The What, Why, and How of Investing in Bonds

The What
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 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.
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.
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.
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.
The How
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.