This post, run again as a Tuesday Classic is part of my Back to Basics Series I wrote years ago. It is very important for you to understand the investments you own. 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 on investing in bonds.
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:
7 Basic Principles of Bond Investing
#1 What is a Bond?
Imagine that you loan your buddy $100 (the principal) 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.
Mutual Funds and Bonds
Some mutual funds do nothing but buy bonds. When the fund gets the principal 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 Inverse Relationship Between Bond Value and Interest Rates
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.
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 the Same as Return
“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 principal. 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 only 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 2.4% 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.
Are bonds included as part of your portfolio? Why or why not? Comment below!