFP®:

No.

Steve Wolff:

Okay. That’s another thing too, and this is another topic that we’ll get into with Greg at another Steve Stock Stories, but about concentration risk. Where you have everything in one company or one bond or one thing. That’s where you can get really hurt.

Greg Carroll, CFP®:

Absolutely. Yeah. Was it Peter Lynch said, “Buy what you know.” But you can buy too much of what you know, sometimes. If you’re too concentrated, there’s a big risk there to.

Steve Wolff:

Right. Or if a person works for a particular company and it keeps getting more and more stock options and shares of stock, et cetera. And all of a sudden, that person has 85% of their net worth wrapped up in one company. Those are things we’ll … I don’t want to get too much into that. We are going to talk at that again with Greg because he’s got another good story and that one’s more on stocks than it is on bonds.

Greg Carroll, CFP®:

Yep.

Steve Wolff:

So, anything else you’d like to tell people about what your experiences shown as far as bonds are concerned?

Greg Carroll, CFP®:

I think, what you said earlier, know what you own and if you ever have questions, talk to your financial advisor, your CPA, whoever your advisor is that you’re entrusting to help guide you. You need to ask those questions. Don’t be afraid to ask questions.

Steve Wolff:

Right.

Greg Carroll, CFP®:

Because the more you know, the more you’ll understand different movements in prices of bonds and stocks. And the more comfortable you’ll be able to stay the course.

Steve Wolff:

Right. I know I have some clients who always say, “I know this is probably a stupid question.” If you don’t know the answer to the question, it’s not stupid.

Greg Carroll, CFP®:

Absolutely.

Steve Wolff:

Now if you ask it 10 times, maybe that’s stupid, but-

Greg Carroll, CFP®:

And Steve never counts.

Steve Wolff:

But if you really don’t know the answer, ask us. We’ll be more than happy to tell you.

Greg Carroll, CFP®:

Always happy to repeat it.

Steve Wolff:

So anyway, appreciate it. This is another Steve Stock Story. I’m Steve Wolff, Greg Carroll. We really appreciate you just listening. For those who are seeing this on video, watching us, we’ll see you next time. Thanks. Bye, bye.