If you had asked me 10 years ago if I knew what a bond was, I would have responded with either “shaken not stirred” or “yeah, it’s that thing you buy from the U.S. Government that makes you a little money.” It wasn’t until several books, articles, and hours of research later did I gain a better understanding of the various types of bonds, the role they play in a diversified portfolio, and risks from changing market interest rates.
To provide a quick introduction, bonds are fixed-income investments in which the purchaser or investor lends money to an entity such as a government, municipality, or corporation with the expectation that the issuer (the borrower) will make interest payments on a fixed schedule and eventually return the principal amount of the bond. The entity issuing the bond is borrowing an amount equal to the price of the bond(s) from the purchaser, hence why bonds are the asset class are essentially a form of debt. In return, the issuer pays an interest rate on the bond, which determines the income that is paid in installments to the investor on a fixed schedule, most often semi-annually. Bondholders will have received both the interest on the bond as well as their principal – the amount of the original purchase price – once the bond reaches its maturity date. Bonds are often classified by their maturity dates as short-term (3 years of less), intermediate-term (4-10 years), or long-term (more than 10 years). Investors can target a particular classification of bonds by purchasing them directly from the issuer – such as the U.S. Government – or investing in ETFs or index funds that track bonds with a particular set of maturity dates.
TYPES OF BONDS: Bonds come in many different shapes and forms, with varying issuers, maturity dates, interest rates and yields, and tax rules.
- U.S. Treasury Securities (Bonds, Notes, and Bills) – The most well-known type of bonds are those issues by the U.S. Government. The U.S. Treasury issues securities of varying maturity dates ranging from a few days to thirty years, with different interest rates and yields depending on the perceived risk and market interest rates. Normally the interest rates of U.S. bonds and treasuries increase with the length of time before the maturity date, as bonds with longer maturity rates have a higher likelihood of being affected by market interest rates. Treasury notes have lower maturity dates of 2, 3, 5, 7, and 10 years. I-Bonds protect against inflation and can earn interest for up to 30 years. Treasury bonds. Treasury bills have short-term maturity dates ranging from a few days to one year. Additional information on U.S. Treasury securities can be found at https://www.treasurydirect.gov/indiv/products/products.htm.
- Municipal Bonds: Municipal bonds, or “munis”, are bonds issued by a states, cities, or counties to raise capital for projects such as new schools or other infrastructure projects. Municipal bonds are often recommended for higher income investors, as they are generally free from federal taxes. They may also be free from State or local taxes if the investor lives in the municipality that issued the bond. Always consult with a tax expert before making investments on the basis of potential tax benefits.
- Corporate Bonds: Corporate bonds are debt securities issued by companies seeking to raise capital for a variety of purposes, including research and development, financing mergers or acquisitions, or buying back stocks.
- International (Non-U.S.) Bonds: Foreign governments also issue bonds, but they are purchased and sold in the local currency.
- Treasury Inflation Protected Securities (TIPS): TIPS are issued by the U.S. Treasury with either 5, 10, or 30 years maturity dates. TIPS provide protection against inflation as the principal and interest rate payments increase with inflation (but also decrease with deflation). For a comparison of TIPS and I-Bonds, see https://www.treasurydirect.gov/indiv/products/prod_tipsvsibonds.htm.
Bonds merit inclusion in a portfolio because of two primary benefits they provide: 1) risk management and 2) fixed income generation. While bonds are not without risk, their inclusion in the portfolio helps diversify a portfolio; reduce downside during bear markets, which enhances long-term growth; hedge against deflation; and generate income through yields that can be spent or re-invested in additional assets.
Risks Associated with Bonds: In addition to market risk, bondholders have to contend with other risk factors that can affect the price or yield of bonds. Interest rate risk, credit risk, and liquidity risk are the primary risks associated with bonds and other fixed-income investments. Inflation risk, directly related to interest rate risk, must also be considered when investing in bonds as it make it more difficult to achieve real returns.
- Interest Rate Risk – The monetary policies of the U.S. Federal Reserve (the “Fed”) have a significant impact on interest rates across the U.S. and global economy for lending and borrowing money, including the price and interest rates on U.S. Government bonds and treasuries. In fact, interest rates on the 10-year U.S. treasury in particular are closely pegged to interest rates as set by the Fed. (Treasury yield curve rates can be accessed daily at https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield.) When market interest rates increase, which can occur as a result of quantitative tightening by the Fed, bond prices will decrease while their interest rates will increase. Bond prices have an inverse relationship with market interest rates. For example, let’s say an investor purchases a bond at a $100 face value with an interest rate of 3%. After purchasing the bond, market interest rates rise to 4% but the coupon rate of 3% for the purchased bond remains intact. If the investor wishes to sell that bond before the maturity date, that investor will only be able to sell that bond at lower than its original price since the older bond is competing with newer, higher-yield bonds at a 4% coupon rate. Additional information explaining the impact of market rates on bond prices can be found in the following useful U.S. Securities and Exchange Commission (SEC) investor bulletin on interest rate risk: https://www.sec.gov/files/ib_interestraterisk.pdf.
- Credit Risk (Default Risk) – The starting point for understanding default risk is recognizing that a bond is basically an IOU and, as with any form of debt, there is a chance the borrower will not be able to pay back the loan or make interest rate payments. The creditworthiness of the issuer of the bond determines both the risk and the potential yield for the bond. U.S. Government bonds are generally considered low risk due to the low likelihood that the U.S. Government will go bankrupt, default on its loans, and be unable to pay back its bondholders. On the other end of the spectrum, high-risk, high-yield bonds, knowns as “junk bonds”, have higher yields because of lower creditworthiness and a higher likelihood that the corporation issuing the bond will default on its obligations and be unable to pay back its bondholders. However, junk bonds are not the only bonds with default risk and high credit ratings do not equal zero risk. (Before the financial crisis of 2008, hundreds of billions of dollars in mortgage securities that held inaccurately high credit ratings were ultimately proven to be an extremely high risk after the underlying mortgages went into default.) Credit ratings for corporate bonds range from the highest rating of AAA (“triple A”) to the lowest rating of D. Anything above BBB- (S&P and Fitch scale) or Baa3 (Moody scale) are considered “investment-grade”. Anything BB+/Ba1 or below are considered “high-yield” or junk bonds.
- Inflation Risk: Inflation is the general increase in the prices of goods and services throughout the economy, which reduces the purchasing power of money. Inflation is not a characteristic or risk specific to bonds, but rather a normal and expected occurrence in the overall economy and directly related to interest rate risk. Inflation expectations can prompt the Fed to hike interest rates to make it more difficult to lend and borrow money in an attempt to prevent an overheating economy. In addition, inflation cuts away at nominal returns, making it more difficult for bond yields (and other assets) to provide a real return (the return to the investor after accounting for inflation). TIPS and I-Bonds are Treasury securities that can protect investors against inflation.
- Liquidity Risk: Liquidity is how fast an investor can sell an asset and convert it into cash. Investors seeking to sell their bonds face the risk of not being able to receive the price that reflects the true value of the bond. Liquidity risk is directly related to interest rate and credit risk as those variables can change the price at which one can sell a bond before the maturity date. Purchasing bonds through ETFs may increase the liquidity of bonds by making it easier to sell them during normal trading hours, but it will not eliminate interest rate and credit risk.
The Role of Bonds in a Portfolio: Bonds play an important role in an investor’s portfolio, as they provide both a means of diversification as well as a means of fixed income. Having only stocks in a portfolio – even if it is a diversified group of stocks is fully diversified – poses significant risk to an investor as the stock market as a whole can move in the same downward direction in a bad bear market or during a financial crisis. Bonds and other fixed income investments are often less correlated with equities and other investments and will continue to provide some predictable income even when the rest of a portfolio is struggling.
- Diversification – Bonds and other fixed income investments are often less correlated with equities and other investments, meaning their prices often move in different directions. Diversification and rebalancing one’s portfolio, if done effectively, can decrease risk in a portfolio without sacrificing gains. (For more in depth background, research into Modern Portfolio Theory).
- Predictable Income – Yields from bonds can provide an effective means of predictable income even when the rest of a portfolio is struggling. Investors nearing retirement or already retired may desire a higher ratio of bonds in their portfolio to provide some stability and regular income when the overall stock market or other sectors are struggling.
- Hedge against Deflation – While bonds may be less appealing during times of inflation, long-term bonds in particular are often considered a good hedge against deflation, as bonds tend to perform better than stocks during deflationary periods (Deflation is caused by an overall decrease in consumer demand and a resulting decrease in prices, which hurts companies’ profits and may require worker layoffs).
- Protecting Principal – In addition to the benefits from diversification, bonds are an effective tool for reducing risk by protecting your principal. While low-risk bonds may have lower nominal returns, or even negative returns in times of significant inflation, bonds are more effective at protecting your initial investment than equities and commodities. Corporate bonds are generally considered less risky than equities as companies have a legal obligation to pay back bondholders and in the event of the a bankruptcy companies will pay back bondholders before paying dividends to stockholders. This is discussed in further detail in 5 Examples of Fixed-Income Investments.