Bonds #26: Yield Pickup: Buy Financials

You have accumulated cash through savings or earnings in you investment account.

Good work!

And you call your broker to see what bond yields are for different credit ratings and maturities.

In general, you know that longer-term bonds give you a higher yield. Why? Because you are committing your money for a longer time. You are exposed to greater RISK from market fluctuations the longer you hold an investment. But you have limited this risk by investing in bonds that mature from one to ten years—a fairly short “horizon.”

And lower-quality bonds must give you a higher yield because you have increased RISK. As quality decreases, the chance of downgrade or default on payments increases. But you have limited your credit risk by buying only high-grade investments – single A, AA or AAA names.

But there is another way to increase income, and that is to look at bonds issued by banks and financial companies. At most times, a bond issued by a financial services company will have a higher yield than an industrial company, even though they have a similar credit rating and maturity date!

Why???

Mostly, it is supply and demand. There is a lot of borrowing done by banks, financial services companies and the finance divisions of industrial corporations.

Investors want a balance of different names in their portfolios, and it’s pretty easy to pick and choose among the many financial names. So, they have to keep their prices low and yields competitive.

Let’s look at typical examples…

Here are two bonds that you might be offered:

Ford Motor Credit 6.7% due July 2004, yield 7.26%

Daimler Chrysler 6.9% due Sept 2004, yield 7.01%

Let’s compare them:

both have a higher yield than a AAA Treasury bond which has a yield in ‘04 of about 5 ¾%

both are issued by automotive corporations

both are rated single A, though the Ford is A2 and the DCX is rated A1

both mature in the third quarter of 2004

both carry coupons just under 7%, so…

both have a price just under face value.

The main difference is that the Ford bond is issued by Ford Motor Credit. The perception is that there is no “bricks-and-motor” collateral behind the bond, should something go wrong.

In my opinion, this would be a greater concern if the company were not so well rated. With a “junk bond” I would demand A LOT MORE than a quarter-percent extra yield. For a name like Ford, I sleep well with the credit-company backing, the slightly lower credit rating and an extra ¼% in yield.

This difference holds true for longer maturities, as well. In today’s market, the difference between the same two issuers is slightly narrower, though it could be parallel or wider.

Here is a comparison of two ten-year corporate bonds, at a time when the 10-year Treasury has a yield of about 5.73%:

Ford Motor Credit 7.875% due 6/10 yield 7.88%

Daimler Chrysler 8.0 % due 6/10, yield 7.68%

Compared to Treasuries, the Ford Credit issue is 0.20% or 20 basis points wider than the Daimler Chrysler. But both issues give a great amount of higher yield over the ten-year Treasury bond—nearly an extra 2%!

So, keep a balance of bonds in your portfolio, but watch for opportunities to increase yield.

Next: Government Agencies: the best of both worlds?