Some bonds are sexy, but most are not. James Bond may be sexy, but investment-grade bonds are not. Personally, I would rather have the latter than the former, but not everyone would agree. I don’t dare ask my wife which one she would choose.
But back to investing: stocks seem to reign supreme in all investing conversations these days. Real estate is a close second. Bonds are the red-headed stepchild that isn’t discussed.
On the other hand, there are trillions of dollars invested in bonds across the world. Some of your money should likely be invested in this asset class.
Let’s review some bond basics. After all, knowledge is power, and we need to start with the fundamentals.
I Owe You
What is a bond? Ultimately it is an I-owe-you. You are loaning money. For example, if you invest in a corporate bond that the company is borrowing a thousand dollars from you. They will pay you interest payments twice a year. At the end of the term, several years down the road, they will also return your original investment.
Are You Mature?
As an investor, you get interest-payments and then at “maturity” you get your original money back. That is a safe and predictable bet. That is why bonds are a great way to invest and to produce passive income.
The interest payment is paid at the “coupon rate.” If you buy a $1,000 bond and it pays you $25 every six months, then your coupon rate is $50/$1,000 or 5%. The $1,000 is the “par value” or original price. That is also the amount that will be returned to the owner at “maturity.”
The Bond Teeter-totter
If interest rates go up, then the price of the bond will go down. If the price of the bond goes down it will sell “below par.” Why does the price go down when interest rates go up? Well, think about it. How could it not?
Let’s say you are enjoying your $50 income on your $1,000 bond. That is a 5% coupon rate. But interest rates have gone up to 6%. If you must sell your bond before maturity, how much would you get for it? Do you think someone would pay you $1,000 for a 5% bond when they could buy a different bond for $1,000 and get a 6% coupon yield?
No. To make up for the lower coupon payments they will expect a bigger return at maturity. If they pay $950 for the bond, they would still receive $1,000 at maturity giving them another $50 at the end to help make up for lost earnings while they owned the bond.
If on the other hand, the interest rates fall to 4% your bond now pays a higher coupon rate than other $1,000 bonds being issued. Your bond will be so desirable that you can charge a premium. They could pay $1,050 and take a small loss at maturity when they receive the $1,000. That loss was offset by the higher coupon rate during the life of the bond.
This helps explain why so many investors are nervous about buying bonds in a low-interest environment. It is a double whammy. You receive a low coupon rate and then there is a risk of principal loss when interest rates rise again.
Bonds are often described as a ‘safe’ investment. Compared to stocks this is generally true. Taken by itself that statement is a bit deceptive though. Bonds are a financial instrument and therefore have risks. There are default risks since the company or bond issuer may go bankrupt. Bond prices fall when interest rates rise resulting in interest rate risks. Foreign bonds are subject to currency risks.
Despite these risks, bonds are still safer in the short-term and medium-term. But you could invest in a high-yield (aka “junk”) bond that could soar or crash with more extremes than any given stock or stock fund. You still must understand your investments.
Price variation can be measured and plotted on a bell-curve. Bond standard deviations (a measure of price variation) is about 10% over the long-term. This is half of the stock market variation of 20%. The standard deviation for short-term bonds is closer to 5%. This dampening of price variation is why bonds are considered safer. As JL Collins says, “Bonds smooth the ride.” This smoother ride leads to more restful nights for the investor.
The sooner you will need the money, the more it makes sense to park your money in bonds. If your wedding or house down payment is only 2-3 years away, you won’t want to take the risk of having to sell stocks after a market decline. Bonds or cash would better serve the purpose. Also, you may consider matching the duration of the bond with the time horizon of your need. For example, if you will need the money in 5 years, invest in 5-year duration bonds.
One of the main determinants of bonds is the duration. Longer bonds are IOUs for a longer period and thus should return a higher return on average overall. Shorter bonds act more like cash with less return and less risk. Longer duration bonds are more susceptible to interest rate risk since there is a longer period for interest rates to rise.
Stocks versus Bonds
There is no guarantee that bonds will return a positive value in any time-period. There is no guarantee that stocks will outperform bonds. The longer the timeframe the more likely that will be the case. It can still take 4 decades to achieve a reasonable degree of certainty of stock’s superiority.
How do bonds fair as an investment compared to stocks? Not well. Three London School of Business professors studied a century of data and compared investment returns. The long-term real (after inflation) return is 1.6%. Stocks (conservatively calculated and inflation-adjusted) put out 6.7% over the same timeframe. For bills (less than 1-year duration) the rate was 0.9%.
Types of Bonds
There are 6 different categories of bonds. Although they work on similar principles, the risk, return, and taxes vary. They come in six flavors: treasury bills, treasury bonds, corporate bonds, high yield, inflation-adjusted, and municipal bonds.
1. Treasury bills are the safest of all options. They are backed by the full credit of the U.S. government. Since the Federal Reserve has a printing press, they could literally print the money they owe you: there is no risk. The short timeframe of T-bills also reduces risk since interest rate changes won’t significantly affect the value.
This safety is offset by a lower coupon rate. If you are more interested in avoiding loss, consider T-bills. Although the payments are low, throughout history they have beaten inflation.
2. Treasury bonds are longer bonds. They are also backed by the credit of the U.S government. Since they are longer, they are more sensitive to interest rate changes. If interest rates shoot up, the resale price of the bond will decline. Given this slight interest rate risk, there is some increased yield to make the investor “whole” for taking on this minimal risk.
3. Corporate bonds don’t have the backing of the U.S. government. Their default risk depends on the financial status of the corporation issuing the bond. Credit rating services such as Standard and Poor, Moody’s, and Fitch are helpful when estimating default risks.
The default risk is low in a normal economy. That rate can shoot up during a severe recession. Although there is an increased risk of corporate bonds, the higher coupon yield may offset this enough to make this investment worthwhile.
4. High-yield bonds are also called “junk bonds.” Their quality is low since their default risk is high. The underlying fundamentals of the companies are so poor that the company may never be able to pay the par value at maturity. In fact, by then the company may be bankrupt. Because of this increased default risk, junk bonds pay a much higher yield. Those who need a high income now may invest in high-yield bonds.
5. Inflation-adjusted bonds are very safe. One of the risks of investing in traditional bonds is that the coupon payments may not keep up with inflation. The payments are fixed throughout the life of the bond, but that amount will buy less and less as inflation ravages its purchasing power.
Inflation-bonds, such as I-bonds or TIPS, are guaranteed to return at least as much as the inflation increase. This eliminates one of the major risks of bond investing. Since this reduces the risk, it reduces the coupon rate as well.
Are you seeing a pattern yet? Lower risk equals lower return. Higher risk equals higher return. That is a pattern seen throughout all of investing.
6. Municipal bonds are securities issued by public municipalities like a city, county, or state. They have a low default risk in a normal economy but are not completely exempt from bankruptcy risk.
Their primary appeal is to the high-income investor. The interest paid is not taxable at the federal level. If you are in the same state as the bond issuer the payments aren’t taxed at the state level either. For those in a high marginal tax rate, this can make an enormous difference. For example, for a 35% marginal tax rate, a municipal bond paying 3.9% would be equivalent to a taxable bond paying 6%.
So, are you convinced that bonds should be part of your portfolio? Which category appeals to you the most? Do you want to concentrate on one or two types of bonds? Or diversify across all categories?