Part of must-read guide: How to build an all-weather portfolio, step-by-step.
Step 5: Learn more about bond risks and returns. Why? Because you will be tempted towards higher yields. Learn about the risks.
Nearly all the risk from owning bonds is driven by two factors: the time to maturity and the credit quality of the issuer. This chapter explores these two, plus mentions others to be aware of, so you can understand what bond investments are appropriate for your portfolio.
A simple map of investment possibilities might look like this 9-box style guide. For most investors, the role of bonds is to add safety and anchor your portfolio during falling stock markets (“bear” markets), allowing you to stay disciplined. We will discuss why short- and intermediate-term low-cost bond funds comprised of the highest grade bonds satisfy your needs. There are also times when locking in high interest rates with longer-term CD, individual bonds, or especially TIPS can be valuable. And just as important: why you should avoid lower-quality bonds and more expensive actively-managed bond funds.
Yield, Price And Making Comparisons
- Yield-To-Maturity (YTM) is the best way to compare individual bonds.
- 30-day SEC Yield is best way to compare bond funds.
- Total return is the best way to measure and compare the performance of any investments, of any types.
This chapter will clarify the key metrics to compare bonds and bond funds, the importance of total return for measuring performance, the usefulness of duration for controlling interest rate risk, and some practical insights we can infer about the market’s expectations for the future as revealed by current pricing (yield curves).
How To Compare Individual Bond Returns
The word yield is used in multiple descriptive phrases but three are the most important: coupon yield, current yield and yield to maturity. Each has a very precise meaning. Let’s look at each.
Coupon yield is set when a bond is issued. It is the interest rate paid by the bond, and it is listed as a percentage of par, or face value, which is the principal amount that will be paid at maturity.
The coupon yield designates a fixed dollar amount that never changes through the life of the bond. If a $1,000 par value bond is described as having a 10% coupon, that coupon will always be $100 for each bond, paid out in $50 increments every six month for the entire life of the bond—no matter what happens to the price of the bond, or to interest rates. That is the reason bonds are called fixed-income securities.
Current yield. Almost as soon as a bond starts trading in the secondary market, it ceases to trade at par. A bond’s current yield is its annual coupon divided by its market price.
Example: Say a bond has a face value of $20,000 and makes annual interest payments of $1,200. You buy it at 90, meaning that you pay 90% of the face value, or $18,000. It is five years from maturity. The bond’s current yield is 6.7%:
($1,200 annual interest / $18,000 x 100) = 6.7%
While current yield is easy to calculate, it is not as accurate a measure as yield to maturity. See in the next example why the yield to maturity for this same bond is 8.54%.
Yield to Maturity, sometimes called the bond’s yield for short.
You can see from the above description that current yield is based only on the coupon and the current market price. Current yield fails to measure two important sources of income that investors earn from bonds: compound interest—from reinvesting (not spending) the coupon payments—and changes in the bond price.
Yield to maturity (YTM) is a more comprehensive measure of potential return than “current yield” and it is the most valuable measure for comparing individual bonds. It estimates the total amount that a bond will earn over the entire life of an individual bond, from all possible sources of income—coupon income, interest-on-interest, and capital gains or losses due to the difference between the price paid when the bond was purchased and par, the return of principal at maturity. The next example and picture will illustrate this.
Example: In the previous example we calculated that bond’s current yield is 6.7%. But the bond’s yield to maturity in this case is higher. It considers that you can achieve compounding interest by reinvesting the $1,200 you receive each year. It also considers that when the bond matures, you will receive $20,000, which is $2,000 more than what you paid. The next picture shows that each future payment is discounted to what it is worth today. The YTM is 8.54%, or the discount rate such that the values of all future payments sum to the current market price.
Pricing The Bond With Yield of 8.54%
In this example, the market establishes the yield for 5-year maturities (the amount remaining on our 10-year bond) at 8.54%. Each future coupon is discounted by dividing by (1+YTM) for each year. We can see that the current bond price is exactly the present value of future coupons and return of face value at maturity:
The yield to maturity will give you an estimate of the total return of the bond, assuming the bond is held to maturity and all coupons are reinvested at a rate equal to the yield to maturity.
Key Point: The chief usefulness of YTM quotes is that they allow you to compare different kinds of bonds—those with dissimilar coupons, different market prices relative to par (for instance, bonds selling at premiums or discounts), and different maturities.
How to Compare Bond Fund Returns
Unlike individual bonds, since there is no single date at which the entire portfolio of a bond fund matures, bond funds cannot quote a YTM equivalent to that of individual bonds.
Indeed, most bond funds maintain what is known as a constant maturity. That means, for example, that if a bond fund invests in long-term bonds, then bonds are bought and sold continually to maintain a portfolio long-term maturity of ten years or greater.
SEC Yield. Yield of a bond fund measures the income received from the underlying bonds held by the fund. The 30-day annualized yield is a standard formula for all bond funds based on the yields of the bonds in the bond fund, averaged over the past 30 days. This figure shows you the yield characteristics of the fund’s investments at the end of the 30-day period. It does not indicate the fund’s future yield. The 30-day yield also helps you compare bond funds from different companies on a standard basis.
The chief value of the 30-day SEC Yield is to compare various types of bond funds. Think of the SEC yield as the average YTM of the fund for a recent 30-day period.
The price of a bond fund changes continually in response to changes in interest rates—exactly as with individual bonds (because that’s what it’s a collection of!). As a result, the price of any bond fund at any future date is impossible to predict, but it doesn’t vary any differently than the individual bonds of which it is comprised.
Returns posted by bond funds for prior periods, and listed in daily newspapers, are total returns. They always include changes in the price of the bond fund due to changes in interest rates. This is always the best way to measure and compare past performance of any bonds or bond funds. In the next chapter we will learn how to use duration to reduce risk from changing interest rates.
Don’t be tempted to compare funds based on other numbers that might look attractive. For instance, Distribution Yields, which are sometimes computed from the prior year’s distributions. These are particularly misleading because they reflect interest rate changes and capital distributions. Instead use Yield-To-Maturity to compare individual bonds, use 30-day SEC Yield to compare bond funds, or use total return to compare anything with anything.
Total Return—To Measure And Compare Performance
Total return. A bond fund’s total return measures its overall gain or loss over a specific period of time. Total return includes income generated by the underlying bonds and (both realized and unrealized) price gains or losses. Investors should focus on total return when evaluating performance of bond funds.
Investors in fixed-income securities sometimes make the mistake of equating interest income or advertised yield with return. But this does not take into consideration what is happening to principal.
Total return for bonds consists of whatever you earn in interest income, plus or minus changes in the value of principal. (To be totally accurate, you would also subtract taxes and commission expenses from return.)
Example: Let’s assume that a year ago, you invested $10,000 in a bond fund, purchasing 1,000 shares at $10.00 each. Assume also that the bond fund was advertising a yield of 10%, or $1.00 per share, which was maintained for the entire year. But suppose that in the meantime, interest rates have risen so that now bond funds with similar maturity and credit quality yield 11%. As a result, your bond fund is now selling for $9.00 per share. What is the total return on that investment for the past year?
You have earned interest income (based on the monthly coupon distributions) of 10%, or $1,000. But, that ignores the fact that your bond fund has now lost approximately $1 per share (10% of its principal value) and that your principal is now worth $9,000.
Add the income earnings of $1,000 to the current value of your fund ($9,000). Your investment is now worth $10,000. (For the sake of simplicity, I am ignoring interest-on-interest and commission costs.) Therefore, the net return is $0, or 0%. That is your total return, to date, even though you have received 10% interest income.
If instead interest rates had declined to 9%, the price of your bond fund would have risen to $11,000, and your capital gains would have added to the interest income your fund distributed, and your total return would have risen to 20%:
($1,000 interest + $1,000 price increase)/$10,000 = 20%
The concept of total return applies equally to individual stocks and bonds and to funds of every kind.
Total return is ultimately what we care about—and we want this to be larger than inflation. And the beauty is that it gives us a way to compare any of your investments with any others.
For both stock and bond funds, total return over time is conveniently depicted by a chart that is called Growth of Hypothetical $10,000. This is the fair way to compare funds comprised of different types of assets.
Example: Comparing Total Returns
Suppose you wanted to consider how two portfolios with different asset allocations fared over the great recession in 2008-2010. You would do this by comparing total returns, which is most easily accessed in charts titled Growth of Hypothetical $10,000. The 100% stock portfolio lost more than 51% from its peak in 2007 whereas the 60/40 portfolio lost 37% over the same period. If withdrawals were required and recovery took a decade, the safety in the balanced portfolio is apparent. As it turned out, the stock market rebounded relatively quickly this time and so long-term stock investors escaped scot-free this time—except for those that panicked and abandoned their plans. Remember, a very important reason to own a balanced portfolio is to give you the emotional fortitude to “Stay the Course”.
Remember, when comparing bond funds, look at total return (also called Growth of $10,000) and the 30-day SEC Yield.
High-quality bond investors have fared well 2008-2012, both because interest rates dropped as the Federal Reserve tried to stimulate the economy and from a flight to quality that accompanied the uncertainty. But since interest rates can change in both directions it is important that we learn how to reduce risk from interest rate changes for when we need to.
How To Reduce Risk From Interest Rate Changes
- Duration is an essential attribute for understanding the riskiness of a bond fund or ladder over time.
- The duration of a bond, or a bond fund, is a measure of its price sensitivity to interest rate changes.
- Investors are indifferent to interest-rate changes if they hold their bond (or bond fund) for the length of time called duration after interest rates change.
- Individual bonds have declining duration. (This is useful.)
- Bond funds have constant duration. (This is also useful.)
We’ve learned that all bonds and bond funds are subject to interest rate risk—that is: if rates go up, the bond prices instantly go down, preserving the time value of money.
Bond maturity provides a rough indication of ‘riskiness’. All other things being equal, the longer the time period to maturity for each bond, the greater the volatility of its price. However, this measure only takes into account the final payment (not any other cash flows), does not take into account the time value of money and therefore does not give an accurate comparison of relative ‘riskiness’ across bonds.
Heads-up! I’m going to teach you a new word. It’s valuable, useful, and worth knowing. But, you are going to trip because your brain already thinks it knows this word. It will help if every time I write duration, you mentally replace it with the words “financial duration”. Then you’ll remember it is special, and you’ll be fine.
Duration is a better factor to characterize risk than time to maturity. It’s a more sophisticated measure as it takes into account all cash flows and time value of money. It tells how long you’d have to hold a bond or bond fund after an interest rate change to be indifferent to such changes. After demonstrating this, you’ll learn how to use duration to compare riskiness across bonds and estimate the impact of an interest rate change.
Duration: The Point of Indifference to Interest Rates
The first valuable way that the duration of a bond or bond fund can be applied is to reduce interest rate risk by matching duration to the point in time of specific liabilities. I’ll walk you through this. William J. Bernstein offers a valuable definition:
Duration is the point at which you become indifferent to changes in price and yield.
Mr. Bernstein provides this example to illustrate the first important concept of finding the point in the future where you become indifferent to an interest rate change today. Consider a one-year Treasury bill. A bill is in reality a zero coupon bond. It is bought at a discount with no interest payments before maturity. For example, a 5% bill will sell for $0.9524 ($1.00/1.05) and be redeemed at par ($1.00). If someone purchases this 5% bill, and a few seconds after it is issued yields suddenly rise to 10%, it falls in price to $0.9091 ($1.00/1.10), with an immediate loss of 4.55%.
But, if our investor holds the bill to maturity, he will receive the full 5% return, the same as if there had been no yield rise/price fall. And beyond the one year maturity, it’s all gravy—our investor can now reinvest the entire proceeds at double the yield. His “point of indifference” is thus the one-year maturity of the bill; before one year he is worse off because of the yield rise/price fall, and after one year he is better off.
The formula for bond duration is complex, but the most important thing to remember is that the bigger the coupon or yield, the larger the gap between duration and maturity—at 10% yields a bond with 10 years maturity will have a much shorter duration than at a yield of 5%. And finally, for a zero-coupon bond, maturity and duration are the same.
Duration tells us how long we must wait to become indifferent to an interest-rate change. The following two sidebars will help you get an intuitive grasp of how this important concept of duration is related to coupons and maturity. The way these interact with each other becomes apparent if you were to consider balancing them on a teeter-totter.
Duration of a Zero Coupon Bond is equal to its time to maturity.
Duration of a Zero Coupon Bond is equal to it time to maturity.
The lever above represents the five-year time period it takes for this zero-coupon bond to mature. The money balancing on the far right represents the present value of the amount that will be paid to the bondholder at maturity. The fulcrum, or the point balancing the lever, represents duration, which must be positioned where the lever is balanced. The fulcrum balances the lever at the point on the time line at which 50% of the cash flows (on a net present value basis) will have been returned. The entire cash flow of a zero-coupon bond occurs at maturity, so the fulcrum is located directly below this one payment.
This extreme case, where the coupons are $0.00, shows that small coupons don’t have much effect on making duration less than the time to maturity. Next, we see that bigger interest payments do.
Duration of a Simple Coupon Bond is always less than its time to maturity.
Consider a simple bond that pays coupons annually and matures in ten years. Its cash flows consist of ten annual coupon payments and the last payment includes the face value of the bond.
The money represents the present value of all cash flows you will receive over the ten-year period. Their sum equals the amount paid for the bond. The fulcrum balances the lever at the point on the time line at which 50% of the cash flows (on a net present value basis) will have been returned. The picture above shows the duration of this bond is 7.5 years.As coupons are distributed and the present value of remaining cash flows are recalculated, the timeline to bond maturity gets shorter and the fulcrum shifts to the right. CDs and individual bonds all have declining duration as time approaches the bond maturity.
This picture provides an intuitive way to grasp why the coupon payments don’t do much to shorten the duration when the bond gets close to maturity.
Regular coupon bonds make coupon payments throughout its life, as do a collection of bonds—be they in a bond ladder or in a huge fund. Very often the term average duration is specified to characterize the entire collection. The point of indifference to interest rate changes applies identically for a fund as for individual bonds. A characteristic of funds is that they are often managed to maintain a collection of bonds that produce a rather stable, or constant, average duration.
Key Point: Individual bonds have declining duration that ultimately becomes zero when the bond matures.
A zero-coupon bond automatically reduces duration by exactly the amount of time that passes, and is therefore the risk-less choice for meeting a future obligation. A coupon-paying bond approximates this: duration declines very slowly at first and then more rapidly once the bond nears its maturity; this is more pronounced when interest rates are high and less important when rates are low.
A bond fund duration is relatively constant. For most purposes, it is easy to gradually shift from intermediate- or longer-term bonds to shorter-term bonds as the need for capital approaches, which will reduce sensitivity to interest-rate changes.
Duration: The Measure of Sensitivity to Interest Rates
To be absolutely assured of receiving a given sum on a future date, your goal is to gradually reduce the sensitivity to interest rate increases as the date approaches. The financial term “duration” is also a measure of this sensitivity. The significance of a declining duration is the declining sensitivity to interest rate changes.
The second valuable application of duration is for a quick estimate of just how much the price of a bond or bond fund would immediately change after a small change in interest rates. I’ll call it a rule-of-thumb to give it an appropriate context.
Bond Price Change (%) = – (interest rate change in %) x duration
An example mentioned earlier is that a bond with a 5-year duration will decrease 5% in price with each 1% increase in yield. The same would be true for an intermediate-term bond fund that has a 5-year duration.
Limitations: If you use this as a rule-of-thumb to help you make comparisons you will be making good decisions. If you are expecting precision, you’ll be disappointed.
For one reason, this second application of duration uses a slightly different definition for duration. Secondly, this modified definition is only valid for small changes in interest rates. Historically, rate changes have been rather gradual—so that hasn’t been a problem.
Lastly, it’s not entirely clear how each fund computes duration. For instance, both Fidelity and Vanguard call it ‘Average Duration’, but to define it Fidelity seems to use the time-weighted definition and Vanguard seems to use the ratio definition. In truth, they may both use something different to handle the bonds that have special features like call provisions. My advice: use it then move on! Use it as a rough metric to make good decisions and then move on with your life. Duration is a valuable tool! But if you are using it to manage a corporate pension fund then you would be reading an advanced book.
The earlier example where a hapless investor experienced the one-time instantaneous 5% interest-rate increase was useful to illustrate important point that you can be indifferent to interest rate if you hold the bond for the duration and reinvest the dividends at the new rates. Past history suggests that rates change at a much more gradual rate. This next side bar shows interest rates gradually increasing over 4% over a two year period, and the total returns of all bonds continued to grow.
Example: The Federal Reserve influences interest rates by controlling the very short-term Federal Funds rate. Changes are very gradual. For example they increased from 1% to 5.2% at a steady gradual pace over two years (mid-2004 to mid-2006). Yes, the bond prices responded exactly as I have described—bond pricing is mostly simple math, not emotions or projections—but the loss in bond values from rising rates simply made the total returns less positive. The following chart shows the total return of $10,000 invested in short-, intermediate-, and long-term U.S. Treasury bond index funds—continuing to grow, just slower:
Another important lesson from history is that nobody can predict interest rates. There are currently a lot of people that think rates are so low that there is nowhere to move but up. They have thought this for six years now. And if they have stayed in short-term bonds because of this reasoning they have already lost several years of the higher yields from, say, intermediate-term bonds. Nobody knows how low this, or any, interest rate environment will last. But you can become indifferent to changes! Hold short or intermediate-term high-quality bonds based on when you need the money—avoid speculating on future interest rate changes.
Since we are investors, not speculators (gamblers), we also don’t want to gamble on future rates of inflation. You cannot predict this! Nobody can. But we can own bonds in a way that protects us if inflation is higher than expected, and also if inflation is lower than expected.
How To Reduce Risk From Unexpected Inflation
- TIPS are special bonds where the principal adjusts with the consumer price index; TIPS investors win if inflation is higher than expected
- The market establishes interest rates for every maturity. The result is a yield curve for a set of similar securities (e.g., the U.S. Treasury Yield Curve)
- In the end, we care about real (inflation adjusted) growth
- Nominal interest rates includes market’s best estimate of future inflation; investors win if actual inflation is lower
Inflation is a big risk. Long-term investments in stocks produce growth significantly above inflation, but what about portfolios that have a significant percentage of bonds?
Many choose Treasury Inflation Protected Securities (TIPS) for protection against unexpectedly high inflation. While these are issued with a lower coupon rate, don’t misunderstand this, because both the principal and interest of TIPS are indexed to inflation. So, if inflation increases by 0.2% one month, then the principal of this special type of bond increases by 0.2%, and the coupon interest rate is applied to the new inflation-adjusted principal. As a result, if there is 3% inflation every year for ten years, a $1,000 TIPS will return $1,344 (=1000*(1.03)10)to the bond holder when it matures, rather than $1,000 as would a normal Treasury bond. The purchasing power of the invested principal will be the same as the $1,000 had ten years earlier, it’s just that the principal money has been adjusted for inflation.
That’s it! You can skip ahead to the next chapter now about how to build your portfolio. Or, read on to learn more about how it works.
Real versus Nominal Interest Rates
Learning more is easy, but I need to teach you another word. All through this book we have talked about interest rates but now we need to be more precise. They were actually nominal interest rates.
Nominal interest rates are not inflation adjusted.
Real interest rates have inflation subtracted out from them.
Ultimately, we all seek to grow the purchasing power of our money after inflation. The coupons for Treasury Inflation Protected Securities (TIPS) are smaller and represent this real interest rate because the principal amount of these securities grow with the Consumer Price Index . The real interest rate is just that—the rate of interest an investment earns that is above inflation. The nominal interest rate that we have discussed so far is comprised of the inflation rate plus the real interest rate .
Nominal = Real Interest Rate + Breakeven Inflation Rate
Our goal is to protect ourselves from inflation. We will identify strategies to protect our investments both if inflation is higher than expected, and if inflation is lower than expected. First we have to return to our friend, the yield curve. We are now in a position to discuss the determinants of a bond’s yield. As we will see, the yield on any particular bond is a reflection of a variety of factors, some common to all bonds and some specific to the issue under consideration.
The Valuable Meaning in a Yield Curve
I’m going to introduce this to you, not because you need to interpret yield curves (you don’t), but because this will help you to understand the relationship between interest rates and expected inflation.
A yield curve is a graph demonstrating the relationship between yield and maturity for a set of similar securities. A number of yield curves are available, but the one that investors compare all others to is the U.S. Treasury Yield Curve.
At any point in time, short-term and long-term interest rates will generally be different. Sometimes short-term rates are higher, sometimes lower. Each day, in addition to a table of Treasury prices and yields, a plot of the yield curve for U.S. Treasuries is published at treasury.gov.
These yield curves change over time. The Federal Reserve’s policy drives the yields for short maturities. All other rates (longer maturities) are set by the market.
In this example, the nominal interest rate curve represents the current yields for U.S. Treasuries of each maturity. The curve beneath this are the current yields for Treasury Inflation Protected Securities (TIPS) of each maturity. The difference between them represents the Breakeven Inflation Rate.
Breakeven Inflation Rate is mostly the expected inflation that is built into Treasury interest rates. If inflation is less than expected, then investors that buy Treasuries come out ahead. If inflation is more than expected, then investors that buy TIPS come out ahead. The Breakeven Inflation Rate is actually slightly bigger than expected inflation because it also included a small premium being the cost investors are willing to pay to guarantee real returns.
This composite yield curve is hypothetical to illustrate the key concepts in a simple way. It would look different if inflation is expected to fall. Additionally, expected future real rates could be larger or smaller than the current real rate.
In 2012, all Treasuries with less than 20-year maturities were yielding less than inflation. Investors are paying a premium for safety when they invest in these securities. While unusual, this price for safety is not a good reason to abandon your investment plan and accept a higher level of risk than you accepted before.
That means that the corresponding real interest rates were negative! Why would you invest in a bond with negative yield? This does not mean that an investor will experience negative returns. Read on …
Why Include TIPS In Your Portfolio?
TIPS are like traditional Treasury bonds but offer insurance against inflation in a different manner. At each semi-annual coupon payment, the principal value of the bond receives an adjustment based on the current rate of inflation. Future interest payments are computed from the new inflation-adjusted bond value.
Traditional Bonds are a better investment if future inflation is less than expected, and TIPS are a better investment if future inflation is greater than expected. But there is more.
With a normal yield curve, investors can earn higher interest rates if they accept the risks associated with longer-term bonds—and that includes unexpected inflation.
Key Point: The biggest advantage of TIPS is that investors can earn that term premium without taking the risk of unexpected inflation.
TIPS have only been in existence since 1997, but long enough for bond expert Larry Swedroe to assert that TIPS are even slightly negatively correlated with the stock market (i.e. better than traditional Treasuries). This means a smaller amount of TIPS can achieve an investor’s risk position, enabling a bigger investment in the stock market for higher expected return.
Consider this: can you determine, based on these numbers, which is the better investment?
10-year Treasury bond yielding 2%, or
10-year TIPS yielding -0.5% (yes, that’s negative 0.5%)
No. You don’t know and you can’t know at the time you purchase the bond. That’s because the yield of the TIPS does not include the inflation adjustment that will be applied monthly to the price of the TIPS. It may be higher than 2% or lower, depending on the future inflation rate.
But these yields do tell us what the market expects will be the Breakeven Inflation Rate:
Breakeven inflation rate = YTM(traditional) – YTM(TIPS) = 2.5%
Key point: The breakeven rate is defined as the rate that would result in equivalent total returns for both types of bonds.
The expected return for the traditional Treasury bond is simply the yield to maturity (on the nominal curve). For TIPS, the expected return is the yield to maturity (on the real curve) plus the expected inflation adjustments. Notice that the expected returns between the two bonds are the same!
If the rate of inflation turns out to be higher than 2.5%, then due to the inflation adjustment, the TIPS will turn out to have been the better buy. But if the rate of inflation is lower than 2.5%, then because of higher interest payments during the life of the conventional T-bond, that will turn out to have been the better buy.
In this first scenario we see how the TIPS bond is the better buy when actual inflation turns out to be higher than expected:
Actual Inflation = 3.5% (higher than originally expected 2.5%)
Yield to Maturity
In this next scenario we see that when actual inflation is lower than expected, then traditional bonds do better.
Actual Inflation = 1.5% (less than originally expected 2.5%)
Yield to Maturity
A strategy many investors use to protect themselves from inflation being different than expected (because nobody can predict the future), is to purchase half (or more) of their bonds as TIPS.
Key Point: The difference between the yield of a Treasury bond and a TIPS with the same maturity reflects the market’s expectation of inflation for the period.
Key Point: The market’s expectations for inflation is built into the rates. If inflation turns out to be less than expected, investors come out ahead. And if inflation is greater than expected, investors do better with TIPS.
Key Point: There is not a single interest rate and the government does not set interest rates. Rather, the U.S. federal government sets Federal Funds rate and the market determines these yield curves based on their expectations about inflation and prospects for the future.
Key Point: A bond rides the yield curve for its entire life. It might be originally issued as a 20-year security, but after ten years it gets priced like it is a 10-year bond (because it is one now). And as it approaches maturity, the yield on it falls to essentially money market yields. Bond funds rarely hold bonds all the way to maturity.
Key Point: There are sweet spots on the Yield Curve. Investors might get a 0.1% per year increase in yield for extending maturity in the very short-term. Returns might increase 0.3% per year for extending maturity for years 4 through 10, and then decrease to only 0.1% per year for extending longer.
Bond expert Larry Swedroe has suggested a rule-of-thumb of choosing: select the longer maturity if the return is at least 0.2% per year for nominal bonds (or 0.15% per year for municipal bonds).
Lastly, taxation matters, and issues can be avoided by holding TIPS as mutual funds, or holding individual TIPS in a tax-advantaged account.
To summarize, two factors are most important to characterize a bond’s risk: term to maturity, and credit quality of the issuer. The past few sections in this book have been discussing the implications of short-term or long-term bonds—and the premium you can earn by taking on term risk.
While maturity dates for individual bonds are explicit, funds are generally divided into three broad groups based on average maturity:
- Short-term (1 to 5 years)
- Intermediate-term (5 to 10 years)
- Long-term (more than 10 years)
As you’d expect, you can also earn a premium by taking on additional risks. The biggest of these would be investing in bonds with lower credit quality, which have increased risk of default. But other premiums can be earned for bonds that can be “called” or paid back early—depriving investors anticipated return when interest rates drop. Next we will look at credit ratings and why we normally want only the highest quality.
Credit Quality or Default Risk
- Credit quality ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest).
- Treasuries are low cost, don’t require diversification, and are the highest credit quality.
- Even the highest quality corporate bonds should be purchased in mutual funds because they lack price transparency and require diversification.
- High-yield corporate bonds should be avoided because they are more correlated with the stock market, illiquid, and have additional reasons for being called early.
Credit quality indicates the market’s assessment on whether a bond is likely to be repaid on schedule.
This is determined by several major rating firms. Here is how Standard & Poor ratings map onto a simple style guide.
The rating agencies each use slightly different nomenclature and fund companies have minor variations of the 9 box style guide, but the concept is the same.
Who should you loan your money to?
Many wise investors approach this like they approach their stock investments and simply invest in the total bond market by using a low-cost index fund. Since this is weighted to match the overall bond market, most of the funds will be U.S. Treasuries. This approach is extremely diversified and highly recommended. If you are not choosing a Treasuries fund, or a total bond market fund, then you need to look a little closer about what you are investing in.
You are choosing who you will loan your money to—or more precisely, who will issue the bond. Some people call simple bonds, like U.S. Treasuries, plain vanilla bonds, because they don’t have special ingredients—like a “call provision”. Homeowners are actually familiar with this concept if they use a mortgage to purchase their house. In this case, the banks are loaning money at specified rate while the homeowners want a call provision to be able to refinance their mortgage if interest rates become significantly lower.
I will discuss the important types of bonds in this section.
Prices for Treasuries are highly transparent and the market is highly liquid. Many mutual fund providers like Vanguard or Fidelity waive the transaction costs for new issues bought at auction, making these commodities with low to zero transaction costs. Investors may also purchase them directly from TreasuryDirect.gov. The bonds are as straightforward as I have described with no complicated call provisions. Interest is subject to federal income tax, but exempt from state or local income taxes.
U.S. Treasury Bills, Notes, and Bonds are the standards by which other bonds are measured because we essentially ascribe their likelihood of default to be zero.
Treasury instruments with a maturity of up to six months are called Treasury bills. Treasury bills are issued at a price less their face value (or, “discounted”) and the interest is paid in the form of the price rising toward that face value (or, “par”) at maturity. Treasury instruments with a maturity of two to ten years are called notes; and maturities beyond ten years are called bonds.
Treasury Inflation Protected Securities (TIPS) are special U.S. Treasury Bonds where the face value changes with the Consumer Price Index (CPI) and is paid at maturity. The coupon rate is lower than a nominal Treasury bond with the same maturity but both the principal and the interest payments are indexed to inflation. TIPS are a good hedge against unexpected inflation.
Series I Savings Bonds (I Bonds) are government savings bonds issued by the U.S. Treasury that offer inflation protection. I Bonds offer tax-deferral for up to 30 years and are free from state and local taxation. I Bonds are not marketable securities and cannot be traded in the secondary market.
These are currently limited to $10,000 per year per social security number so I will not expand upon these here but suffice it to say that, like bank-issued CDs, these are slightly cumbersome to set-up but can be more attractive than Treasuries for individual investors and excellent short summaries can be found here:
U.S. Government Agency Bonds include mortgage-backed securities or other asset-backed securities backed by the government, and by government-sponsored enterprises, such as Fannie Mae and Freddie Mac, that are not explicitly backed by the U.S. government.
Government-sponsored enterprises issue bonds to support their mandates, which typically involve ensuring certain segments of the population—like farmers, students and homeowners—are able to borrow at affordable rates. Examples include Fannie Mae, Freddie Mac, and the Tennessee Valley Authority. Yields are higher than government bonds, representing their higher level of risk, though are still considered to be on the lower end of the risk spectrum. Some income from agency bonds, like Fannie Mae and Freddie Mac are taxable. Others are exempt from state and local taxes.
Agency bonds include the world of mortgage-backed securities. Banks and other lending institutions pool mortgages and submit them to quasi-government agencies which turn them into securities that investors can buy that are backed by income from people repaying their mortgages. This raises money so the lenders can offer more mortgages. Examples of MBS issuers include Fannie Mae, and Freddie Mac, which are public companies, but their obligations do not carry the full faith and credit of the U.S. government. Mortgage-backed bonds have a yield that typically exceeds high-grade corporate bonds. The major risk of these bonds is if borrowers repay their mortgages in a “refinancing boom” it could shorten the investment’s average life and lower its yield. These bonds are also risky if many people default on their mortgages.
One of my mantras is “don’t invest in things I don’t understand” and mortgage-backed-securities fall in this category of very complicated financial instruments—despite their stellar credit rating. It sure seemed like this category surprised a lot of people in the sub-prime mortgage crisis of 2007.
John C. Bogle also recommends the Vanguard Intermediate-Term Bond Index Fund. It is very similar to the Total Bond Market Index Fund except does not include the “bond-like” mortgage-backed securities. It includes both more Treasuries and more investment-grade corporate bonds.
International bond funds invest in a range of taxable bonds issued by foreign governments and corporations. The argument against investing in these is that they don’t offer anything beyond the rich choices that already exist in the U.S. bond markets. Worse, investors are not compensated for the currency rate risks which are introduced. The argument in favor of these is that they help investors diversify by spreading interest rate and economic risk across the globe. I’m not an expert about this, but I am not even tempted.
Investment-grade corporate bonds range from high-grade down to medium-grade producing slightly higher expected yields. Only funds should be considered at, or below, this level to ensure diversification, low-cost, and liquidity.
High-yield bond funds include bonds rated below investment-grade. They sometimes also called high income, high opportunity, or aggressive income bond funds. They are regarded to be high-credit risks and because of their default risk they are generally called “junk” bonds. Proponents of actively managed funds (not me!), and speculators of all sorts, are going to be tempted to look at these.
Special Types of Bonds
Municipal bond funds. States, cities, counties and towns issue bonds to pay for public projects (roads, sewers) and finance other activities. The majority of munis are exempt from federal income taxes and, in most cases, also exempt from state and local taxes if the investor is a resident in the state of issuance. As a result, the yields tend to be lower, but still may provide more after-tax income for investors in higher tax brackets.
Even though bonds seem to come in flavors ranging from vanilla to whiskey hazelnut—they are all just ice-cream. And most of the time vanilla works just fine. Boring—maybe.
We’ve covered the bonds I think you need to know about, but there are others. Flavors are really unlimited.
Stick With High Quality
In the prior chapter we looked at bond maturity and term risk (interest rate risk). This chapter we have looked at credit quality and the risk of default from the issuer (the entity we loan our money to). Credit quality (or, risk of default) is the second of the two important factors that characterize bonds. While buying Individual Treasury Notes and CDs is often smart and attractive, buying lower quality bonds is usually not if your total bond investments is less than $500,000—because of cost and liquidity. Low-cost mutual funds offer an attractive alternative. We can summarize this as three levels of increasing risk:
- Low Risk: Bond or fund’s average rating: AAA or AA.
- Medium: Average rating below AA, but BBB or better.
- Higher Risk: Average credit rating is below BBB.
Staying with the highest quality bonds (AAA and AA) is desirable because they are the least correlated with the stock market. Some experts suggest staying away from lower quality bonds because they tend to correlate with the stock market at the worst times. It’s better to take risks in the stock market and use bonds to anchor the portfolio.
Municipal bonds have their own ratings and typically range from very low for infrastructure projects (e.g., water and sewer plants) to occasionally higher risks for projects like new hospitals.
This brings us, finally, to the central point of this book and your most important investment decision: What is the right allocation of stocks and bonds for you?
Next is STEP 6. Start with your goals to determine your appropriate level of investment risk./build-an-all-weather-portfolio/how-much-risk/