What is a Bond & Why Are They Important?
Investment portfolios generally consist of stocks and bonds, but stocks seem to get all of the attention. Stocks seem easier to understand conceptually, companies feel tangible because we might know a company name or use a company’s products, and brokers have always made it easy to “invest” in hot stocks.
Bonds are generally considered a safe haven, functioning as ballast while earning modest, and predictable, long term returns. Let’s take a deep dive into bonds: the types, how they behave, why they are important, and ways they can sometimes become risky.
The Humble Bond
A bond is simply a loan that pays interest and matures at a future date, typically issued in $1,000 increments that can be bought and sold on a public market like stocks.
Much like car loans and home mortgages, the better the credit of whoever is issuing the bonds, the lower the interest rate, and higher the certainty that the bond holder will be paid as expected.
Also, much like car loans and home mortgages, the longer you’re borrowing, the higher the rate. Typically, a bond maturing in thirty years pays more than one maturing in five years.
Types of Bonds
United States Treasury & Agency Bonds
The United States government is one of the largest issuers of bonds in the world, and bonds sold by the US government are considered some of the safest available. The assumption is that the US government will never fail to make a payment on a bond. This is why investors flock to these bonds when panic strikes: they are a safe haven. Because the credit of the US government is generally considered perfect by global investors, these bonds typically have some of the lowest interest rates in the market. The lower return is the cost of safety.
The next largest bond market is very similar to US government bonds and is largely made up of home mortgages. When you take out a mortgage, the bank often sells that mortgage to a company like Fannie Mae. Fannie Mae bundles mortgages into bonds that are then sold on the public market. These are also considered very secure because the issuer covers mortgage defaults, and issuers like Fannie Mae are US government entities, which means there is another credit backstop in place.
Corporate Bonds
The next largest bond market comes from corporations, and this is where credit begins to play a role. The easiest way to think about corporate bonds is that companies with great credit pay the lowest rates while companies with less than great credit pay the highest rates. The bonds of companies with great credit ratings are often referred to as investment grade bonds, and the bonds of companies with lesser credit ratings are often called high yield bonds because the interest rates are higher and high yield has a better ring to it than “junk bonds”, but high yield and junk bond generally mean the same thing.
Municipal Bonds
The last major grouping of bonds are municipal (“muni”) bonds. These are bonds issued by states, counties, cities, towns, and other municipalities. The interest paid on most muni bonds is tax free, but it’s not “too good to be true.” This special status was created so states, cities, and towns would not have to compete with the US government bond market and risk being “crowded out.”
The downside: because these bonds are tax free, they have significantly lower yields. These bonds are only appropriate for people in the highest tax brackets because at those tax rates these bonds become more attractive than corporate bonds and government bonds. There is a calculation called “taxable equivalent yield” that your financial advisor or CPA can use to determine if these bonds are appropriate for you. This calculation tells you the yield a taxable bond must offer to equal the tax-free return of a muni bond for your specific tax bracket. If you’re in a mid to lower tax bracket, muni bonds may not be your best option.
Credit is also an issue here as well because cities, counties, and other municipalities have defaulted, causing a mess for investors.
If Bonds are Safer then Stocks, then How Risky Can It Get?
Bonds have a nemesis called inflation. In order to offer any actual return a bond must consistently pay more than the prevailing rate of inflation. If inflation creeps up during the life of the bond, the real return comes down. If inflation were to drop, you might get a small lift.
This inflation threat is one of the reasons even the most conservative investors should hold some stocks. Over the long term stocks are the best hedge against inflation because corporations always increase prices as inflation rises, which helps ensure that earning beat inflation.
But the market is prone to fits. When stocks quickly lose 10% or 20% of their value this long term inflation argument falls flat as investors cling to bonds for protection, but it’s worth noting that stocks typically recover and begin gaining again within twelve months of these big drops. It’s always about the right balance of investing long term while knowing things can go sideways fast in the short term.
The other major risk with bonds is default. If an issuer goes bankrupt, bondholders might be out of luck, but this can be a long downward spiral as the credit rating and price of bonds drop over time. In the event of a bankruptcy bondholders are typically paid first as a company is liquidated while common stockholders are usually dead last.
When Yields Go Down, Prices Go Up
The price of bonds and the rate or yield are inversely related. If interest rates go up, the prices of bonds drop, if interest rates go down, the prices of bonds rise.
A simple way to think about this see-saw is to imagine a bond priced at $1,000 and paying 3% interest annually. If interest rates on similar bonds rise to 3 ½% our bond must yield 3 1/2%, since the interest rate it pays is fixed, the only way for this bond to yield more is for the price to drop, meaning buyers become willing to buy the bond at $965 or a discount. If held to maturity, the holder will receive $1,000 from the issuer and the lower price it was purchased at provides that extra ½% of return.
If similar bonds begin yielding 2 ½%, our bond is now worth $1,044. The higher price compensates the seller of the bond for the decline in yield.
When the Federal Reserve changes the Fed Funds rate or the overnight lending rate between banks, all interest rates shift up or down slightly to compensate for that change in the fundamental cost of money. Different types of bonds and different lengths of bond terms impact how sensitive they are to these changes in the overnight rate.
When the Fed cuts interest rates our bond portfolios will rise in dollar value as the yield & interest received drops. When the Fed raises rates our bond portfolios decline in value as our yield & interest received increases. It is a double edged sword.
Major changes to inflation will have a similar effect: if inflation unexpectedly increases, bond yields must rise to compensate investors, and bond prices will drop. Also, the longer the term of the bond the more sensitive the price is to changes in interest rates. There is a lot more uncertainty about all of the things that can happen over thirty years than over five years.
Just as a side note, you can think about these examples when it comes to home mortgages. Ultimately the rate you pay on a home mortgage is determined by the prevailing yield on the mortgage bonds we discussed earlier because ultimately that mortgage is going to end up in one of those bonds. This is why mortgage rates may not perfectly mirror changes made by the Fed: what they are really mirroring is where the bond market prices the mortgage bonds that are the end product.
Wrapping It Up
The easiest, lowest cost, and most effective way for most investors to buy bonds is via a low cost exchange traded fund (ETF) or no-load, low-fee mutual fund. There are a lot of great options available that allow you to determine exactly the type of bonds you want to own. The institutions that manage these funds buy in massive quantities, which helps them achieve the best price possible in a given market, they also manage the holdings. If a company’s credit slips from investment grade to “junk bond” status, the issuer will sell that bond and replace it with a bond that meets the fund’s stated objectives.
This is also something an investment advisor can manage for you, and we are here to help!
I hope this blog has been helpful and has offered you a fresh perspective on the humble bond.
Buoyant Financial, LLC is a registered investment adviser located in Charlotte, NC. Buoyant Financial may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. A copy of Buoyant Financial’s current written disclosure statement discussing Buoyant Financial’s business operations, services, and fees is available at the SEC’s investment adviser public information website – www.adviserinfo.sec.gov or from Buoyant Financial upon written request. This note is for informational purposes only, and should not be construed as investment advice, or a recommendation to buy or sell securities.