Why Bonds, Why Now?

Chris Keith

Senior Vice President, Fixed Income Manager

The U.S. bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. market was down 10.3% through the first half of this year. What’s worse, bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. fell in tandem with stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company., causing many investors to wonder if bonds had lost their power to protect portfolios and act as a dependable hedge against volatilityA measure of how large the changes in an asset’s price are. The more volatile an asset, the more likely that its price will experience sharp rises and steep drops over time. The more volatile an asset is, the riskier it is to invest in..

The good news for bond investors is that the market rebounded in the second half of June and continued to make gains in July. The Bloomberg U.S. Aggregate BondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. index was up 1.7% month-to-date through July 27.

The even better news for long-term investors is that bonds have a special quality that sets them apart: They are self-healing.

What do I mean when I say bonds are self-healing?

Well, the mechanism is simple: When you buy a bond, you are getting an investment asset that has a known outcome. Individual bonds have a maturity date. And when they get to that date, they mature at “par,” or 100 cents on the dollar. In short, the issuer has to pay back the money they borrowed on a specific date. This basic dynamic occurs even when interest rates are rising. So long as the borrower doesn’t default, the only way you’ll get less than the bond’s par value is if you sell before it matures.

Therefore, putting money back into the bond market even when rates are rising is not throwing good money after bad. Reinvesting principal and interest may sound counterintuitive as you see market values decline on existing positions. But by waiting it out and reinvesting, we eventually see the self-healing nature of bonds on display: Rising rates lead to higher bond fund yieldsYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price. and higher income payouts. To be clear, this may take time, but bond investors can afford to be patient because they get paid interest while they wait.

Let’s see how this played out for a real-life two-year Treasury bill over the six months before it matured at the end of June.

Over the period shown, the Treasury bond’s price fell and then recovered to par value even though rates were rising and the bond market was declining during the entire period. This quality is not unique to Treasury bonds—the same thing happens with municipal and corporate issues.

Seeing your bonds fall in price is never fun, but due to their contractual nature, bond prices will heal if only given time to do so.

Bond fund investors benefit from this phenomenon through a different means. The typical bond fund has no final maturity date and rising rates lead to lower share price NAVs, but they also lead to higher bond fund yields and distributions. When reinvesting bond fund distributions, you are acquiring additional shares at lower prices with higher yields. Your bond fund may hold hundreds or even thousands of bonds (Vanguard’s Total Bond Market Index fund had over 10,000 positions toward quarter-end) but make no mistake—a bond fund’s underlying positions have the same self-healing nature as individual bonds.

In other words, bonds continue to do their job. In the most difficult days, bonds produce income and balance riskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline.. Even as the market value of our bonds fell along with the major indices in the first half of this year, bonds continued to earn and pay interest when due.