Anyone else getting old? With my kids headed back to school I have been thinking a bit about how different the world looks for them, how their options in life will be very different than mine. Some of these options confuse me - I still haven't figured out what a "tumblr" is, for example.
But sometimes new options can be a good thing. And since I'm always bringing everything back to investing (sorry, nature of the job), this got me thinking about how the investment landscape has changed since my parents or even my grandparents were my age -- and how it will likely change again by the time my kids are grown.
For one thing, in my grandparents' day there were no ETFs available, and few mutual funds. The average investor likely bought some blue chip stocks, U.S. savings bonds and maybe a few corporate bonds in the utility or industrial sectors. Now investors have a tremendous number of choices at their disposal, even when it comes to bond investing. Let's take a walk down memory lane to review how the fixed income landscape has changed for investors over the years.
Seventy years ago, the fixed income markets were all about "War Bonds", which were U.S. savings bonds issued by the U.S. Treasury to (obviously) fund the war efforts. Then, after World War II, investors looking for yield turned to debt issued by corporations. Many early corporate bonds were called "bearer bonds" and were issued as physical certificates. Anyone holding the bond (the bearer) could redeem the coupons and final principal value. The holder would literally clip the coupon and send it to the issuer to collect payments.
An interesting note about bearer bonds -- since they're unregistered, ownership is proven by possession of the bond. For this reason, they have at times been used for less scrupulous purposes, such as avoiding income taxes or even money laundering. Bearer bonds have even been featured in many Hollywood movies - the plots of Die Hard, Panic Room and Beverly Hills Cop all involve stealing these somewhat infamous bonds.
But while bearer bonds were widely acceptable debt instruments, the U.S. government changed tax laws to discourage their use in 1982 with the passage of the Tax Equity and Fiscal Responsibility Act. After that, more bonds became registered and ownership was recorded via book entry, making a depository responsible for recording changes in ownership. So while bonds were still traded over the counter, they now largely lived as book entries and eventually electronic entries rather than as physical certificates. Of course, individual investors still had to work with a broker to buy and sell them, and as a result, pricing and trading volumes were not transparent and individual bonds suffered from periods of illiquidity.
Given some of these difficulties, rather than holding individual bonds, more investors have turned to managed vehicles over the years for diversification and liquidity. The first mutual fund began in the United States in 1924, but they entered the mainstream after the Securities and Exchange Commission outlined the laws and regulations governing mutual funds in the Investment Company Act of 1940. Index tracking funds and money market mutual funds developed in the 1970's to give investors more precise exposures to various sectors of the bond and cash markets. The rising bull market and the need to save for retirement increased the growth of the mutual fund industry.
In the early 1990s, a new fund structure developed: the exchange-traded fund. The first group of fixed income ETFs was launched in 2002 (check this post for a brief history of bond ETFs), and with that, individual investors could now trade a basket of fixed income securities on the exchange.
I can only imagine what the bond markets might look like when my kids begin to invest. All they want to do for now is borrow against their future allowance. Time to teach them about credit risk!
Bonds and bond funds will decrease in value as interest rates rise; they are also is subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. Shares of the iShares Funds may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from a Fund by Authorized Participants, in very large creation/redemption units.Transactions in shares of the iShares Funds will result in brokerage commissions and will generate tax consequences. iShares Funds are obliged to distribute portfolio gains to shareholders. When comparing bonds and iShares Funds, it should be remembered that management fees associated with fund investments, like iShares Funds, are not borne by investors in individual stocks or bonds. The annual management fees of iShares Funds may be substantially less than those of most mutual funds. Buying and selling shares of iShares Funds will result in brokerage commissions, but the savings from lower annual fees can help offset these costs.Diversification may not protect against market risk. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.