Do bonds belong in your portfolio?
They belong in mine, and I’ve held about 10% of my portfolio in bonds since I came up with my first basic Investor Policy Statement. It’s not a large percentage, but it’s enough to make me feel at least a little bit protected when the stock market does lose value, which it tends to do about 30% of the time.
There are many ways to invest in bonds. You can purchase individual bonds or you can buy them in bunches with an ETF or mutual fund. You can buy short-term or long-term bonds and many durations in between. They can be of the corporate, municipal, or federal variety, and some federal treasury bonds, known as TIPS, are inflation-protected.
I’ve taken the route of simplicity, owning about 20,000 different bonds via Vanguard’s Total Bond Fund.
The creator of the excellent IQ Calculators site penned this piece to explain in plain and simple terms how bonds work and why you should consider owning them in your portfolio. This is his second guest post on the site, having shared an article on tax-advantaged charitable giving, Giving Faceoff: Charitable Remainder Trust (CRT) versus Donor Advised Fund (DAF), in 2018.
Why Bonds Belong in Your Portfolio
Bonds are a debt investment where the investor lends capital to the borrower in exchange for a fixed rate of interest.
While a bond is held, it will typically make interest payments to the lender. The interest is paid periodically up until maturity by what is called a coupon. If there is no coupon payment, then the bond will be purchased at a discount to par value so that as time goes by, the bond appreciates as it gets closer to its maturity date. This bond’s appreciation replaces the interest earned by the periodic coupon payment. This is what is known as a zero coupon bond.
If a bond is held until maturity, then the rate of return the investor can expect is called the yield to maturity. Maturity is the moment in time when the borrower must return the lender’s original capital as laid out in the bond’s contract. The rate of return an investor expects to receive if held to maturity is called the yield to maturity. The yield to maturity is the rate the investor will receive barring some other negative event like the company going bankrupt or the bond getting called (more on call risk below).
Bond Price vs Interest Rates
It is important to understand that a bond’s price will move while you own the bond. A bond’s movement in price is usually due to a change in underlying interest rates, but it may also change due to the public’s trust in the company’s ability to pay back the debt and continue as a going concern.
Assuming the bond’s price moves due to interest rates…a bond’s price will move inversely to interest rates. For example, if interest rates rise, then the price of the bond will decrease. Conversely, if interest rates decrease, then the price of the bond will increase.
The reason that a bond’s price moves inversely to interest rates is because the lower the interest rate environment, the lower the yield one should expect to receive from a bond. Thus, the market will require a higher price for the bond, thus decreasing the yield to be in line with the market interest rates.
Buying A Bond At a Discount Versus a Premium
When buying a bond in the open market, the bond will either be purchased at a premium to par value or a discount to par value. All that this means is that the purchase price will either be above or below the par value.
What is par value? Par value is the nominal or standard value of a bond as it is laid out in the contract of the bond. Usually, this is an even number like $1,000 or $10,000 depending on how large of increments the bond is sold in. The par value is the value the bond is issued at (in most cases) and the value at which it is redeemed at maturity.
Buying a bond at a discount creates the opportunity for a greater return than the rate of the coupon payment. This is made possible by the bond appreciation towards the par value as the bond gets closer to maturity. Remember, the bond will be redeemed at par value. Conversely, buying a bond at a premium will decrease the rate of return below the rate of the coupon payment.
Duration vs Volatility
It is often misunderstood that bond prices are not volatile. This is not always true as bond prices can be quite volatile. But it is important to understand that if an investor’s intention is to hold the bond to maturity, then volatility won’t play a factor in the investor’s decision making process. This is because the final price at maturity will be par value, regardless of the volatility before then.
If volatility does play a role, then it is important to understand that longer duration (synonym for time until maturity) bonds are more price sensitive to interest rates. A one percentage point move in interest rates in either direction can make a bond with a duration over 10 years move quite significantly whereas it may only cause a short term bond’s price with 3 years until maturity to barely move.
If you are investing with hopes that the bond’s price will go up so you can sell it at a gain at some point in the future, then the prediction/hope is that interest rates will decrease in the future. In this case, it would be more strategic to purchase a longer duration bond to capitalize on a larger increase in the bond’s price.
Risks of A Bond Being Called
When purchasing a bond, the investor should research whether the bond is callable. A callable bond means that the bond can be called by the company issuing the bond at which time they would return the capital to their investors at par value. The primary reason this sometimes takes place is so that the company can refinance their debt at a lower rate by reissuing new bonds. The risk this presents to the investor is that they will not have received the future coupon payments were the bond held until maturity. Rather, they will likely have to go back to the market to purchase a new bond, which will likely have a lower yield to maturity.
The second risk(and larger risk) is only a risk if the bond was bought at a premium above par value. If this was the case, the bond return will be purchased back by the borrower at par value which could potentially create a negative rate of return. When interest rates are low, bond prices tend to be higher, which makes this risk more common in a low interest rate environment.
If this risk is present, it is best to calculate a yield to maturity as well as the yield to worst. The yield to worst is the yield that is the worst possible given the possibility of the bond getting called.
Should Bonds Be A Part of Your Investment Strategy?
Bonds should definitely be a part of every investors long term strategy. Bonds add a degree of diversification that equities/stocks cannot offer. The reason bonds make a great diversification tool is because interest rates are often moving downward at the same time that the economy is slowing and stocks are potentially decreasing in value. If interest rates are decreasing, the value of a bond portfolio is likely increasing which can create a natural hedge against stock market volatility. It doesn’t always work like this but it can in most cases.
Second, although bonds can have volatility, most bonds are not as volatile as the stock market. This offers the portfolio greater stability.
And lastly, bonds can be a great income strategy both before and in retirement. Because most bonds pay interest via periodic coupon payments, the coupon payments create a natural income strategy for retirees.
Bonds are another tool every investor should understand so that they can add it to their investing tool belt. By understanding how bonds work and behave in different interest rate environments, it can help an investor better position their portfolio and reduce volatility risk to the portfolio.
Are bonds a part of your portfolio? At what percentage? What stage of life are you in (early career, late career, retired, etc…)?