Bonds matter. According to the Securities Industry and Financial Markets Association, (SIFMA) the value of the global bond markets was greater than the value of global equity markets at the end of 2021 ($126.9 trillion vs $124.4 trillion).
The Basics
When you buy a bond, you are lending money to a borrower, which may be the U.S. Treasury, a corporation or a municipality, among others.
A bond has three basic components:
- Principal (aka the Face amount or Par value): The amount you have loaned to the borrower.
- Term: The period of time from the issue date to the Maturity date, e.g. two years. At maturity your principal will be returned to you.
- Coupon (aka interest rate): The annual rate of interest paid to you over the term of the bond in annual or semi-annual installments.
The largest issuer of bonds is the U.S. Treasury. They come in three flavors: Bills, with terms from four to 52 weeks; Notes, which have maturities between two and 10 years; and Bonds with maturities of 20 and 30 years. (Collectively, “treasuries”.)
You can purchase them directly from the Treasury. (www.TreasuryDirect.gov)
Brokerage firms and banks provide access to the secondary market where millions of dollars of bonds are traded daily. The price of a bond in the secondary market will likely be higher or lower than its par value. (Selling at a “premium” or a “discount”.)
If a bond with a $1,000 par value is purchased at a discount, say $900, it will mature at par and the investor’s rate of return calculation would reflect that $100 gain. Conversely, had the bond been purchased at a premium, say, $1,100, the $100 loss at maturity would be recognized in the investor’s rate of return calculation.
Why invest in Bonds?
They provide a fixed stream of income for a stated period of time. They can reduce overall portfolio risk, as bonds prices are less volatile than stock prices. Bond returns, with rare exceptions, do not correlate with equity returns.
Associated Risks with Bonds
Credit/Default Risk: The risk that the interest and principal payments will not be made by the issuer, which makes Treasuries popular because they have virtually no default risk. Other borrowers must offer higher yields to attract investors.
Liquidity Risk: Liquidity refers to the ability to sell a bond quickly and at an efficient price. If there is a large spread between bid and ask prices, there may not be the opportunity for a quick sale. There is always a ready market for treasuries, but there may not be for some corporate bonds due to a thin market with few buyers and sellers.
Interest Rate Risk: Interest rates and bond prices have an inverse relationship. When interest rates rise, bond prices fall. Conversely, when interest rates fall, bond prices rise. Interest rate increases are of no concern to an investor who buys a bond at issue and holds it until maturity.
Prepayment Risk: Some bonds may be issued with a “call” provision enabling the issuer to prepay the principal and avoid future interest payments. This usually happens when interest rates fall, leaving the investor to reinvest at lower rates (Reinvestment Risk).
Inflation Risk: In a period of rising inflation, the principal payment received at maturity, would have much lower value (purchasing power) than today. Inflation may also contribute to falling bond prices during the holding period as discussed below.
Bond Yields
There are a number of ways to calculate or express bond yields. But first, let’s get to know the Bond Yield Curve.
Bond Yield Curve: A yield curve is a graphical representation of the yield on bonds of equal credit quality over a range of maturities. It plots yields (vertical axis) against maturities (horizontal axis). Its slope and shape measure investors’ feelings about risk and the direction of the economy. Generally, longer maturities have higher yields than shorter maturities as investors want a higher return when they are taking longer term risks. Consequently, the yield curve is usually upward sloping and gradually flattens out as maturities get longer. The most widely used yield curve is for U.S. Treasuries.
The current yield curve is inverted as yields on short term treasuries are higher than longer term treasuries: 2 year 4.284%; 10 year 3.492%. A sign that investors expect further rate increases and a slower economy. Inverted yield curves are unusual and often precede a recession by nine months, plus or minus.
Nominal Yield: The Coupon rate of the bond at issue, relative to its par value.
Current Yield: If a $1,000 bond had 6% coupon, it would pay interest of $60 per year. If its price fell to $900, it would still pay interest of $60. The current yield would be $60 divided by $900, or 6.67%.
Yield to Maturity (“YTM”): YTM measures what the return on a bond would be if held to maturity and interest payments are reinvested at the yield to maturity rate. The calculation includes coupon payments and any gains or losses from purchases made at a premium or discount. Essentially, a bond’s YTM is the present value of its cash flows. It is the most important yield measure for investors.
Yield to Worst: This is YTM with a wrinkle. Callable bonds have a date when the issuer can first exercise its call privilege. The yield to worst calculation assumes that the bond (or multiple bonds in a portfolio or fund) is called at that date and future coupon payments are foregone.
Why Bond Prices Rise and Fall Inversely with Interest Rate Movements
The secondary market pricing mechanism essentially works to set prices so that YTMs equate to nominal returns currently available on new issues. Let’s look at a few simplified examples:
If you had purchased a five year, $1,000 bond two years ago, with a coupon of 4% and want to sell it in the secondary market today, assuming that new bonds offer 6% coupons, you would be hard pressed to find a buyer. Your only option would be to sell it at discount so that your $40 coupon payments and the appreciation at maturity would provide the buyer with a 6% return.
Conversely, if new issues were going at a 2% coupon rate, you would offer to sell at a premium, such that her $40 income payments and principal loss at maturity would give them a 2% return.
In more simple terms, bond prices in the secondary market are driven by supply and demand. Yield, current interest rates and the bond’s rating are the factors that most influence a bond’s price.
Is This a Good Time to Invest in Bonds?
To answer that, we first need to understand duration. Duration measures how much bond prices will likely move when interest rates move. Essentially, the higher a bond’s duration, the larger the change in its price when interest rates change. Mathematically, duration measures how long it takes for an investor to receive the bond’s present value based on the expected future cash flows.
A rule of thumb: For every one percent increase or decrease in interest rates, a bond’s price will change one percent in the opposite direction for every year of duration. For example, if a bond has a duration of five years and interest rates increase by one percent, the bond’s price will fall by approximately five percent.
The duration of a bond portfolio, a bond fund for example, is the weighted average of the durations of all of the bonds in the fund.
Effective Duration: Like the yield to worst calculation, effective duration incorporates the impact of call options on the expected cash flows from a bond or bond portfolio.
Overall, we expect bond returns to be limited to their YTMs over the next few years at least, with little or no appreciation potential. But opportunities do exist.
There are a number of short duration mutual funds and ETFs with YTMs ranging between four to six percent with durations ranging between 2 and 2.5 years. If a mutual fund’s duration is 2 years and interest rates increase by 1%, the portfolio’s value would decrease by approximately 2%. This may be an acceptable degree of interest rate risk, if the fund’s YTM is 4% or higher. An investor could reinvest the yield in the fund or take it as income. In the longer term, if the FED lowers interest rates, perhaps a few months into a recession (third quarter of 2023?), there could be the opportunity for price appreciation as well.
Interestingly, selected high yield bond funds and ETF’s are also a consideration. Their YTMs range from six to nine percent. These high yields shorten duration. Look for funds or ETF’s with durations of less than three years.
Let’s not forget credit risk. Only consider funds or ETF’s holding quality credits. Fortunately, that information is also available. As we have learned, credit quality not only lessens default risk, but also factors into pricing. This will be especially important if you consider high yield options.
Finally, we prefer an ETF over a bond fund, all other things being equal, because they can be traded throughout the day.
The Bottom Line
Bonds will continue to have a role as a risk modifier and a source of income in most portfolios. Short duration treasuries, mutual funds and ETF’s continue to offer opportunities for investors at this time.
Chuck Baldwin
Co-Founder & President
Baldwin & Clarke Advisory Services, LLC
Email: chuckb@bcasi.net
