Bond Basics: A Fixed-Income Primer
When stocks are surging or interest rates are low, investors tend to overlook the value bonds bring to a portfolio. But bonds serve an important role for long-term investors year in and year out. To help you gain a better understanding of fixed-income investing and provide a foundation for future conversations, let’s go over some of the basics.
All terms in bold are referenced in the AI Bond Basics Glossary at the end of this page.
Bonds are like an I.O.U.
When a company or government (the issuer) wants to raise money, it borrows money by selling bonds. The investor purchasing a bond is essentially making a loan to the issuer. In return, the investor is entitled to interest payments (the coupon) and a promise that the face value of the bond will be repaid at a specified time (the maturity date). The appeal of bonds thus lies in the rewards of interest plus the safeguarding of your investment.
As bond investors, we know what our income will be and how much money will be returned to us at maturity on the day we buy a bond; this is why bonds are commonly referred to as fixed-income securities.
The Price/Interest-Rate Seesaw
Bond prices and interest rates move in opposite directions. If interest rates rise, most bond prices fall. If interest rates go down, bond prices go up.
The concept looks simple enough, but why does it work this way?
When a new bond is first issued, it typically, but not exclusively, is sold at “par” value, which simply means that $1,000 will buy you $1,000 worth of bonds. Say you buy a new 10-year Treasury bond with a 2% interest rate at par. The government will pay you $20 each year in interest for the 10-year life of the bond.
If interest rates rise, a new 10-year Treasury costing $1,000 might now be issued with a 3% yield and pay $30 a year. Why would anyone pay $1,000 for the 2% bond issued earlier and earn just $20 a year in interest when they could buy the same type of bond paying them $30 a year for the same price?
They wouldn’t. The price of the bond paying $20 will fall and it will trade at a discount to (or below) par. This is why bond prices fall when interest rates rise, and vice versa. (Depending on what buyers will pay, if you sell a bond before maturity, you risk selling at a discount and may not recover your full principal.)
Interest-rate risk is the impact on a bond’s price due to changes, up or down, in interest rates. This risk is commonly measured by duration. A bond or bond fund’s duration is a number expressed in years, although it is easier to understand as a percentage—a bond fund with a duration of 8 years could be expected to lose 8% of its value if interest rates rise 1% and gain 8% if rates drop 1%. The longer the duration, the greater the interest-rate risk.
Credit risk is the risk of default—failure of the borrower to pay interest or to pay back the bond’s face value at maturity
U.S. Treasury bonds have little to no credit risk. The U.S. government is going to be able to keep paying off its I.O.U.’s through thick and thin—either by raising taxes or printing money. The only real risk they bear is interest-rate risk; Treasurys are the most sensitive bonds to changes in interest rates. But not everyone asking to borrow your money has the resources of the federal government.
In contrast, the primary concern with high-yield or “junk” bonds is default. And the greater investors’ concern about this negative outcome, the more compensation they demand. These riskier bonds can offer eye-popping yields relative to extra-safe U.S. Treasury bonds.
High-yield bonds, unlike Treasurys, are more dependent on the economic climate—similar to stocks—than they are on the movement of interest rates, since a weak economy can have a greater impact on the financial strength of the lower-quality companies that typically issue junk bonds.
In the graphic below, you can see the spectrum of interest-rate and default risk for broad categories of bonds.
In periods when interest rates are low or the economy is booming, inflation can become a concern for fixed-income investors. If inflation is 4% and you own a bond with a yield of 3%—over the course of a year, even though you are earning regular income, your real return is -1%.
The Benefits of Bond Fund Investing
When you buy a bond fund, you are purchasing shares of that fund and its portfolio of fixed-income securities. Just as with a stock fund, the share price may rise and fall.
Unlike an individual bond, bond fund shares do not provide a promise to return your initial investment at a predetermined end date (maturity). So why own a bond fund over an individual bond? A bond fund offers instant diversification. Your portfolio won’t get wiped out if an individual bond defaults.
Also, while a bond’s interest payments are fixed, a fund’s dividends are not. With bond funds, while prices may initially fall when interest rates rise, reinvested income purchases more shares of the fund at lower prices. This enables the fund manager to buy additional bonds at higher yields, eventually generating gains as prices stabilize and those greater interest payments begin accruing to the shareholder.
Because of the almost constant flow of income into the portfolio, a strong bond fund manager can spot opportunities and capitalize in ways that simply aren’t possible for an individual bondholder to achieve—purchasing undervalued bonds, managing risk and repositioning the portfolio in anticipation of changing interest rates or credit availability
If you’re looking for exposure to a wide variety of fixed-income securities within or across asset classes, a bond fund is likely a better fit to achieve your goals.
Bond Funds’ Role In Your Portfolio
Diversification is at the core of Adviser Investments’ longstanding investment discipline.
So while there is always a spirited debate about the types of bond funds to invest in, we don’t think there can be any debate about the importance of holding bond funds as part of a well-diversified portfolio. Bond funds function as a critical buffer during inevitable stock market declines, while generating income and the potential to grow your investment.
At a time when bond yields are rising from historic lows, it is important to understand why fixed-income investments can still add balance to your portfolio. While stocks have outperformed bonds since the economy began to turn around in early 2009, and investors have questioned bonds’ efficacy and utility, we don’t believe they should be abandoned. We don’t know when stock market pullbacks like those we saw during the coronavirus pandemic will occur, but when they inevitably happen, the shock absorbing characteristics of bonds and bond funds can help limit the impact on your overall investment portfolio. Prudent and pragmatic long-term investors should always have some bonds in their asset mix.
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