Understanding Bonds – And Is It Time To Invest In Bonds?

Most people understand stock investment but investing in bonds is… well, confusing. Part of the confusion comes from the interplay of the interest that the bond pays versus the price of the bond. But another aspect of confusion comes from the words used in bond investment that can seem like a totally different language that requires a translator for the average investor.

 

The foundations of a healthy investment portfolio for retirement are diversification and balance. Diversification means owning stocks or bonds in a lot of different companies. The simplest way to achieve diversification is to invest in a broad sector index mutual fund, for example, an S&P 500 index fund for stocks. Balance means maintaining a desired percentage of stocks versus bonds in your portfolio. A simple way to achieve balance is to own a target retirement mutual fund that frequently buys and sells stocks and bonds in order to keep a fixed percentage of stocks and bonds; the fund then adjusts that percentage each year as you get closer to retirement. If you are the kind of person who does not want to put a lot of time into investing, then a target retirement mutual fund that is composed of index stock funds and index bond funds is for you – no investment expertise is required and the annual expenses are low.

But if you invest in individual stocks or stock mutual funds, then it is up to you to ensure that your portfolio is diversified and balanced. This is particularly the case if you are invested in a 401(k), 403(b), or 457 plan that does not offer target retirement mutual funds as an investment option. This then raises the question of when is the best time to re-balance your portfolio by buying or selling bonds? To answer that question, one must first understand the basics of bond investing.

Bond investing 101

Terminology

When you purchase a corporate bond, you are loaning a company money for a specific amount of time and in return, that company will pay you interest every year until the loan is paid off. A government bond is similar – you are loaning the government money for a specified amount of time and in return, the government pays you interest every year until they repay the loan. So, if you purchase a 30-year bond at 3% interest, then the company or government will pay you 3% of the value of the bond every year for 30 years and at the end of the 30 years, you redeem that bond and get back the amount of money that you originally paid for the bond. This is exactly what happens if you purchase a bond, hold it for the entire duration of the bond, and then redeem it at the end of that period of time. However, most people do not purchase a bond and then hold it for the entire duration, instead, most people resell and buy bonds in a secondary market. And this is where the terminology gets complicated. Let’s take a look at some of the words used in the language of bonds. To illustrate these terms, let’s take an example of a bond that is initially sold for $1,000, pays 6.0% annual interest, and has a duration of 10-years before it will be redeemed. Two years after the initial purchase, the bond is then re=sold on a secondary market for $900.

• Maturity. This is the amount of time until the bond is redeemed. Think of this as the duration of a loan. In the example above, the maturity is 10 years when the bond was initially purchased but 8 years when it was re-sold on the secondary market.
• Par. This is the original face value of the bond when it is first issued. It has absolutely nothing to do with golf. In the example above, the par value is $1,000. This is also the amount that the buyer of the bond is paid by the bond issuer at the end of the maturity period ($1,000).
• Coupon. This is the dollar amount of annual interest that is paid by bond. The amount of interest is set at the time that the bond is first issued and is then fixed for the entire duration of the bond. In the example above, the coupon is $60 ($1,000 x 6.0%).
• Coupon rate. This is the amount of annual interest (coupon) paid each year expressed as a percentage of the initial purchase price (par value) of the bond. In the example above, the coupon rate is 6.0%. In simplest terms, the coupon rate is the interest rate.
• Price. When a bond is re-sold on a secondary market, this is the amount that that bond sells for. Bond prices fluctuate and so the price is usually not the same as the par value. In the example above, the price of the bond was $900 when it was re-sold. When the price is lower than the par value, it is said to be sold “at a discount”. When the price is the same as the par value, it is said to be sold “at par”. When the price is higher than the par value, it is said to be sold “at a premium”. Importantly, regardless of the price paid for a bond in a secondary market, the redemption amount of that bond will still be the bond’s original par value. So, in the example above, the person who bought the bond at $900 would be paid $1,000 when they cash it in at the end of 8 years in addition to being paid $60 in interest in each of those 8 years. To take into account both the change value of a bond when it is eventually redeemed as well as the value of the annual interest payments until it is redeemed, we need another measurement and this is where “yield” and “yield-to-maturity” come into play.
• Current yield. Here is where bond terminology gets even more complicated. In simplest terms, the current yield is the coupon divided by the current price. Think of it as a way of adjusting the effective interest rate when the price of a bond varies. In the example above, the yield of the bond when it was resold was 6.7% ($30 ÷  $900). The current yield will fluctuate as the bond price fluctuates on the secondary market. A key point to understand about bonds is that there is an inverse relationship between a bond’s price and its yield. When the price goes down, the yield goes up and vice-versa.
• Yield-to-maturity. This is expected annual rate of return earned on a bond under the assumption that the bond is held until maturity and all annual interest is re-invested at the same interest rate. Think of it as the effective interest rate when the current price paid on the secondary market for a bond is different than the original par value of that bond. The calculation is illustrated in the equation below and shows that in our example, the yield-to-maturity is 7.6% when the bond is re-sold at $900 with 8 years of maturity left. For simplicity, you can also use an on-line calculator to determine the yield to maturity of a bond. The good news is that bond mutual funds will normally calculate the average yield-to-maturity of all of the component bonds that it holds and the mutual fund will update the fund’s yield-to-maturity number on-line regularly.

Types of bonds

The term “bond” is fairly generic and is often used to describe a lot of different forms of loans that investors can make to corporations and governments. A more accurate, all-encompassing term is “securities”. Here is a list of some of the more common types of securities:

• Treasury bills. These have a maturity of less than 1 year. Currently, the U.S. Treasury offers bills of 4-week, 8-week, 13-week, 17-week, 26-week, and 52-week maturities.
• Treasury notes. These have maturities between 1 year and 10 years. Currently, the U.S. Treasury offers notes of 2-year, 5-year, 7-year, and 10-year maturities. The 10-year Treasury note (10-year T-note) is often monitored by investors as representative of the overall U.S. government bond market.
• Treasury bonds. These have maturities between 10 years and 30 years. Currently, the U.S. Treasury offers bonds of 20-year and 30-year maturities.
• Treasury inflation-protected securities (TIPS). These have variable interest rates that fluctuate based on the current inflation rate. The U.S. Treasury currently offers TIPS of 5-year, 10-year, and 30-year maturities.
• Floating rate notes (FRNs). These have a coupon (interest rate) that moves up or down based on the most recent coupons of Treasury bills sold at public auction. The U.S. Treasury currently offers FRNs with a 2-year maturity.
• Government National Mortgage Association (GNMA) securities. These are bonds sold by the GNMA (an agency of the U.S. Department of Housing and Urban Development) to provide money to buy mortgages from banks and other mortgage lenders. These are mortgages that are insured by the Federal Housing Administration (FHA), which typically insures mortgages to first-time home buyers and and low-income borrowers. Think of a GNMA security as a bundle of a lot of different mortgages.
• Municipal bonds. These are bonds sold by state and local governments and are tax-free for federal income tax and state income tax from the state that the bond was issued from. Because the interest is tax-free, municipal bonds pay lower interest rates than other government bonds.
• Corporate bonds. These are sold by private corporations. Because companies can go out of business before the bond maturity date, they are considered riskier than government bonds and consequently pay higher interest rates than Treasury bonds. The interest rate is affected by the company’s credit rating. “Junk bonds” are issued by companies with a low credit rating and pay higher interest rates than other corporate bonds because of the higher risk that the company will go out of business.
• International bonds. These are bonds issued by non-U.S. corporations and governments.

The individual investor can either purchase bonds directly or purchase shares of a bond mutual fund. The U.S. Treasury regularly auctions off bills, notes, bonds, TIPS, and FRNs through the TreasuryDirect website. Individual investors can create a TreasuryDirect account through which they can bid on and pay for these auctioned bills, notes, and bonds. They can also be purchased through a bank, broker, or dealer if you do not want to bid through a TreasuryDirect account. Once you own one of these securities, you can sell them on the secondary market if you wish.

Most people prefer to purchase shares of bond mutual funds rather than buy and sell individual bonds. This adds another layer of bond complexity because a given mutual fund will contain many different bonds with different coupon rates and different maturity dates. This is where the yield-to-maturity value can be helpful because it allows the mutual fund to express the overall average yield-to-maturity of all of the component bonds when the fund is composed of bonds of varying coupon rates, prices, and maturities. Bond mutual funds are categorized based on the average maturity dates of the component bonds and are typically classified as short-term (average maturity about 2-3 years), intermediate-term (average maturity about 6-8 years), and long-term (average maturity about 22-23 years). Bond mutual funds may be composed of corporate bonds, government bonds, or a mix of both so it is important to look at the composition of each bond mutual fund.

The 2 major risks with bonds

Inflation and a future rise in interest rates are the two main risks of bonds. If the inflation rate of the U.S. economy is higher than the coupon rate of a bond, then over time, the owner of the bond actually loses buying power. Inflation is perhaps best measured by the consumer price index (CPI) which is the average amount that consumers pay for common goods and services. The U.S. Bureau of Labor Statistics website reports the CPI. Since 1958, the CPI has averaged 3.7% but as shown in the graph below, it has varied from a low of 1.0% in 2010 to a high of 12.4% in 1980. The Federal Reserve strives to keep inflation at 2% by using its monetary policy, which includes adjusting the Federal funds rate (the interest rate charged for banks to lend each other money overnight to maintain liquidity). For 25 years (from 1995 – 2020), the Federal Reserve’s monetary policy worked quite well and kept inflation at an annual average of 2.1%. The COVID pandemic was highly disruptive economically, however. As a result, during 2022, the CPI increased 6.2%, giving 2022 the highest annual inflation rate in 40 years.

Rising interest rates is the second major risk of bonds. Let’s say you have a bond with a par value (i.e., initial purchase price) of $1,000 that has a coupon rate (interest rate) of 3.0% with a 30-year maturity. Plugging those numbers into the yield-to-maturity formula above, the YTM on the day that you first purchased the bond was 3.0% (the same as the coupon rate). Now let’s say that 5 years later, the coupon rate (interest rate) for new bonds being issued has increased to 5%. If you want to sell that bond that you bought 5 years earlier, no one is going to pay you $1,000 for it because it would still have a yield-to-maturity of 3.0% whereas a newly issued 30-year bond would have a yield-to-maturity of 5.0%. Therefore, to find a buyer for that older bond, you would have to drop the price below the par value (initial purchase price) of $1,000. If you do the math, you would have to drop the price of the bond to $700 in order to give it the same yield-to-maturity as a newly issued bond. In other words, over the 5 years that you owned the bond, you would have made $150 in annual interest but you would have lost $300 when you sold the bond. This illustrates why it is not advisable to buy bonds just before interest rates are hiked up.

The corollary of this is that it is a good time to buy bonds if (1) inflation remains lower than the coupon rate of the bond and (2) interest rates are about to fall. In other words, when you buy a bond, you are betting that the bond’s yield is higher than the future inflation rate. You are also betting that the bond’s current yield is higher than coupon rate for bonds sold in the future.

How bond interest rates are determined

In a pure free market setting, interest rates would be governed by supply and demand. When demand for bonds is low, corporations and governments have to pay higher interest rates to entice people to buy their bonds. Conversely, when demand is high, corporations and governments can drop interest rates and still sell plenty of bonds. However, there are a number of non-free market forces that have a profound effect on bond interest rates (coupon rates). One of the most important is the Federal Reserve lending rate (funds rate). This is the rate that the Federal Reserve sets for banks to charge other banks to lend money, usually for overnight loans to maintain liquidity.

The Federal funds rate has a profound effect on short-term bond yields but has less effect on long-term bond yields. In the graph below, the Federal funds rate set by the Federal Reserve is in blue and the market yield for the 6-month Treasury bill is in purple. The two lines match almost exactly, illustrating the close relationship between the Federal funds rate and short-term bond yields. The market yields for 5-year Treasury notes (a form of intermediate-term bond) is in red. The graph shows that intermediate-term bonds are also affected by the Federal funds rate but the relationship is not as tight as with short-term bonds. The market yield of 30-year Treasury bonds (a long-term bond) is in green and this shows even less correlation with fluctuations in the Federal funds rate. The reason for these relationships is that short-term bond yields reflect current interest rates and inflation whereas long-term bond yields reflect what investors think will be future interest rates and inflation.

The current yields on U.S. Treasury bills, notes, and bonds are shown in the table below based on Federal Reserve data from August 16, 2023:

In addition to the Federal funds rate, there are several other variables that affect bond interest rates (and thus bond yields):

• Anticipation of future inflation. When investors believe that inflation will go up in the future, they are less willing to buy bonds unless the yields on those bonds rises, either because issuers of new bonds pay higher coupon rates (interest rates) or sellers of older bonds on the secondary market are willing to reduce the selling price of those bonds to below the initial par value (initial purchase price).
• Anticipation of future increases in market interest rates. Similarly, if investors believe that the coupon rates (interest rates) on newly issued bonds is likely to rise in the future, then they will be unwilling to buy old bonds with lower coupon rates on the secondary market unless the sellers of those old bonds drop the price below the par value (i.e., initial purchase price) of the bond.
• Anticipation of future fall in the stock market. If investors believe that stocks are about to lose value in the future, then they will often move money from stocks into bonds since bond prices are not as volatile as stock prices. This can increase demand for bonds and so unless there is a flood of new bonds being issued on the bond market, the price of bonds on the secondary market will rise, resulting in a drop in the yields of those bonds.
• Governments or corporations increase borrowing. This can happen if governments increase spending or decrease taxes. When corporations anticipate an increase in demand for their goods, they will also borrow more money in order to build factories, buy new equipment, or hire new workers. This happens during periods of economic growth. When a lot of new bonds are being sold, the supply of bonds can exceed the demand by investors resulting in corporations or governments having to pay higher coupon rates (interest rates) in order to entice investors into buying their bonds.
• Governments or corporations decrease borrowing. The opposite happens when companies and governments stop selling bonds resulting in a reduced supply of new bonds on the market. In this situation, investors may be willing to accept lower coupon rates (interest rates) to purchase new bonds. On the secondary market, bond prices then rise with a concurrent fall in yields.
• Wars and international political instability. The U.S. government is currently perceived as being among the most stable and reliable in the world. It is seen as one of the least likely to default on its debts (bonds) and therefore has a very high credit rating. When wars break out or there is the threat of political or economic instability, investors flock to U.S. Treasury securities given their perceived safety relative to other countries’ bonds. This can increase demand for Treasury bonds and thus reduce the coupon rates (interest rates) of new bonds sold at public auctions. A danger of U.S. legislative debt stand-offs and government shut-downs is that they can erode the U.S. credit rating, thus pushing up the interest rates that the Treasury must pay when issuing new bonds.

Nevertheless, U.S. Treasuries are currently considered to be the lowest risk bonds in the world and sell at lower yields than other bonds. In the graph below, 10-year U.S. Treasury note yields (green) are consistently lower than Aaa corporate bonds (red) and Baa corporate bonds (blue). This illustrates the maxim that credit ratings determine interest rates.

Is now a good time to buy bonds?

The current state of bonds

Currently, the yield-to-maturity of the Bloomberg U.S. Long Treasury Index is 4.1%; the intermediate Treasury index is 4.2%; and the short Treasury index is 4.7%. The corporate bond yield-to-maturity for companies with a high credit rating is running about 1% higher than U.S. Treasuries. The Bloomberg U.S. Aggregate Float Adjusted Index (a gauge of the total U.S. bond market, including both corporate and government bonds) has a current yield-to-maturity of 4.9%, midway between the Treasury and corporate values. Most total U.S. bond market index mutual funds should have a similar yield-to-maturity value – around 4.8% – 4.9%.

The inflation rate has been cooling off for the past several months. The consumer price index has increased 4.7% from July 2022 to July 2023. But for the past 3 months, it has only increased by a total of 0.8% and if that trend continues for the next year, then that would result in an annual inflation rate of 3.2%. Although not back to the Federal Reserve’s target inflation rate of 2.0%, it appears that the worst of inflation is behind us.

The Federal Reserve’s Federal Open Market Committee holds eight meetings each year. During those meetings, decisions are made about whether to change the Federal funds rate. Most analysts predict that the Committee will raise the Federal funds rate one more time this year and this would put it at about 5.6%. If inflation appears to be under control, this may be the peak in the Federal funds rate before the Committee eventually starts to lower the rate in another year or two. This implies that current coupon rates (interest rates) on newly issued bonds are likely also at or near their  peak values. Because new bond coupon rates correlate with bond yields when bonds are re-sold on secondary markets, this means that bond yields-to-maturity are also likely at or near their peak. Because bond yields are inversely correlated with bond prices, this additionally means that bond prices (and bond mutual fund share prices) are at or near the lowest point that they will be for the next few years.

Rebalancing your investment portfolio

I have covered investment portfolio balancing in a recent previous post. But in general, the stock-to-bond ratio (“balance”) in a retirement portfolio depends on two factors: the number of years to retirement (in other words, your age) and your tolerance for investment risk. An example of how these two factors affect your desired stock-to-bond ratio is shown in the graph below:

Since January 2023, the S&P 500 index is up 20% but the total U.S. bond market is only up 2%. As a result, investors who last rebalanced their retirement portfolios in January are now significantly out of balance with higher percentages of stock holdings than bond holdings. What this all of this means for the average investor is that now is a good time to buy bonds, whether that means buying newly issued U.S. Treasury securities or buying shares of bond mutual funds. I am normally not a fan of “market-timing”, that is, making investment decisions based on when you think the market is at a high or low. However, the bond market is undeniably attractive right now.

Perhaps the safest strategy is to do a checkup of your portfolio now to determine your current actual stock-to-bond ratio and compare that to your desired stock-to-bond ratio. Next, calculate the amount of money that you would need to re-allocate to bonds in order to re-balance your portfolio to your desired stock-to-bond ratio. Then spread out those bond purchases over the next 4-6 months, using a “dollar-cost averaging” tactic. As an example, say that your desired stock-to-bond ratio is 70%/30%. Because of the recent strong stock market and weak bond market so far this year, you now find that your actual stock-to-bond ratio is 75%/25%. To re-balance, you would then convert 1% of your stock holdings into bond holdings each month for the next 5 months. By spreading those conversions over 5 months, you avoid the potential pitfall of trying to time the stock-to-bond conversion to when you think the Federal Reserve will do its final Federal funds rate hike.

So, is now a good time to buy bonds? More than likely, the answer is… yes!

August 18, 2023