Based on FunMoney Podcast Episode
I mean, seriously...what is up with bonds? Most people I know have some working knowledge about what bonds are and how they work. Still, recent pains in both the stock and bond markets have many wondering what is going on.
The typical investor has somewhere between 5-50% of their money in the bond market. Conventional investment wisdom suggests that bonds provide both stable value and an income stream to counterbalance the more risky stock market investments in your portfolio.
Yet for months now, investors have been pained by their performance reports when they see that BOTH their stock and bond holdings are down, leaving many to wonder just what is happening with bonds and should they be concerned.
Some Bond Basics
Contrary to popular belief, a Bond is not merely the surname of a legendary MI6 agent (rimshot?). Bonds are debt instruments – essentially loans. Think of it this way. Suppose I ask to borrow $1000 from you and promise to pay you $50 per year for the next five years, then return the original $1000. If I am an organization, then I just described a bond with a 5% coupon (interest payment).
Bonds are considered more stable than stocks for two reasons. First, consider your monthly budget. As you prioritize spending, the top of the list will be any debts you owe like your mortgage and car payments. Corporations are no different, prioritizing debt payments to maintain a good credit rating.
Furthermore, should a corporation default and ultimately file bankruptcy, they will be forced to liquidate their assets. Debts are settled as much as possible with bond holders first. If stock holders get anything, it is only after bond holders have received their payout.
How Are Bonds Priced
The initial price is quite simple. Bonds commonly have an initial price tag of either $100 or $1000[1] each. However, preowned bonds are much more complicated. Things like interest rate changes and shifts in credit rating on the issuing company can affect a bond’s price on the secondary market. As that price changes, so does something called Yield to Maturity (YTM), or the interest income an investor will make if he purchases the preowned bond and holds it to maturity.
What’s Affected Pricing
Let’s go back to my money lending example. Suppose you want your money back sooner than five years. What could you do? One option is to sell the bond to someone else. Theoretically, someone could just give you $1000 and take over receiving the income payments until the money is returned. But what if interest rates have changed? What if new bonds have a 6% coupon? Suddenly, your bond isn’t quite as attractive. Why would I give you $1000 for a 5% coupon when I can get a 6% coupon on that same $1000?
That is exactly what the bond market has been experiencing lately. At a time when the stock market has lost considerable value, our economy has been running red hot, driving inflation to levels we’ve not seen in decades. In response, the Federal Reserve has been raising interest rates in an attempt to slow inflation.
Any companies wanting to raise money by issuing bonds must do so at these higher interest rates. If the bonds you hold in your investment portfolio are paying less interest than new bonds, then to sell them you must do so at a discount to be competitive.
But what if I don’t want to sell?
In that case, you’ll continue receiving the expected income and subsequent return of your original $1000 as promised. Yet in the meantime, your performance report will reflect the lower value of the bonds you currently hold. However, the closer you get to each bond’s maturity (when you get your money back), the bond’s value will rise closer and closer to its par value.
How Does this Impact Bond Mutual Funds and ETFs?
Bond Funds, including both Mutual Funds and Exchange Traded Funds (ETF), work much the same. Since bond funds are a collection of hundreds or even thousands of bonds, their pricing and income will follow whatever is happening in the interest rate world.
The big difference here is that, since you do not directly own these bonds, it is difficult to ascertain exactly what your income will be from the ETF over a stated period of time. An estimate could be made based on the average YTM of the bonds held in the fund, but even that is a best-guess since the fund will likely buy and sell bonds regularly, making the average YTM a moving target.
While bond funds offer great diversification and liquidity, that comes at the cost of higher expenses and imprecise expected returns.
What do I do Now?
You’ll definitely want to freak out, sell everything, and live in a cave. Alternatively, you can stick to a good strategy. Remember, bond pricing may fluctuate, but by their nature, that pricing will recover the closer bonds get to maturity. Be careful not to allow emotions to lead to bad short-term decisions with damaging long-term consequences.
Additionally, consider discussing your potential to harvest losses with your financial advisor or accountant. Tax-loss harvesting involves selling investments at a loss, then netting those losses against investment gains and/or income to reduce tax liability.
Bonds can be a great part of a long-term investment strategy, so it’s important to know how they work. While recent dips in bond pricing may have some spooked, a prudent investor should take a long-term approach that understands how they got there, how they’ll recover, and what, if any, moves to make along the way.
Josh Hargrove is a CERTIFIED FINANCIAL PLANNER™ professional with more than ten years in the business. His practice emphasizes objective financial planning and investment management. For more information about Josh, and the firm he represents, visit www.insightwp.com.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements. Individuals should consult with a qualified tax professional or CPA for any tax advice.
[1] While these figures represent the most common “par value,” an initial issue bond purchase could still be made at a premium or discount depending on a number of factors.