Understanding Bonds

If you’re a typical investor, there are three asset types that make up the majority of your investments. They are stocks, bonds, and cash. And each has a role to play in an investor’s portfolio. 

Cash is for principal protection. If I have a need for dollars currently, those dollars are going to be held in cash. The only asset that guarantees it will be worth the same dollar amount in the future that it is valued at today, is cash. Inflation may lessen the value of those dollars, but at least there won’t be any fewer of them. 

Stocks are for growth. Because we want our portfolio to keep pace with inflation…likely a bit better…some of our money is in stock. 

So why do we hold bonds? What role do bonds play in our portfolio? The probable answer for most investors is to accomplish something in between. Meaning, we don’t want the bond portion of our portfolio to have the volatility of the stock market, but we also don’t want to see its value slowly degraded by inflation, like cash. Typically, that’s the role that bonds are used to fill.   

But how does that work? Meaning, if bonds land somewhere between stocks and cash, what exactly is a bond and how do I make money owning one? And, how volatile are they? Do they go up and down in value more like stocks, or do they hold a steady dollar value like cash?   

Those are good questions. Questions that, in my experience, many investors are not well prepared to answer. And, as recent headlines have shown us, nor are they always perfectly understood and managed by professional money managers. (Those who managed the deposit assets of a certain California bank in Silicon Valley are a case in point...) 

First up, what is a bond? When you invest in a bond, what exactly are you investing in? 

The short answer is: when you buy a bond, you are making a loan. You are lending some entity (likely a company or a government) your money. If it is a government, it could be either foreign or domestic, and it could be at any level, such as federal, state, or even local, as in a municipality. Buying a bond means loaning your money to whoever issued that bond and, in return, receiving an investment return in the form of interest payments. 

There are many types of bonds and many ways in which they can pay that interest. However, we’ll keep it simple. Here’s an example of a typical bond:

Bonds are commonly purchased in $1,000 increments. If I buy ten bonds, I might expect to pay $10,000. The interest bonds pay is generally set at the time the bond is issued and is commonly paid to the bondholders semi-annually. Therefore, if I bought a bond that was issued paying 5% interest, I would likely receive two semi-annual payments of $25 each. 5% of $1,000 is $50, paid semi-annually, the result is two $25 interest payments per year. 

Bonds also generally begin their life with a “term.” The term when referring to bonds is the time the bond issuer has until needing to pay back the bonds and return to the bondholders their principal. In other words, it’s when the bond issuer’s “loan” comes due. Should I purchase a bond, at the end of that bond’s term, I can typically expect the bond issuer to return the face value of my bond. In my earlier example of a bond with a ten-year term paying 5%, the face value was $1,000. When I receive the second payment in the tenth year for that bond, the payment will likely be $1,025. This will represent $25 for my final interest payment, plus a $1,000 return of my original principal.

On the surface, bonds seem like a straightforward investment. Almost like putting money in a bank, I simply give my money to a bond issuer and, from that point on, I can expect to get regular interest payments for a set duration, and eventually receive a return of my original investment dollars. 

Here I should point out that, for the sake of simplicity, I have avoided several “complications” that bonds may have. For example, bonds of publicly traded companies might have a feature that allows the bond to potentially be converted into shares of the company’s stock. Also, some bonds do not make semi-annual interest payments but are purchased at a discount to their face value. These bonds then pay all accumulated interest to the bondholder in one payment when the bond matures. This is called a zero-coupon bond. Those are just a few examples, and there are several types of bonds.

Regardless of the features of this or that bond, you might wonder, can anything go wrong when investing in bonds? If bonds pay regular interest payments, and eventually I will have my principal returned, is there any way to lose money?    

This is where the complexities of bonds begin. The short answer is yes. You can certainly lose money with bonds.

First, there is always the possibility that the issuer of the bond will become insolvent and therefore unable to make the bond’s interest payments, return the bondholders’ principal, or both. After all, not all loans get paid back. Again, when you buy a bond, you are making a loan. Therefore, that same possibility exists. Should that happen, your bond will be in default, and it will then be an open question as to how much of your invested dollars and expected interest payments you will receive. The range will be between 100%…and nothing. 

Thankfully, most bonds do not default. Furthermore, bond issuers, just like borrowers at a bank, are assigned “credit scores,” which come in the form of a rating on the bonds they issue. Essentially, this is a measure of the bond issuer’s ability to pay their debts. This gives bond purchasers an idea as to the level of Default Risk they are assuming when purchasing this or that bond. 

Investors can also lower their exposure to the impact of Default Risk by avoiding the purchase of individual bonds and instead buying bond funds, such as a bond mutual fund or ETF. Doing so means the investor is diversifying their bond portfolio, much as one would diversify their holdings in stock. Instead of owning one or a handful of individual bonds, buying shares of a fund means jointly owning a share of what will probably be a much larger collection of bonds. This lessens the impact that a default on one or a handful of bonds will have on each individual investor’s overall holding. 

However, Default Risk is not the only risk that investors face when investing in bonds. A second risk to bond investors is Interest Rate Risk. And understanding this risk is where bonds take on another level of complexity still.   

To understand Interest Rate Risk, let’s go back to my earlier example, where I spoke of a bond with a $1,000 face value that pays 5% interest for a term of ten years. Assume I purchased that bond when it was “brand new,” meaning, when the bond was issued. At that point, the bond had both a cost and a value of $1,000, which is both the face value of the bond and the price to purchase it. In ten years when the bond matures, the holder of that bond will receive $1,000 as a return of that initial principal. So, does the fact that the bond both began and ended its life with a value of $1,000 mean that, for the entire life of that bond, it will always be worth $1,000? No, it does not.      

A common misunderstanding regarding bonds is the fact that bonds, every day that they exist, have a market value, just like stocks. An investor is not required to hold a bond until it matures. Bonds are bought and sold at any point during their life, just as any other widely held asset might be. And just because a bond was worth $1,000 when it was issued, and might well be expected to be worth $1,000 again at maturity, does NOT mean that it is worth $1,000 at every point in between. Why? Let me explain.

Back to my bond paying 5% interest and maturing in 10 years. Let’s assume that I have owned that bond for five years and have now decided I would like to sell it. Meaning, I would like to get my $1,000 back. Will I be able to sell my bond? Assuming it is a widely traded bond, yes, it should be fairly easy to get my bond sold. It will probably be no more difficult than putting in a sell order with my broker, just as I would for any widely traded stock. However, although getting it sold will be no problem, there is no guarantee that it will be worth $1,000, the price I paid for it. How much will I get for my bond? That depends.

Let’s assume that, in the time that I have owned this bond, interest rates have gone up. That should be good news, right? After all, bonds pay interest. Shouldn’t a rise in interest rates be a good thing for someone investing in bonds? Well, assuming the investor is buying their bonds today, yes, higher interest rates will be good news. For example, should a bond like the one I purchased five years ago now be paying, say, 7%, that is a 40% increase in the interest revenue one will receive should they choose to purchase the bond now. 

But that won’t be good news for me when I go to sell my bond. Why? Remember, the interest rate that a bond pays is generally set at the time it is issued. My bond is paying 5%. Should I want to sell my bond, who would want to pay $1,000 for a bond paying 5% when they can simply go buy a new bond on the market that would pay them 7%? That has a simple answer. Nobody. 

Does that mean I won’t be able to sell my bond? No, not at all. Again, getting my bond sold will be as easy as putting in a sell order with my broker. What it means is this: I just won’t be able to get $1,000 for it. How much will I get? I will get whatever price results in the purchaser receiving a 7% return, given the remaining interest payments that my bond has left to make, plus the $1,000 return of principal they will receive on the day the bond matures. How much is that? A financial calculator tells me it is $916.83. Paying $916.83 for my bond, and then receiving five years of $50 annual interest payments, plus a $1,000 return of principal, results in a 7% yield for the new bond owner. In other words, an investment yield equal to current interest rates. This is what my bond is currently worth.

In selling my bond, I am going to take a loss of $83.17 from my original principal. This is one of the most common ways investors lose money investing in bonds. We say that bond values have an inverse relationship to interest rates. When interest rates go up, bond values go down. However, the reverse is also true. 

So, how does one deal with Interest Rate Risk when investing in bonds? Well, one way is to remember that all investments, stocks or bonds, are long-term. Investment values fluctuate. The antidote for the fluctuating value of even a well-balanced portfolio is time. The thing that can go wrong for just about any investment is the possibility that the investor will need to sell that investment and turn it into cash at a point when the investment’s value is depressed. Bonds are no exclusion from that possibility.

One of the contributing factors to the collapse of Silicon Valley Bank was the bank’s need to sell bond holdings at a point when rising interest rates had substantially degraded their bonds’ market value. SVB’s bond holdings represented a portion of the savings deposits of SVB’s customers. They had invested those depositors’ assets in bonds. When many of those depositors suddenly wanted their savings dollars back, more than what SVB held in cash-on-hand, SVB was required to sell those bonds at a loss. After what has been several months of rising interest rates, they were now only worth a fraction of what SVB paid for them. Not good news for SVB.

How does one avoid this type of loss? After all, if it can happen to the bankers of SVB as they manage customers’ deposits, surely it can happen to you as you manage your retirement savings, children’s college funds, or any other investment dollars you may have. How do you protect bonds against Interest Rate Risk?

Something to consider here is that there is an attribute that bonds have that sets them apart from stocks. After all, if bonds have the same volatility as stocks, why would we consider them to be a more secure asset? That’s a good question. Here is an answer:

Remember when I sold my bond that was paying 5% interest for a loss of a little over $83 because interest rates had gone up? What would have happened had I not sold that bond? Imagine instead that I had continued to hold my bond until its maturity date. At that point, barring default, my bond will again be worth $1,000. At maturity, it makes no difference what current interest rates are. The loan is now due, and the principal that I am owed by the bond issuer is the same. I will receive $1,000.

This is an important difference between stocks and bonds. Bonds have a maturity date. A date that we know what the value of the bond will be. Stocks have no such equivalent. Yes, bond values can fluctuate day to day, just like stocks. But they are dissimilar in that, at some point, their principal comes due.   

Knowing this, another solution to manage the volatility of bond prices is to take advantage of that attribute of bonds. The attribute that tells you, on the maturity date, your bond is going to be worth: $X. When buying bonds, you can match the maturity date with the date of the expense that you plan to fund with those dollars. When your child’s college tuition needs to be paid, or when planning for the cash you will need to fund this or that year of your retirement, you can simply buy bonds that will mature then. 

There is a term for this strategy among money managers. These are called “bullet bonds.” Bullet bonds are not a “type” of bond, they are simply bonds that were purchased matching the maturity date of the bond with a specific anticipated expense. 

However, bullet bond strategies work with individual bonds, but they won’t work with most bond funds. When you buy a bond fund, which again you are doing to diversify your bond portfolio and mitigate your exposure to Default Risk, you now own a portion of many bonds. Bonds that likely have multiple maturity dates. Gaining the diversification that the fund gives you will usually mean sacrificing the control that is required to implement a bullet bond strategy. And what do we do with a bond fund that is losing money?

Here might be a good time to remind ourselves of a principle in investing; the principle that says: buy low and sell high. This is something almost every investor seems to understand in theory but struggles to execute in practice. Markets go up, and markets go down. Interest rates do also. Your bond fund that has become an eyesore in your portfolio every time you go to check values won’t stay down forever. And the fund manager who is overseeing it is likely now making several hard decisions. Decisions about which bonds in the portfolio to keep, and which to swap for newer, higher-yielding bonds that are paying something closer to our current interest rates. Interest rates won’t stay high indefinitely and remember bond values’ inverse relationship to those rates. When interest rates start coming down, the value of bonds, and the funds that hold them, will likely be an eyesore in your portfolio no longer.