Bonds-Back to Basics

This post is part of my Back to Basics series.  The concepts discussed are simple, but also critical, and I’ve been continually surprised at how poorly understood they are by otherwise intelligent, sophisticated people.  So at the risk of boring some of my audience, let’s get started.

Bonds are far easier to understand than stocks, mutual funds, or even retirement accounts.  There are just a few basic principles you need to understand:

1) A bond is a loan. Imagine that you loan your buddy $100 (the principle) for 5 years (the maturity), but that you want to make some money for doing so.  You decide to charge him 5% a year (the coupon).  So every year he has to pay you $5.   Then, at the end of year five, he gives you $100.  That’s it.  That’s all a bond is.  Some mutual funds do nothing but buy bonds.  When the fund gets the principle back from the bonds that mature, it reinvests the money in other bonds.  Sometimes, for various reasons it buys and sells bonds between the time the bond is issued and the time it matures.  Sometimes the bond issuer (the entity taking out the loan) is a government, such as the US government, the Ethiopian government, the California State Government, or a county or city government.  Bonds are also issued by companies, such as Microsoft or GM.

2) Bond value varies inversely with changes in interest rates and yield In between the time a bond is issued, and the time it matures, its value fluctuates due to changing interest rates and change in the risk of default (the bond issuer not paying you back.)  Consider a bond you own that pays the going rate, 5%.  Now, let’s say interest rates go up to 6%.  Now, the same company issues a bond that pays 6%.  Which one would you rather have?  The 6% bond, of course.  So that means the first bond is now worth less.  How much less?  The value will drop until the bonds have the same yield to maturity. When interest rates go up, the value of bonds goes down.  When interest rates go down, the value of bonds goes up.  When the value of a bond goes down, it’s yield goes up.  When the value of a bond goes up, it’s yield goes down.  Inverse relationship.

3) The higher the yield, the riskier the bond. The longer the maturity of the bond, the higher the chance your bond will go back in value, and that the bond issuer will default.  Therefore, as a general rule, the longer the maturity the more the issuer must pay, so a higher yield must be offered.  Also, some issuers are more likely to default than others.  Who would you rather loan money to, somebody with a good reliable income and a long history of paying it back or someone who has defaulted before and has a sketchy looking income?  Which one would you demand a higher yield from?  So when you see two bonds or bond funds, you can tell which one is riskier simply by looking at the yield.  If one bond or bond fund yields more than another, you can be sure it is riskier.  There are very few free lunches when it comes to fixed income (bonds.)  High-yield bonds are called “junk” bonds for a reason.

4) Yield is not return. As mentioned above, riskier bonds usually have higher yields. If the bond issuer makes all the required payments, AND if it gives you back the principle when it matures, then your return will be the yield when you bought it.  If either of these things goes wrong, your return will be less than the yield.  “But it has a yield of 11%!,” says your Cousin Hal, I’m gonna get rich!  Well, the bond pays 11% the first year, 11% the second year, then the issuer quits paying and goes bankrupt.  What was your return?  How about a minus 40% a year or so?  Another “trick” that occurs is part of the yield comes from return of principle.  Many investments do this.  It might yield 10%, but only 6% of that  yield is income the investment has earned, the other 4% is simply your money that the fund has sent back to  you.  Why would it do this?  To advertise a higher yield.  High-yield bond funds do a similar “trick.”  They pay a high yield, say 8%, but then the value of the investment goes down by 2 or 3% a year due to defaults of the underlying bonds.  The yield might be 8% a year, but the total return may be only 5% a year.

5) The best estimate of the future return of a high-quality bond is its yield. High quality bonds (also called investment-grade) rarely default.  So the best estimate of its future return is its current yield.  If you buy it when it yields 5%, expect a 5% return until it matures.  If you buy it when it yields 7%, expect 7%.  It is the same with high quality bond funds.  Now, chances are good that your return with a bond fund will be either more or less than the current yield, but the best estimate is still the current yield.

6) Keeping costs low is critical. Since bonds return less than stocks and other higher risk investments, it is even more important to keep costs down.  Unlike other things in life, in investing you get (to keep) what you don’t pay for.  A typical bond fund, such as Vanguard’s Total Bond Market Index Fund, yields about 2.5% right now.  If you’re paying commissions, loads, fees or high expense ratios, there won’t be much left for you.  Just 1% in fees or expenses cuts your return by 40%.

7) Duration helps you estimate how sensitive your bond or fund is to interest rate changes. Duration is determined by a rather complicated mathematical equation.  A bond with a 24 year maturity may have a duration of 14 years or so.  If your bond or bond fund has a duration of 14 years, that means that for every 1% that interest rates change, the value of your bond or fund will change by 14%.  In the last year or two, many investors have been extremely worried about a “bubble in bonds.”  They are worried that interest rates will go up and the value of their bonds will be crushed.  That’s a valid concern if your bonds have a duration of 14 years.  But most bond funds have a duration of 2-6 years.  If your duration is 3 years, your yield is 3%, and interest rates go up 1%, then you lose 3% of value initially, but you also now get a higher yield, so you break even in just over two years and for every year after that that you hold the investment, you’re better off with the higher rates.  Hardly a risk to be paranoid about when a typical stock bear market may cost you 20-30% of your investment with no promise of ever getting your money back.

Watch for future posts that will discuss different types of bonds, how to build a bond portfolio, what types of bonds to consider and what types to avoid, and how and where to buy them.