Bonds 101 - Adviser Investments

Bonds 101

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Bonds 101

The politicians call it Super Tuesday, but for investors it felt like anything but. The Federal Reserve’s announcement of a surprise rate cut, the first such unscheduled cut since the 2008 financial crisis, was supposed to soothe jumpy markets. Instead, it appeared to churn them up even further, with the yield on the benchmark 10-year Treasury bond dropping to 1.00%, a level never before seen. When yields fall this low, the potential for further gains is muted and income investors begin searching for better payouts—taking on increasing risk as a result. So, maybe the bond market’s Super Tuesday wasn’t so super after all.

You may well be wondering if your portfolio is well-positioned to handle continued volatility. That makes now the perfect time to discuss bonds, which serve as shock absorbers in many investors’ portfolios.

Historically, bonds have been seen as conservative, income-generating investments that may not make you a millionaire overnight, but won’t give you nightmares either. It’s been years since the fixed-income world could be called sleepy, though. This week, we want to offer a brief refresher on how bonds work, the risks all bond investors face and what the implications are for long-term investors in the current environment.

What Is a Bond?

A bond is simply a loan, a type of contract between lender and borrower that states the amount being borrowed, the interest rate being charged, and when and how the borrower must pay the money back.

When you need to borrow thousands of dollars to buy a car or a house, you head to a bank and apply for one. When large corporations and governments need to borrow millions or billions of dollars to build a factory or fill a deficit, they generally head to the bond market, offering investors the chance to lend them a chunk of the money they need under terms of the issuer’s choosing.

The basic components of a bond are:

  • The issuer: the entity borrowing the money
  • The principal (or face value): The amount being borrowed via the bond (your investment)
  • The coupon: The interest rate the issuer will pay those who own its bonds (typically, payments are made twice a year)
  • The maturity date: The date when the bond’s principal will be repaid. Unlike most consumer loans, where each repayment installment reduces the amount of principal owed, bond coupons generally only cover the interest, with one final balloon payment that returns the full principal due at the maturity date

Imagine, for example, that you bought a 10-year, $1,000 U.S. Treasury bond with a 2% coupon. That means you’d receive $20 in interest payments every year for the next 10 years, with your principal returned to you at the end of year 10. Hold the bond to its maturity, and you’d expect a yield of $200 from your investment. That certainty—the fact that we can easily calculate the return on our investment if we hold a bond to maturity—is why bonds are also known as “fixed-income securities.”

In today’s bond market, however, 10-year Treasury bonds are being issued with coupons of about 1%. An investor buying now should only expect a yield of $100 if they hold the bond to maturity.

If you decided you wanted to sell your 2%-coupon bond today, you could expect to receive a premium for it. Instead of the $1,000 you paid at purchase, another investor would be willing to offer a higher price for your 2% bond, since it offers double the yield of a new issue with a 1% coupon rate.

Bonds whose market price matches their face value are said to be trading at par. Bonds whose prices have risen above their face value (as your 2% 10-year T-bill did, in our example above) are said to be trading above par. Conversely, bonds that are trading at a discount to their face value are said to be trading below par.

How much of a premium or discount you can expect to receive when buying or selling a bond depends on more than just the current interest rate, however. Time to maturity is also an important factor. The longer a bond has left to pay out its coupons, the more a change in interest rates will affect its price.

The magnitude of the change in rates relative to the coupon also matters. In our T-bill example, a 1% decline in interest rates from 2% to 1% cut our expected yield in half. If you were holding a bond with a 10% coupon and rates dipped to 9%, however, your expected yield would take a much smaller hit—and therefore the bond’s price isn’t likely to increase by much. (Fund companies are able to use some complicated equations to take all these factors into account to come up with a statistic called duration, which tells you how a 1% change in interest rates is likely to affect a bond’s yield.)

Understanding the Risks of Bonds

As we saw this week, news that interest rates are dropping ought to—and did—send bond prices rising, good news for those of us with fixed-income holdings. But even if we wisely ignore headline hysteria, low rates aren’t always good news when it comes to bonds. It’s important to understand the risks that can come with owning bonds before determining what role they should play in your portfolio.

The first risk, as we’ve already touched on above, is interest-rate risk—the risk that interest rates will increase and the price of your bond holdings will decline. If you intend to hold a bond until its maturity date, relying on its coupon payments for income, changes in interest rates won’t impact your returns. If, however, you ever find you need to sell some of your bonds before their maturity date, interest rate increases may well prove costly. And if you own bond funds—whose managers regularly buy and sell securities in order to maintain a diversified portfolio—interest rate changes will definitely affect your returns.

Recent changes in interest rates have mostly been boosting bond fund returns, of course, as they have increased the value of the bonds in the funds’ portfolios. Other risks that crop up in low-rate environments are less beneficial. Bond investors who hold their securities till maturity face reinvestment risk, the possibility that when your money is returned to you at maturity, you won’t be able to find another suitable bond investment offering a similar risk and return profile.

If producing a certain level of income via your bond investments is important for you, low-interest-rate environments may force you to invest for longer, or with less creditworthy issuers, increasing your default risk­—the possibility that the institution you’re lending to simply won’t be able to pay you back when the time comes. U.S. Treasury bills are generally considered the safest fixed-income investment when it comes to default risk, followed by other government issuers and then corporate bonds. This is not a hard and fast rule—while defaults on government-issued bonds are rarer than on corporate bonds, they do happen (Chicago and Puerto Rico are two recent examples).

If the thought of default risk makes you want to stick to the safest bonds possible, you still won’t manage to have eliminated all risk. Currently, interest rates on many Treasury bonds are lower than the rate of inflation, leaving investors particularly susceptible to inflation risk—the possibility that rising inflation over the period you’re holding the bond will mean your money is worth less at the maturity date, lowering your real rate of return on the investment.

Today’s Bond Market   

As you can see from our discussion, while the headlines may holler about low interest rates, that doesn’t necessarily mean bonds are a bad investment. Indeed, 2019 was one of the best calendar years ever for bonds, with the broad U.S. bond market gaining 8.7% on a total return basis.

2019 was also a very strong year for stocks, as the S&P 500 returned 31.5%. But if we look back to 2018, when the stock market fell 13.5% in the fourth quarter and finished the year down 4.4%, bonds helped to ease the ride, with a 1.6% gain over the final three months of the year and a flat return for the 12-month period. While those 2018 bond-market returns may not be anything to get excited about, they show how bonds can serve as providers of steady income and portfolio stability even in down markets. In a long-term low-rate environment, however, you’ll be subject to increased inflation and reinvestment risks, making it tough to build wealth with bonds alone.

If you are considering reallocating toward fixed income, you will also have to decide whether to invest in individual bonds or bond funds. If your only goal for your bond holdings is generating a predictable income stream, there can be advantages to holding individual bonds, which allow you to tailor your bond portfolio to your needs. (Adviser Investments’ Managed Bond Program can help you do exactly that.) However, if you’re not willing or able to invest substantial assets into your bond portfolio—$500,000 is probably a reasonable start—it can be difficult to truly diversify your holdings (the bond market is also truly massive, with tens of thousands of issuers, which can make it hard for individual investors to research and make purchases on their own). Holding the bonds of only a handful of issuers can leave you much more susceptible to default risk.

Bond funds, on the other hand, do not offer a return of principal or a contract that states exactly how much interest you’ll receive and for how long. They do, however, offer the benefits of professional management and diversification—and often, lower prices than those that can be obtained by individual investors. If your total return (both growing your assets and generating income over time) is important, you may be better served by bond funds.

The important thing to remember is this: Despite today’s low interest rates and low yields, if you’re investing to generate income or manage risk, bonds will likely need to be a crucial part of your strategy. Review the yields of the funds or bonds you are considering investing in and examine how they measure up against your investment time horizon and risk tolerance.

With today’s low yields, bonds may not be the best tool for building your wealth. They can help absorb the shocks of an up-and-down market and provide steady income even during the stock market’s worst dips. If you have any questions about how to use bonds in your portfolio, please contact us for a complimentary portfolio review.

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