Education

The What, Why, and How of Investing in Bonds

Here we offer simple, practical responses to some of the most commonly asked questions about bonds.

The What

Bonds are basically loans. A company, state or government issues bonds to raise money to fund expansion programs or build schools and hospitals. The bond issuer agrees to pay its investors periodic “fixed” interest payments (hence, the name “fixed income”), while the loan is outstanding, and to pay back the full loan at the end of the bond’s life (called maturity).

Governments have been using bonds to raise funds for centuries. While it’s not entirely clear when the first bond was issued and by whom, historians believe Venice was an early innovator. To defend itself against war in the 1100s, Venice “taxed” its citizens to build a fleet of ships, but unlike a regular tax, the government promised to pay it back with interest. And so the bond – or prestiti – was created.

Source: Goetzmann, William (2016). Money Changes Everything: How Finance Made Civilization Possible. Princeton University Press.

Government/Sovereign: They tend to have less risk than other asset classes as governments have the ability to print more money – albeit at a very high social and economic cost.

Government-related: These quasi-government institutions include agencies and local authorities.

Corporate: Credit issued by companies, generally offering investors a premium because lending to a company is usually riskier than lending to a government.

Securitized: These securities are backed by assets, such as mortgages, auto loans and credit card debt.

A coupon is the yield, or annual interest payment, that the bondholder receives from the bond from its issue date until it matures. Coupons are normally described as the “coupon rate,” which is calculated by adding the sum of coupons paid per year and dividing it by the bond’s face value. For example, if a bond has a face value of $1,000 and a coupon rate of 5%, then it pays total coupons, or interest, of $50 per year.

It is a bond’s return. Setting aside time and interest rates, a bond yield equals the bond’s coupon. But since money today is not worth the same as an IOU in the future, yields tend to be higher for longer-maturity bonds. This is because investors demand a higher return for the higher risk taken and for the effect of inflation, which will eat into the principal’s value over time: A million dollars or euros can buy you a dream home today – but probably not in 20 years’ time.

When economies face low growth and low inflation, investors tend to favor bonds as they are usually seen as "safe-haven" assets. But increased demand raises bond prices and pushes yields downward. At times, bond prices may rise so much that their yields turn negative. When this happens, creditors (investors) do actually pay borrowers (some governments) for lending them money. This has been a feature of bond markets over the past decade: Central banks have spent billions to refloat economies through the purchase of bonds, which has pushed bond yields in countries such as Germany and Japan into negative levels.

A bond’s price is based on its features, such as quality, coupon size and maturity. Like most products, high-quality bonds are usually more expensive than lower-quality bonds. After a price is set and a new bond starts trading in the market, investors will soon notice that bond prices move in the opposite direction from interest rates: When rates rise, bond prices fall because the bonds sold in a lower interest rate environment will have lower coupons – making the security less attractive relative to new bonds sold in a higher-rate environment. The opposite happens when rates fall: The price of an old bond will rise because it typically has a higher coupon.

A spread is the risk premium that investors demand, over a base government bond yield, to compensate for the risk taken. During volatile times, the spread of high yield corporate bonds can rise to as high as 10% over the base government yield – so, if a government yield is 2%, the total corporate bond yield would be 12%. But, while this return may seem very attractive, investors should understand that higher-yielding bonds often have considerably higher risk.

Duration is a measure that helps us calculate how much a bond price will rise or fall given a change in interest rates or in the bond’s yield. Duration is expressed in years and tends to be linked to the maturity of a bond: Generally, longer-dated bonds have longer duration, while shorter-dated bonds have shorter durations. When interest rates are expected to fall, investors tend to favor long-duration bonds because the effect of the yield drop, and subsequent price increase, will be much higher. The opposite happens when rates are expected to rise: Investors may favor bonds with shorter durations to help mitigate the negative effect of rising rates on bond prices.

Credit quality is the assessment of how trustworthy a bond issuer is. The more likely it is that investors will receive their money back, the higher a bond’s quality. On the other hand, companies with a dubious track record are usually in the “speculative/high yield,” or bottom bucket of the credit spectrum. These higher-risk companies will often pay higher coupons because they need to compensate investors for the risk they are taking. Government bonds, on the contrary, usually pay low coupons because they tend to be viewed as safe.

Yield curves plot the yields of bonds with the same credit quality but with different maturities. A healthy yield curve is usually upward-sloping, as investors forecast economic growth ahead and demand higher yields for longer-maturity bonds – they want to be compensated for inflation (which usually comes with higher growth). On the other side of the spectrum, an inverted yield curve can sometimes signal a recession ahead, as investors believe the future is bleak, inflation will fall and so will interest rates.

Issuers that cannot meet interest payments will default on the bond – the worst outcome for a bond investor. After a default, the insolvent company will pay its bondholders before paying stockholders, but often, struggling companies cannot pay all bondholders their principal back. This is why risk-averse investors tend to prefer the higher-quality bonds – because they get paid first if the company goes bankrupt. Historically, the global corporate default rates tend to rise in weak economic times and drop during expansionary phases. The default rate level, though, has remained low over the past decade as low interest rates have reduced corporate borrowing costs.

Most bond portfolios have an objective, so meeting it and delivering on investors’ expectations is optimal. Unlike stocks, from which investors mostly expect capital appreciation and dividends, bond portfolios are often designed to meet other goals, such as capital preservation and steady income generation.

Active management is an investment strategy where the portfolio manager invests with the goal of outperforming a specific benchmark. In contrast, a passive manager will seek to buy and hold a portfolio that represents a benchmark with the goal of offering the same returns as that benchmark. Because bond markets are bigger and more complex than stock markets, managers often say that they offer more opportunity to find inefficiencies, making bonds more appropriate for an active approach.

The Why

Capital preservation: Like any loan, the borrower promises to pay back the principal amount, thus protecting the lender’s capital.

Income: The regular cash flows received in the form of periodic coupons help to plan future spending needs and liabilities.

Diversification: A diversified portfolio helps reduce risk because if any single asset class performs poorly, others may perform well.

Inflation-protection: Certain bonds add the ongoing inflation rate to their payments, which protects against rising prices.

Capital appreciation: Government bond prices tend to increase when economies are in weak economic times, while low-rated corporate credit generally increases in value when economies are strong.

Individuals are sometimes tempted to keep the bulk of their savings in cash or cash-equivalent investments (such as Guaranteed Investment Certificates (GICs), money market accounts and bank accounts) so they don’t risk losing their money. However, the value of cash diminishes with rising inflation. Also, given the present environment of low interest rates, cash and cash equivalents usually offer a low return.

Bonds are in principle safer than stocks because the borrower has committed to return the principal. With stocks, investors may put $100 of equity into a company, but they may lose it all if the company goes bankrupt, but bondholders, by law, will be paid first and may get everything that the company has left. Investors therefore demand higher return to hold stocks, often making them more profitable. This, of course, doesn’t always hold: In recessionary environments bonds tend to outperform equities.

Bonds have multiple sources of return, including their coupon, duration and spread moves, whereas stocks’ returns are usually driven by a company’s earnings outlook. Some companies, for instance, may only have one single-traded stock, but can issue thousands of different bonds, all with different maturities, coupons and credit quality. This makes their analysis more difficult because more factors, other than the company’s outlook, have to be considered.

The media has traditionally had more of an equity bias. This is due to the inherent complexity of the bond market, and also because most bonds trade over the counter (directly between investors or brokers), as opposed to equities, which mostly trade on organized exchanges – making them easier to track. Also, as bonds tend to be less risky than equities, their price moves tend to be less dramatic – and less newsworthy.

Interest rates are the price of money – the result of the supply of capital offered by lenders and the demand of capital put forward by borrowers. The resulting base interest rate sets the tone throughout financial markets, making companies adjust the coupons they pay to be in line with the ongoing interest rate level, more or less. Since coupons can be one of the biggest components of a bond’s return, the level of interest rates is crucial. Large interest rate moves can have a big effect on a bond price if the duration of the bond is not the optimal.

Just like individuals, governments that have high levels of debt have a worse credit “score” than those who save and are well positioned to weather tough times. Highly indebted governments run large deficits – something that can lead to a negative domino effect. For example, if a country’s income are not enough to finance its investments, it will need to borrow capital from abroad, leading to an external deficit, which could erode the value of its currency. Also, having more investments than income leads to higher interest rates (demand for capital outweighs supply), and this usually impedes economic growth and may lower domestic asset prices.

Historically, bond markets have signaled an approaching recession months before equity markets. This happens because bonds look at the present health of an issuer, mostly through a company’s balance sheet, while stock prices are representative of future cash flows. This makes bonds quicker to react if the present situation is less than positive. As lenders, bond investors function like a bank, and as such, can see if a company is struggling financially, long before customers and suppliers do.

In the U.S, the stock market has a total market capitalization of over $30 trillion, less than the $40 trillion of total debt owed through bonds. This is due to the fact that governments issue bonds, not stocks, and also because bond financing tends to be cheaper than equity issuance, so more companies choose to raise funds in the bond market.

The bond market has always been less liquid because of the difficulty of matching bonds with the exact same characteristics, since bonds can vary so much in terms of maturity, coupon, duration and credit quality. Also, following the global financial crisis, new regulations have made it more difficult for financial institutions to trade risky assets. While the move, aimed at preventing another banking crisis, has indeed improved banks’ buffers, it has also led to a reduction of some banks’ bond trading desks, reducing overall market liquidity.

Local regulators around the world often require banks and insurance companies to invest in bonds because they are less volatile than other asset classes in principle – if insurance companies held their savings in stocks and a natural disaster happened, a potential market crash would mean that the insurance company wouldn’t be able to meet due payments, leading to a major crisis. Pension funds also need bonds to better predict their future payments, as bond coupons and principal paid at maturity are easier to predict than stock prices.

Since liquidity has generally dropped in the bond market, leveraged investors who urgently need cash during a sell-off rush to the most liquid parts of the market to execute their sales. As in most asset classes, the highest-quality securities tend to be more liquid. In the case of bonds, U.S. Treasuries and U.S. agency mortgage-backed securities are two of the most liquid asset classes in the world, which is why they attracted investors desperate to sell. This led to heightened volatility, despite their traditional role and government support.

A “safe haven” is an investment that is perceived to be able to retain or increase in value during times of market volatility. Investors seek safe havens to limit their exposure to losses in the event of market turbulence. All investments contain risk and may lose value.

The How

Bond investors can choose from many different investment strategies, depending on the role or roles that bonds will play in their investment portfolios. Investors may buy bonds and hold them until they mature. Or, they may also consider bond funds. These are mutual funds or exchange-traded funds that usually invest in a variety of bonds, such as corporate, Treasury, or high yield bonds. For a low investment minimum ranging from a few hundred to a few thousand dollars, bond funds allow individuals to invest in a whole range of bonds, managed by professional investment managers.

Each investor must determine how much risk they are comfortable with – their risk tolerance level. It is generally advised to match one’s investment goals with bonds that can help meet those goals. For example, if an investor’s main goal is to fund their immediate living expenses, an allocation to liquid, cash and cash-like strategies may be appropriate. For more mid-term or long-term goals, such as children’s education and retirement, government and corporate bonds may provide the income needed. Finally, for goals and objectives that are more aspirational, a higher-risk strategy may be appropriate as long as the investor is comfortable with that risk.

A top-down and a bottom-up focus are two of the best-known investment approaches. A top-down approach offers a big-picture, macroeconomic view that helps bond managers see the general direction of macro trends such as interest rates and inflation. Top-down is usually combined with a bottom-up approach, which typically takes a deep dive into the financial health of the individual companies issuing the bonds to make sure they are positioned to handle the macro forces that may be coming their way.

All investments carry some degree of risk. These risks include the possibility that an investor will lose the money they invested if a bond defaults. Investors generally require more return potential to take on more risk, although the correlation of risk and return is not always perfect – sometimes significant levels of risk deliver dismal returns. One of the measures that investors use to assess the relationship between risk and return is the Sharpe ratio, which quantifies the return earned per unit of risk taken. Investors favor bonds with high Sharpe ratios.

Coupon: The coupon is the periodic interest payment investors receive.

Duration: Duration can enhance gains (if you have long duration when rates fall) or exacerbate losses (if you have long duration when rates rise).

Spread: If the corporate, asset-backed or emerging market bonds improve their credit quality, the spread that investors demand to compensate for risk will fall – since the spread is part of a bond’s total yield, falling yields will lift bond prices. The opposite will also happen: Rising spreads will lead to losses as bond prices fall.

Foreign exchange: When investing abroad, investors are exposed to the rise or fall of foreign currencies.

Independent credit rating services assess the credit quality, or credit risk, of bond issuers and publish credit ratings that not only help investors evaluate risk, but also help determine how much investors should be paid as compensation. Investing in an issuer with a high credit rating will earn a lower return than one with a low credit rating. Again, investors who purchase bonds with low credit ratings can potentially earn higher returns, but they must bear a higher degree of risk.

Most bonds provide the investor with “fixed” income. On a set schedule, whether quarterly, twice a year or annually, the bond issuer sends the bondholder an interest payment, which can be spent or reinvested in other bonds. Stocks may also provide income through dividend payments, but dividends are often smaller than bond coupon payments, and companies make dividend payments at their discretion, while bond issuers are obligated to make coupon payments.

Bond prices don’t tend to move as much as equity prices, but some higher-risk bonds have some equity-like features. For instance, high yield bonds have a higher correlation to equities because their prices depend more on their unique business fundamentals and their spread (the premium investors demand to compensate for the security’s specific risk) than on underlying economic fundamentals. In this sense, significant spread compression can lead to hefty gains – as much as spread widening can lead to losses. Sovereign debt can also rally in risk-off environments when rates drop, and provide substantial gains for investors with long-duration positions.

Diversification is one of the main techniques to reduce risk. However, some investors favor a “barbell” approach, owning securities in almost two opposite poles of the risk spectrum: low-risk government debt combined with high-risk credit. While the strategy provides certain balance, the loss of the higher risk credit securities may not be entirely offset by the government bonds in a sharp sell-off. Some investors prefer to balance portfolios by spreading maturities and risk more evenly across the spectrum. Having a mixture of credit quality, industry and geographic exposure may also enhance diversification.

Because of their low correlations to stocks, bonds, particularly core bonds, have been less volatile than stocks. This diversification benefit can help lessen the impact of volatility on an overall portfolio. Importantly, some types of bonds have more risk than other types, which make them more volatile. High yield bonds, for example, are issued by entities with lower credit ratings, making them riskier than higher-quality bonds.

Scrutinizing every fluctuation in the market or in the value of an investment can create anxiety. Instead, investors may consider reviewing performance and making any adjustments regularly, such as annually or quarterly. It is important to keep in mind, however, that a disciplined approach to a long-term investment strategy may yield the best results.