Stepping foot into the vast investment world can be overwhelming and emotionally draining. Confusion derived from the seemingly endless consortium of asset classes and investment philosophies is only compounded by the noise of financial media. Arming yourself with foundational knowledge about core investing tools and approaches is a great way to quell the anxiety of being a novice investor.
It can seem like stock performance dominates the headlines, with significantly less media coverage on other asset classes, such as bonds. The phenomenon has been quantified in studies to show that 40% of individual investors do not know the basic financial mechanics behind bond prices.1
Although it is difficult to directly compare the availability of information between fixed-income and equity markets, the bond market is often less understood than the stock market. As a crucial part of any investor’s portfolio, bonds are a shining example of an asset class that would greatly benefit from an educational overview.
In simplistic terms, bonds are loans made by an investor to a borrower. Bonds are commonly referred to as fixed-income or debt-securities. The borrower can take various forms; however, they are typically comprised of a corporation or a governmental entity.
Bonds are issued with a coupon rate, a maturity date and a “face” or “par” value. The face value is equivalent to the principal amount that the investor expects to receive upon the maturity date of the bond. Interest is paid based on the coupon rate to the investor in regular intervals over the term of the bond. Interest payments to the investor are referred to as a bond’s “coupons.” A bond’s yield simply divides the annual coupon payment of the bond over the bond’s value. The coupon rate and maturity date of a bond do not change after purchasing the bond. However, the underlying value of the bond is subject to change over the bond’s term. Investors are paid back their principal on the bond’s maturity date, thus completing the loan.
At a high level, bonds are affected by three main factors: term risk and changing interest rates, credit quality and ratings, and inflation.
The value of bonds is inversely affected by changes in interest rates. For example, when the Fed raises the federal funds interest rate, the underlying value of bonds would fall because the newly issued bonds will fetch higher yields than existing bonds. Longer maturity bonds correspond with higher yields because, with time, there is a greater risk of interest rates rising. Duration describes a bond’s sensitivity to interest rate fluctuations over time. Lower duration bonds have shorter maturity dates, resulting in lower risk and potentially lower yield for the investor.
Another key variable in a bond’s price and corresponding yield is its credit rating. Credit ratings are an approach to determine the credit quality of a security. Large rating agencies study borrowers to assess the risk of default. A default on a bond occurs when the borrower is unable to repay the bond’s interest or principal. Crucially, each rating agency has its grading nomenclature. Despite using different ratings, all bonds are named “investment grade” or “junk.” Junk bonds have much higher yields than investment grade bonds because of the higher risk involved in loaning money to a comparatively uncreditworthy borrower. As a rule of thumb, any bond rated AAA through BBB- using the Standard and Poor’s ranking system is investment grade. Although a bond deemed “investment grade” is a testament to its credit quality, it is prudent to consult with an advisor to better understand the specific risk associated with the bond.
When inflation rises, as we are seeing in the economy so far this year, the real return of bonds is affected. As with all securities, inflation eats away at returns. For example, if inflation is 2% and the bond’s yield is 3%, the real return is 1%.
The yield of a bond is primarily dependent on the risk associated with the bond. Thus, low-risk bonds correspond with lower yields.
The Treasury of the United States backs its issued debt securities with the full faith and credit of the federal government. These securities are thus considered to be the lowest risk available, which corresponds to their low yield. The U.S. Treasury sells bills, notes, and bonds among other more complex securities. Do not be deterred by the multitude of names given to different treasury offerings as the main differentiator is the maturity of the securities. Treasury bills are the shortest to mature with bonds being the longest and highest yielding.
Municipal bonds, often referred to as “munis,” are issued by states, counties, or cities to fund general operations or public works projects. They are higher risk securities than Treasury-issued bonds, thus they tend to have greater yields. Municipal bonds are attractive to high-income investors because of their advantageous tax structure. Like the majority of federally issued bonds, interest on municipal bonds is typically exempt from state and local taxes if the investor lives in the same state or city as the muni bond’s issuer. However, interest on municipal bonds is also often exempt from federal taxes. The tax structure of municipal bonds varies by municipality, so it is in your best interest to consult a financial advisor to maximize tax efficiency.
Corporate bonds generally carry higher risk than municipal bonds and as a result tend to have higher yields. Their credit ratings are largely dependent on the financial outlook of the borrowing corporation. When analyzing corporate bond offerings, you should look closely at the company’s credit ratings. Although tempting, it is risky to “reach for yield” by buying non-investment grade bonds. Poorly rated corporate bonds reflect significant liquidity issues within the corporation that could lead to defaults.
TIPS are a hot topic as investors look for opportunities to hedge against rising inflation. The principal value and yield of TIPS rise with inflation. Although TIPS can continue to perform in an inflationary environment, they do still have potential downsides. Firstly, increased coupon payments resulting from a rise in inflation are subject to higher taxes. Secondly, the interest rate offered by TIPS are typically lower than standard bonds. Finally, if inflationary rates do not increase, TIPS may lose their utility in a portfolio.
Like stocks, bonds are issued in the primary market and then traded among investors in the secondary market. However, most individual bonds are not traded in the secondary market via open exchanges, such as the New York Stock Exchange. Instead, many individual bonds are traded over the counter (OTC) via brokerages. OTC transactions are warranted in bond markets because the vast differences in yields, maturities, and qualities among bonds make it difficult to trade via an exchange.
Individual bonds from a particular company or government entity can be bought via an online broker. If you are looking to buy treasury securities, Treasury Direct is the federal government’s website for direct purchases, thus avoiding any brokerage fees. Investors must keep diversification in mind when buying individual bonds. On the other hand, bond ETFs and mutual funds aid in the diversification of your bond holdings, as they provide exposure to a large basket of debt instruments.
We believe diversification must be a central tenet in all aspects of portfolio design. Bonds can and should be diversified over multiple variables such as the type of bond, (municipal, Corporate, and Treasury) country of origin, rating, and time to maturity to mitigate the portfolio’s overall risk. It is also important to understand that different fixed-income asset classes can perform quite differently depending on the economic environment. As an example, during the first quarter of 2020 U.S. Treasury securities outperformed U.S. corporate bonds by 11%. Then in Q2, U.S. corporate bonds outperformed U.S. treasury bonds by 7.7%.2
At Dowling & Yahnke, we believe that bonds can play a crucial role in a portfolio. Bonds provide an anchor of stability by counterbalancing the volatility of equities. A thoughtfully constructed fixed-income strategy can help preserve capital and hedge equity risk.
Since 1980, there have been only 4 years with negative bond yields: 1994 (-2.92%), 1999 (-.82%), 2013 (-2.02%), and 2018 (-.05%)3. A bad year in the stock market dwarfs these losses such as in 2008 when the stock market (as evaluated through the S&P 500 index) dipped 38.49%. Comparatively, bonds rose 5.24% in 2008 and 5.93% in 2009.3
In large downturns, bond holdings also allow for portfolios to be rebalanced to realign the portfolio with the desired risk tolerance. If a 60% equity and 40% fixed-income portfolio sees a ten percent decline in equities, the portfolio becomes evenly split between the two asset classes. Bonds provide the “dry powder” needed to purchase equities at a discount to rebalance the portfolio to a 60% 40% equity/bond ratio.
Despite today’s complex macroeconomic environment, at Dowling & Yahnke Wealth Advisors we thoughtfully craft risk-appropriate portfolios with strategic fixed-income strategies that are tailored to your goals. If you desire to learn about fixed-income on a deeper level, our team of industry-leading advisors is available to assist in your financial journey. We encourage you to contact our team with any questions or concerns regarding your finances.