Introduction to Bonds

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Text on screen: PIMCO EDUCATION, Introduction to Bonds with host Roger Nieves (11 minutes)

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Text on screen: Roger Nieves, CFA, Senior Advisor, PIMC Advisor Team. PIMCO provides services to qualified institutions, financial intermediaries and institutional investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized.

Roger Nieves: Welcome to Introduction to Bonds.  Bonds are a subject that have been near - and dear - to our hearts here at PIMCO for close to five decades, and we are glad to have the opportunity -- to discuss this with you today.

Text on screen: TITLE – Agenda, NUMBERED BULLETS – 1) Bond market basics, 2) Why invest in bonds? 3) How do bonds fit into a portfolio

Our goal is threefold: One, we are going to spend a few minutes reviewing Bond Market Basics. Two, we are going to take a look at why you may want to consider investing in bonds. And three, we are going to review how bonds fit in to your overall portfolio.

Let’s begin with the basics. When you invest in the bond market, you are essentially loaning money. 

The bond market takes large loans, breaks them into pieces, and turns them into tradeable securities.

The length of these loans varies, and is known as the maturity of the bond.  Common maturities include 5, 10, or 30 years.

Text on screen: TITLE -- A bond is a tradeable security used to borrow or lend money. SUBTITLE -- bonds usually provide the lender with interest that the borrower pays.

Image: Icon of concentric circles with text, Principal (face value): the amount of money borrowed and repaid at maturity; icon of money with text, Coupon: the interest paid at specific intervals for the money borrowed.

The amount that the bond market borrower repays at maturity is called the principal, or face value. The interest payment that the borrower makes - often semi-annually and expressed as a percentage of the face value - is called the coupon.

The term coupon comes from the fact that years ago, investors would actually cut coupons out from a certificate that looks like this -- and present it to the issuer for payment.

Here you see an illustration of the concepts of coupon, maturity, and principal.

Text on screen: Yield-to-maturity

Image: Green rectangles representing four coupons align over a gray arrow labeled “maturity”. The line of coupons ends with a blue box representing principal at $100. On the right side under the maturity arrow is a maroon box representing price $100. Text explains: Yield-to-maturity is the estimated rate of return for a bond assuming an investor holds a bond until its maturity date.

Another important term is yield to maturity.  Yield to maturity is the estimated rate of return for a bond, assuming an investor holds that bond until its maturity date. The yield of the bond is related to the coupon rate but can sometimes be quite different, as it factors in the price that you actually paid for that bond. Bonds can sell at a discount to par value and bonds can sell at a premium to par value.

So who borrows in the bond market?

Text on screen: Three major bond sectors

Image: Blue icon with a shield surrounding a padlock with text below that reads: U.S. Government Bonds: Proceeds historically used to fund defense and social programs; green icon with a house with text below that reads: Mortgage and asset-backed bonds: Lending money for real estate assets like a house or property; maroon icon with a coupon with text below that reads: Corporate bonds: Issued by corporations as a way to raise assets to expand the business, improve operations, new acquisitions, etc.

Turns out that the US government is one of the largest, and highest quality borrowers globally.  The US government borrows to fund programs like national defense, Medicare and Social Security. A second major sector here in the US is the Mortgage and Asset Backed market.  This market provides funding – often to consumers - for home loans, car loans, credit cards, and other needs. Corporations represent a third major sector.  Companies often borrow money in the bond market to build new facilities, grow their businesses - and to fund day to day operations.

How big is the bond market? The bond market is large. 

Text on screen: How big is the bond market?

Image: A bar graph of four sectors of the bond market, from left to right: $28 trillion U.S. Stock Market (dark blue); $38 trillion U.S. Bond Market (green); $69 trillion Global Stock Market (maroon); $110 trillion Global Bond Market (light blue).

In fact, if you look at the green bar here you see that at $38 trillion, the US bond market is much larger than the US stock market and that at $110 trillion -- the global bond market is larger still.

This $110 trillion market is very diverse. 

Text on screen: How big is the bond market?

Text on screen: TITLE – Bonds are issued all over the world; SUBTITLE -- composition of the global bond market (% of issuance).

Image: A pie graph showing Other emerging markets 3%; U.S. 39%; Eurozone 19%; Japan 12%; U.K. 6%; Other developed 8%; China 13%.

The US is the biggest piece, but Europe and Japan have large bond markets also, representing 19% and 12% of the market respectively. Note here how China represents 13% of the global bond market.This size and scale creates a rich opportunity set for all of us as investors.

Earlier, we covered the concept of yield to maturity.  Let’s see what happens to bond investors when yields move around a bit.

Text on screen: What happens to the price of a bond as interest rates move?

Image: A chart showing yield in the left column and price on the right: 2% at $100; 1% at $101.97; 4.6% at $95.13. The 1% row has a note with text: In a world of 1% yields, a two-year note’s 2% coupon is appealing. The $95.13 row also has a note with text: In a world of 4.6% yields, a ywo-year note’s 2% coupon is less attractive.

Here we see, for example, the price of a two year note with a 2% coupon in different yield scenarios. Let’s say I buy this two year note for $100, and then interest rates fall to 1% as shown here in green. 

It turns out that move makes me quite happy, as I now have in my possession a note that pays 2% when comparable notes in the market pay only 1%. 

Given how much more attractive 2% is relative to one percent, investors are now willing to pay me a premium price, roughly $102, if I tried to sell my note

If on the other hand, I buy my two year note and then the yield on comparable notes moves up to 4.6%, I am now quite sad.  In fact, investors would now - only pay me $95 - if I went to sell it.

Text on screen: TITLE -- Bond prices are typically inversely related to interest rates. SUBTITLE – As yields move up and down, bond prices move up and down.

Image: A seesaw with a blue circle on the left, upper side of the seesaw that reads “Rates Rise” with an upward arrow and a maroon icon that reads “Prices Fall” with a downward arrow on the right, lower side of the seesaw.

It is this relationship that sets up the teeter totter concept that many investors are familiar with.  If interest rates move up, bond prices move down.  And vice versa, if interest rates go down, bond prices generally move up.

Text on screen: Duration

Text on screen: Duration (measured in years) estimates the % change in a bond’s price for a 1% change in yield.

Duration is a term that is used to measure the strength of this relationship.  Duration, measured in years, estimates the percentage change in a bond’s price for a 1% change in yield. 

This is an important measure of risk that is often prominently featured on fund fact sheets.

Text on screen: Duration

Image: A graph titled Example Duration Calculations, with three columns: duration, yield change and price impact. From left to right, the first line reads 5 years, +1% increase and -5%; the second line reads 5 years, -1% decrease, and +5%.

Note here for example a bond with a duration of 5. If interest rates were to fall by 1%, this bond would go up in value by 5%.

As bond investors, we face risks. One is interest rate, or duration risk as we just mentioned. We also face the related risk of inflation. 

Text on screen: Bond investors can face risks

Image: Three icons from left to right: A blue circle with a downward-trending bar graph with text below that reads: Inflation risk: purchasing power of principal declines over time; a green circle with a dollar sign with arrows pointing up and down and a bar graph from the left with text below that reads: Interest rate risk: bond prices adjust as interest rates (and coupons) increase or decrease; a maroon circle with an icon of a hand holding money with text below that read: Default risk: Borrowers may fail to pay on obligations.

Inflation is the risk that money paid back to me when my bond matures in the future will purchase fewer goods and services than it does today.

Default is another risk.  If I lend money to say a corporation, it is possible that company may run into stress down the road -- and may not be able to honor their obligations to me as a bondholder

Text on screen: TITLE – Agenda, NUMBERED BULLETS – 1) Bond market basics, 2) Why invest in bonds? 3) How do bonds fit into a portfolio

All of this begs the question, well if there are so many darn risks, why do investors allocate to bonds?

The good news is that in short, there are also benefits, opportunities, and certain protections for investors.

Text on screen: Bond investors can benefit from protections

Image: A chart of protections: A blue icon of a federal building labeled “U.S. treasuries”: full faith and credit of the U.S. government; a green icon of a hand holding a dollar sign labeled “Municipal bonds”: backed by taxing authority of states and local governments; a maroon icon with a coupon labeled “Corporate bonds”: potential collateral like real estate, automobiles or aircraft; and a light blue icon of a money bag with a bar chart showing up and down arrows labeled “Seniority”: Bonds are senior to stocks in a company’s capital structure; bonds are repaid first in the event of a sale or bankruptcy.

Investments in US Treasuries, for example, are backed by the full faith and credit of the US government. Investments in municipal bonds are backed the taxing authority of state and local governments. Investments in corporate bonds are backed by the financial strength of the issuing company, and in some cases by hard collateral such as commercial real estate. In addition, in the event a company runs into distress, bondholder claims are generally viewed as senior to those of stock investors.

Here you see an illustration of those potential benefits.

Text on screen: TITLE -- Bonds can help preserve wealth and are a defensive asset; SUBTITLE -- high quality bonds can perform well during times of market stress. Plus, the principal is expected to be paid back to the investor.

Image: A bar graph shows historical equity draw downs with blue bars representing BBG BC U.S. Aggregate and green bars representing S&P 500 during five periods of economic stress. The range is from 15% to -65% with the BBG U.S. Aggregate trending higher while the S&P 500 dips lower during each period.

In green, we see returns for the stock market, represented by the S&P 500, during some tough periods including the 2008 financial crisis – shown here on the far right hand part of the page, when stocks fell by 55%.

Immediately to the left of that on this chart, you see returns for the stock market during the COVID selloff in 2020, where the stock market fell by close to 27% in less than a month.

In the blue bars, you see the returns for a diversified high quality bond portfolio -- as represented by the widely tracked, Bloomberg, Barclays index -- during these same periods of stress. You can see that historically, high quality bonds have helped preserve wealth, generating positive returns during these volatile periods.

Text on screen: TITLE – Agenda, NUMBERED BULLETS – 1) Bond market basics, 2) Why invest in bonds? 3) How do bonds fit into a portfolio

Next, let’s review the role of bonds in a diversified portfolio.

This chart shows you 20 year annualized returns and 20 year annualized volatilities for different asset classes.

Text on screen: The role of bonds in a portfolio: diversification

Image: A graph showing 20 year risk vs return. The x-axis is labeled “Risk (annualized volatility)” and ranges from 0% to 8% and the y-axis is labeled “Annualized return” and ranges from 0% to 18%. Five points are labeled on the graph: Cash (3 month T-bills) at 1%/2%; Bonds (U.S. agg) at 4%/5%; 60% stocks + 40% bonds portfolio at 9%/5% with a comment box that reads: Volatility reduction with a similar return profile; 60% stocks + 40% cash portfolio with a comment box that reads: Going to cash means reduction in return, with no meaningful reduction in volatility; and Stocks (S&P 500) at 15%/5%.

Volatility is a statistical measure of the dispersion of returns for an investor. Two points here. First compare the annualized volatility for stocks - represented by the maroon diamond - to the annualized volatility of a balanced portfolio that includes 60% in stocks and 40% in bonds.  That balanced portfolio is represented by the green diamond.

Notice how the volatility of the balanced portfolio is much lower than that of the all stock portfolio, providing investors with a much smoother ride over this 20-year period.

Second, note how a stock investor that held a 40% allocation in bonds, again represented by the green diamond, outperformed a stock investor that held a 40% position in cash. That stock/cash blend is represented by the blue diamond just below the green one.

While past is not always prologue, it is important for investors to keep this historical return difference in mind as they consider the potential role for both bonds and cash in their portfolios

A key question for every investor to ask as he or she builds his or her portfolio is where do I want to be on the risk and return spectrum?

Text on screen: Investor risk tolerance

Image: A graph of risk on the x-axis and potential return on the y-axis, with four points increasing from left to right: government bonds, agency mortgage-backed bonds, investment grade corporate bonds and high yield corporate bond.

As we discussed earlier, certain investments in the bond market like government bonds are defensive, whereas certain parts of the corporate bond market for example pay higher yields, but also expose investors to additional risks.

Some additional considerations as you wade deeper into the bond market waters. There are 344,000 issuers in the global bond market.  A major corporation may have one class of common stock, and at the same time, have over 30 different bond issues outstanding. -- Each with slightly different terms and legal protections. Picking the right bond requires extensive due diligence, analytics, and technology. And If you want to take full advantage of the global opportunity set, you need those resources on the ground in various regions and time zones. Complexity therefore creates challenges, but it also leads to opportunities.

Text on screen: TITLE -- Why active for bonds? SUBTITLE – Active bond managers have a solid track record relative to their passive peers.

Image: A bar graph showing percentage of active funds within each category hat outperform the passive median fund (10 year), with blue representing Morningstar Fixed Income Categories on the left and green representing Morningstar Equity categories on the right. The left bars include Intermediate Core & Core-Plus (84%), short-term bond (63%), high yield bond (83%), Ultrashort bond (100%), with multisector bond showing 0%. The right bars include large blend (19%), large growth (20%), large value (15%), foreign large blend (61%) and diversified emerging markets (76%).

And because of this complexity, active management tends to work really well in the bond market. Here you see the historical track record for that.

84% of active bond managers in Morningstar’s Intermediate Core and Core Plus categories outperformed the median passive fund over a 10 year period. In the Ultrashort bond category, 100% of active bond managers outperformed the median passive fund.

At $110 trillion, the global bond market is massive and full of opportunity. We covered a number of important terms and definitions today and learned that bonds can help us protect our principal and generate income. They also provide us with valuable diversification relative to equities and other risk assets.

Thank you for your time. For additional resources and education, please visit pimco.com/advisoreducation.

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Disclosure

IMPORTANT NOTICE

Please note that this material contains the opinions of the manager as of the date recorded and may not have been updated to reflect real time market developments. All opinions are subject to change without notice.

A Word About Risk: Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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