You need to be investing in bonds for part of your portfolio. This is what controls your level of risk. So, what are bonds? Bonds are simple interest-only loans. It’s that simple! Learn what every investor should know about bonds and fixed-income securities.
Video Transcript: What Are Bonds?
What are bonds? Bonds are simple interest-only loans. It’s that simple!
Unlike buying a stock—where little is promised but the potential reward is unbounded—with a bond, everything is spelled out, and you don’t get more than that. If we draw it as a picture, we’re going to expect interest payments over regular periods but none of the principal is repaid until the end of the loan.
When the borrower is a bank or credit union, these agreements are called certificates. When the borrower is a government or corporation, these are called bills, notes, or bonds, depending on the length of the loan. They have a face value—which is the amount you’ll get back at the end of the term of the agreement, and a coupon which specifies the fixed dollar amount you’ll receive every year as interest, in either monthly or semi-annual payments. Bonds with longer terms or poorer credit ratings need to offer higher coupons to attract investors.
The coupon rate never changes. That’s the reason that bonds, like CDs, are called fixed-income investments. What makes these different from an IOU, a loan, or even a bank CD, is that these are “negotiable”—meaning you can buy and sell these in a market, for the current price.
It’s a competitive market, and that price is determined by the prevailing interest rate for similar bonds. There is only one day that the price has to be equal to the face value of the bond, and that’s its maturity date.
Interest rates move around daily. Today’s interest rate for a 5-year treasury note is around one and a half percent. At one point 30 years ago it was over fifteen percent.(1) Rates are determined by supply and demand in the market.
The credit rating of the issuer is very important. Many corporations with outstanding credit ratings also issue bonds to raise money. Corporations with weaker credit ratings need higher coupons to attract investors, so these are called “high-yield bonds”.
Now, as always, beware of marketing.
While high-yield certificates are good, because they are government insured,
high-yield bonds are bad—at least from our point of view that it’s better use high-quality bonds to stabilize your portfolio and keep your risk in your stock investments.(2) Because, in addition to default risk, junk bonds tend to go south when the stock market tanks, exactly the wrong time!
Test your knowledge about what are bonds . . .
Now it’s time for some fun. I’ll give you two facts. You choose the fact that is true.
Here’s one: All bonds are subject to interest rate risk—unless held to maturity. (F)
Here’s the other: Bonds prices vary with interest rates but not grow like stock prices do. (T)
This is False. Interest rate risk (also known as price risk) refers to the risk that the price of a bond will fall due to an increase in interest rates. There are no exceptions. When interest rates rise, and you have your money locked-up in a bond, you are missing out on investing that money at the new higher rate. The bond you own is instantly worth less from the amount of your lost opportunity. It’s a lost opportunity even if you hold it to maturity and get each and every payment as promised, on time.
This is True. The market prices for Bonds do not grow the way stock prices do, but their prices do fluctuate with interest rate changes.
The value of a stock reflects what people perceive the future profits will be for a company. So as a company grows, the value of the stock appreciates.
Not so with bonds. A bond price, and the current interest rate, are directly connected, but the effect is not permanent.
To see this, consider a 5-year Treasury Note. If interest rates never change, the market price for that bond would remain flat every day for five years.
But if interest rates went up 1% at the end of the first year the value is immediately worth a few percent less. Still, that Note will be worth exactly the face value on the very last day.
And if interest rates fall, the opposite occurs.
If interest rates fell an additional 1% every year for the life of the bond, the value of the bond might look like this. Intuitively this is what you’d expect, because your bond locked in higher interest rates that what’s available in the market, but that ceases to have any additional value when the bond matures and is worth the face value.
Now, can you see that the same size interest rate changes have a bigger impact on the bond price when the maturity date is further away?
Bond prices move instantaneously in the opposite direction when interest rates change by a factor you can control called “duration”. Now I want you to see that if the interest rate were to instantly rise 1%, the price of a bond (or bond fund) with a 1-year duration would go down 1%. Down 1% causes a price rise of 1%. Longer-term bonds, and bonds with smaller interest payments, are more sensitive to interest rate changes because they have a longer duration. If the duration is 8-years, then a 1% change of interest rates causes the price to change by 8%.
The primary point is that a bond price isn’t merely influenced by interest rates, they are directly connected by math.
We care about price sensitivity so we can invest in the appropriate type of bonds. We don’t expect to get a return because of interest rate changes—because nobody can reliably predict interest rates. We’re investors not speculators, so we’re more concerned with total return which includes the dividends and reinvested dividends.
Next, we need to clear up the confusion about whether to buy individual bonds, bond funds, or bond ladders. That’s coming up!
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Footnotes and Video Production Credits for What Are Bonds?
Footnote 3: http://research.stlouisfed.org/fred2/series/DGS5/
Footnote 4: The Only Guide To A Winning Bond Strategy You’ll Ever Need, by Larry E. Swedroe, 2006.
From page 123: “Given that a high (if not the highest) priority for investors, whether in the accumulation or withdrawal stage, is safety or stability of principal, the prudent choice is to restrict holdings to only the two highest investment grades, AAA and AA. One of the major reasons is that as the credit rating decreases, the correlation with equity returns increases. This is a strong negative feature of lower-rated bonds—they are more likely than higher-rated bonds to perform poorly at the same time that stocks are performing poorly.”
From page 128: “The main purpose of fixed-income securities for most investors is to provide stability to their portfolio, allowing them to take equity risk. While it is true that high-yield debt has non-perfect correlation with equities, the correlation may increase at just the wrong time—when the distress risk of equities shows up.”
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