Should You Be Worrying About Bonds?

Today, Standard & Poor's (the bond rating agency) cut the debt of Japan to AA-, it's fourth highest rating.  I remember back in 2003, a client asking me about his Maryland municipal bonds that were AAA-rated, paying excellent coupons and performing well.  He asked why we didn't go out and load up on more.  I cited Japan's last rate cut in 2002 and stated bluntly, "If they can cut Japan's rating, they could Maryland's too."

Worries over bond downgrades will remain a major story for the remainder of 2011. 
Almost unheard of in the history of the US bond market are discussions of US sovereign debt being downgraded and the near panic that would ensue.  This past fall the city of Harrisburg, PA missed a bond payment prompting default procedures and a sudden chill in the almost $4 trillion municipal bond market.  An article this past week in the Wall St. Journal discussed the letter a MD resident received regarding her MD Health and Higher Education bonds and the letter offering 50 cents on the dollar if she sold (she did).  If more stories of defaults surface and people panic, the trading markets for more than a few bonds could all but disappear overnight. 

Question: So, I don't want to panic but do want to take steps to protect myself, what do I do?

• The first thing you need to do is have an adviser pull some research on the bond.  Trading history, size of the offering, the prospectus if available and most recent disclosure document would tell a lot.  An examination of the quality of the bond vs. similar competitors should be done to truly evaluate how it would hold up in a panic. 
• Second, an examination of any change in your risk profile should be discussed and noted by your adviser.
• Third, the bond needs to be examined in relation to other bonds in your portfolio; and another time against the client's overall allocation.

Bonds are confusing; I just don't understand them and wonder if I should be in them at all. 

• Bonds are a lot more difficult for the average investor to understand.  Data is readily available regarding any stock or mutual fund in existence.  To research a particular bond requires knowing where to look plus perspective on the specific market your bond exists plus the bond market as a whole. 
• Unlike stocks which trade on exchanges like NASDAQ, AMEX, and the New York Stock Exchange, there is no organized exchange where bonds trade. 
• Bonds are priced on the spread (the difference between the bid and ask price).  The majority of the time, individual buyers buy and sell completely blind to the spread the broker receives for trading the bond.  Because of this, retail bond investors often get taken advantage of.
• Knowing which bonds are safe, in today's market, is really left to professionals who are experienced in the bond market.  There is a vast array of bonds with myriad characteristics that the average investor is not equipped to understand.   
• Your best defense is working with an adviser you trust.