Why are bonds so important?

Now We Turn To Bonds

Stocks tend to hog much of the limelight when it comes to investment coverage as people are lured by the promise of skyrocketing returns, leaving bonds languishing as the forgotten and unloved counterpart. While bonds lack the showmanship and panache that stock investing brings to the table, they play a vital role in balancing investment portfolios and helping people keep money available for shorter-term needs.

Bonds lower risk, lower reward mantra has failed to grab quite as many headlines over the years. Despite this, their popularity has exploded, as the trend towards lower rates makes financing cheaper than ever for governments and corporate borrowers alike. Estimates suggest the global bond market has more than tripled in size in the past 15 years and now exceeds $125 trillion. By contrast, the global stock market has an estimated value of around $71 trillion. The bond market’s relative size signifies the vital role it plays in the financial industry, even if it doesn’t function as the default talking point for many investors.

What Is A Bond?

A bond is simply a loan given to a government or company by an investor who, in return, is paid interest on the money they have loaned. Like a loan, a bond pays interest periodically and repays the principal (original invested amount) at a stated time in the future, known as maturity.

When you own a share of Microsoft, you become a partial owner of the company. As an owner, you get to participate in the company’s profits. Bondholders don’t share in a company’s profits. The interest and principal they receive doesn’t change, no matter how profitable the company is. This results in a more steady and consistent income stream for investors. Bonds are typically viewed as less risky investments, but like any investment, they are not without risk. For instance, there are rare cases, such as bankruptcy or default, in which a bondholder’s payments may be changed or cancelled.

Fixed Rate Bonds

Bond issuers offer an interest rate to investors known as a coupon rate. This coupon rate is dependent on the bond’s maturity, prevailing market interest rates, and creditworthiness of the underlying issuer. It’s expressed as an annual percentage of the face value. A 3-year $1,000 bond with an 8% semi-annual coupon pays $80 of interest every year in two $40 installments, repaying the original $1,000 principal after 3 years.

Floating Rate Bonds

An alternative to the fixed-rate bond example above is a floating or variable rate bond. The initial coupon rate will be set as a percentage spread over a benchmark, for example, LIBOR +0.5%. Instead of the fixed 8% as per the example above, the coupon rate will be 0.5% more than LIBOR (London Interbank Offered Rate), regardless of what LIBOR is. This allows the coupon rate to rise and fall as interest rates change. LIBOR will reflect the prevailing market interest rate, so if LIBOR increases from 1% to 3%, your interest rate payments will change from 1.5% to 3.5%. As a result, floating-rate bonds have significantly less interest rate risk exposure relative to fixed-rate bonds as their coupon rates change as the prevailing market interest rate changes.

Zero Coupon Bonds

Finally, zero-coupon bonds pay no interest until maturity. Instead, investors buy zerocoupon bonds at a discount and then receive the full face value when the bond matures.

Government Bonds

These are bonds issued by a national government, denominated in the country’s own currency. Government bonds are usually referred to as risk-free bonds, given a countries ability to print money or raise taxes to avoid any potential bankruptcy.

The most common government securities are those issued by the U.S. Government and are referred to as Treasury securities. These government bonds are available across a wide range of maturities, each offering different potential returns.

Given the “risk-free” nature of these treasury securities, broadly speaking, a sharp downturn or an economic crisis won’t hurt their performance. In fact, an economic crisis may help performance as market uncertainty results in a “flight-to-safety” from risk assets like stocks into quality bonds. This uncorrelated relationship with risk assets makes safe-haven bonds such as U.S. Treasuries an important component when diversifying your portfolio.

Short-term bonds such as Treasury-bills provide portfolio liquidity but offer little upside potential. Longer-term bonds are considered riskier because there’s a greater likelihood that adverse events, such as rising interest rates and inflation will hurt the bond’s value during its lifetime. To compensate for this, these longer-term bonds typically offer higher coupon rates.

Treasury bills mature in up to 52 weeks. These are zero-coupon bonds sold at a discount to par.
Treasury notes mature between 2-10 years with interest paid every six months
Treasury bonds typically mature between 10–30 years with interest paid every six months.

Corporate Bonds

These are bonds issued by companies to raise money for business purposes, e.g., to expand operations or fund new business ventures. Corporate bonds typically represent a greater propensity to default as companies can and do go bankrupt. As a result, they often offer higher coupon rates relative to government bonds to compensate for this default risk. Corporate bonds fall into two broad categories:

Investment Grade Bonds

These bonds are believed to have a lower risk of default and, as a result, receive higher ratings of Baa/BBB or above from the credit rating agencies. These bonds tend to be issued at lower yields than less creditworthy bonds.

Non-Investment Grade Bonds

These bonds, also referred to as high-yield or junk bonds, are considered low quality as the issuer has a higher probability of default. Non-investment grade bonds have credit ratings of Baa/BB or below and offer higher yields to compensate for the greater risk.

It is imperative that investors understand the differences between the two as the financial health of issuers can vary significantly across the two categories.

Credit Rating Agency Scale

Credit rating agencies such as Moody’s and Standard & Poor’s assign ratings to bonds based on their overall risk. These agencies evaluate issuers’ creditworthiness based on criteria such as the issuer’s track record of repaying its debt. Based on its rating, a bond qualifies as either investment-grade or non-investment-grade.

These ratings help bond investors to gauge the financial strength of the bond issuer. As previously mentioned, non-investment-grade bonds are considered lower quality. As a result, investors will need to be offered a higher coupon rate to entice them to take on the excess risk, hence why they’re also called high-yield bonds.

Rating agencies can downgrade or upgrade a company’s rating, so monitoring a bond’s rating is essential. If a bond is sold before it reaches maturity, any change in a bond’s rating can affect the price others are willing to pay for it.

Credit Spreads

Credit spreads can be used when comparing different categories of bonds. Credit spread refers to the difference in return (yield) between two bonds with the same maturity but with different credit ratings.

For example, if the 10-year U.S. Treasury note is trading at a yield of 1% and a 10-year corporate bond is trading at a yield of 5%, the corporate bond is said to offer a 400-basis-point spread over the Treasury. Again, this 4% spread is compensation for the extra risk incurred by holding the less creditworthy corporate bond — the more volatile the economic outlook, the wider the credit spread.

Others

While government and corporate bonds issued in developed market hold much of the market share.

Other fixed Income options exist and are becoming increasingly popular as government bond yields remain zero-bound, offering little upside for new investors.

Emerging Market Debt

Sovereign (bonds issued by a national government in a foreign currency) and corporate bonds issued in developing countries are also known as emerging market bonds. Given the variety of countries involved, there is a large disparity in the growth prospects of different emerging market bonds. These bonds usually offer very attractive yields and pose unique risks such as currency fluctuation and political unrest.

Mortgage-Backed Securities

These are groups of home mortgages that are pooled together and sold as a single security. Mortgage lenders sell individual mortgage loans to another entity that bundles those loans into a security. This new security pays an interest rate similar to the mortgage rate being paid by the homeowners. MBS, like all other bonds, are sensitive to changes in prevailing interest rates.

Agency MBS are backed by the U.S. government as guarantors, offering credit comparable to U.S. Treasury securities.
Non-agency MBS are more exposed to the credit quality of the U.S. consumer and their probability of default on the underlying mortgages. Many of these non-agency loans were the “subprime” loans that gained notoriety during the 2008 financial crisis.

Risks

As discussed, some fixed income securities will be riskier than others, but all bonds come with some element of risk.

Default Risk/Credit Risk

The possibility that the issuer will be unable to make the required interest and principal payments when they are due. The higher the default risk, the higher the coupon rate. The amount of risk depends on the financial stability of the issuer. For example, most governments are relatively stable issuers and issue bonds with low coupon rates as a result.

Interest Rate Risk

The potential for investment losses that result from a change in market interest rates.

Before diving any deeper, it’s important to remember that a bond’s price and market interest rates move inversely (in opposite directions). As interest rates rise, the value of the underlying bond falls, and vice versa.

This makes perfect sense when we think about it logically. When market interest rates rise, more investors will want to invest in these newly issued, higher interest rate bonds. If you are looking to sell your old, lower interest rate bond during this time, you would need to sell your bond at a discount to make it a worthwhile purchase for another investor, hence, the reduction in bond values as interest rates rise.

Nobody wants your second-hand banger of a car if there is a shiny new one in the showroom for the same price.

Duration quantifies the amount of interest rate risk a bond is exposed to. The higher a bond’s duration, the more sensitive its price is to interest rate changes. For instance, if interest rates rise by 1%, the price of a bond with a duration of 4 will fall by 4%.

While some bonds, such as U.S. treasuries, are virtually devoid of any credit risk, all fixed-rate bonds will have a sensitivity to interest rate changes. Generally speaking, long term bonds will be exposed to more interest rate risk than short-term bonds.

Price fluctuations caused by changes in interest rates are only relevant to individual bondholders who sell before maturity. As long as you hold your bonds until maturity and the issuer doesn’t default, you will receive your full principal back, plus interest, regardless of the market price fluctuations experienced between issuance and maturity dates. As a result, interest rate fluctuations should make little difference to a buy-and-hold investor intent on keeping the underlying bond until maturity.

Inflation Risk

Broadly speaking, bondholders will suffer when inflation surges as this inflation will erode the purchasing power of the fixed payments you receive. Longer-term bonds will face more significant inflation uncertainty, which is reflected in the higher return on offer.

To reduce inflation risk, investors may choose to invest in floating rate bond. As inflation rises, market interest rates rise. As previously discussed, the coupon rate of floating rate bonds moves in tandem with market interest rates. As a result, the coupon on the the underlying floating rate bond will rise as market interest rates rise in response to higher inflation, thereby reducing your exposure to inflation.

Why invest in bonds?

Capital Preservation

As discussed, some fixed income securities will be riskier than others, but all bonds come with some element of risk.

Income

Most bonds provide bond holders with a fixed income stream on a scheduled basis.

Capital Appreciation

While capital appreciation is more synonymous with stocks, it is not exclusive to the stock market. As mentioned above, bond prices can rise for several reasons, including a drop in interest rates or an improvement in the issuer’s credit rating. By selling bonds prior to maturity, investors can benefit from capital appreciation following a rise in the bond price.

Diversification

Historically speaking, bonds have had a low correlation to stocks, meaning their value is often up when stocks are down. Because of this, high-grade corporate bonds and especially U.S. Government bonds, can be beneficial for diversifying the risks of owning stocks.

Slower economic growth usually leads to lower inflation, which makes bond income more attractive. An economic slowdown is also typically bad for corporate profits and stock returns, adding to the attractiveness of bond income as an alternative source of return.

Changing Face Of Fixed Income Investing

The recent economic upheaval has acted as a catalyst for change across many areas of investing. Arguably the most substantial of these is the fundamental changes to the traditional asset allocation approach.

The risk parity relationship between Equity and Treasury Bonds (mentioned on the previous page) has now seemingly broken down as the long standing incentives for owning treasury bonds have evaporated from an incomegenerating and capital appreciation standpoint given the low yields on offer across the bond universe.

In portfolio construction, retail investors have often gravitated towards a 60/40 asset allocation split (a portfolio made up of 60% equity and 40% bond exposure). Safe-haven bonds have historically functioned as the traditional counter to equity headwinds, ensuring that a blend of the two uncorrelated assets would lead to broad-based portfolio diversification over the longer term.

However, recent monetary stimulus has created a challenging landscape for fixed income, with Treasuries offering interest rates close to zero, all but eliminating their upside potential. (remember bond prices fall as interest rates rise)

The diversification and capital preservation benefits of these safe-haven bonds have not gone away, but longer-term investors may want to be underweight traditional fixed-income as the economy re-emerges, opting instead for alternative investments such as private equity and real estate to generate acceptable returns while still availing of adequate portfolio diversification.

Next up, we explore the merits of these different alternative investments in more detail.

FAQs

Why are bonds so important? - Holdun? ›

Bondholders don't share in a company's profits. The interest and principal they receive doesn't change, no matter how profitable the company is. This results in a more steady and consistent income stream for investors.