Do bonds have more fun?

You probably have some sense of what bonds are, but may wonder how they really work; if so, this note is for you. We’ll cover the long and short of bonds.

What is a bond?

A bond is a contract between a borrower (aka “issuer”) and a lender (aka “investor”) in which the borrower agrees to repay the funds in a structured manner. Typically, the borrower makes semi-annual interest payments (aka “coupon”) and then repays the principal in full when the bond matures. (That reminds me of the old Wall Street joke:  What’s the difference between a bond and a bond trader?  Bonds mature.)

Bonds are typically issued by:

  • US federal government
  • State and local governments (aka “municipal” or “tax-exempt” bonds)
  • Sovereign governments
  • Public agencies controlled by these governments
  • Private corporations

What are some important features?

  • Term — bonds last for different time periods, with maturities typically between two and 30 years. Longer term bonds have greater risk as the value of the bond is more sensitive to changes in interest rates and the investor has to wait longer to get her money back.
  • Creditworthiness — this is a measure of how likely a bond is to default. US Treasury bonds are the safest as they are backed by the “full faith and credit” of the federal government and its trusty printing press. Bonds issued by state governments in the US are considered almost as safe as US Treasuries as there is no legal mechanism for a state to default on its debts. Sovereign debts (i.e., those of foreign governments) may be significantly less safe than US Treasuries, depending on the country, the currency, and the legal system under which they were issued.
  • Tax-ability — generally, interest payments on federal government bonds are exempt from state income taxes; municipal bonds are exempt from federal and state income taxes (in the issuing state); and corporate and sovereign government bonds are subject to all income taxes. These interest payments are treated as ordinary income.
  • Security — some bonds have no assurance of repayment other than the contractual guarantee of the issuer (aka “full faith and credit” or “general obligation”); other bonds are secured by collateral which may be physical assets or, in the case of government issuers, future tax collections or other revenues such as highway toll receipts.

The coupon (i.e., the interest rate) is determined by the interplay of these features.

What are junk bonds?

These are bonds where the issuer has a poor credit rating and there is a significant risk of default. In more polite company, they’re known as “high yield” bonds. As you might expect, investors in these bonds are compensated with higher interest rates because there’s an increased likelihood that they may not receive all the future interest payments or full return of the principal that have been promised.

Are they a good investment? They can be if the higher risk has been properly compensated with higher expected returns. They may offer good diversification with other investment assets but, they’re called junk bonds for a reason. If the economy heads south, these bonds often follow.

What are other types of bonds?

  • Mortgages are repaid monthly with a fixed payment that is a combination of interest and principal. In the early years, the repayment is mostly interest and in the later years, it’s mostly principal.
  • Zero-coupon bonds are as they sound. Instead of semi-annual interest payments, the interest is paid in full at the end of the term, along with the repayment of the principal. These bonds are sold at a discount to the end-of-term principal value, reflecting the implied interest rate.
  • Commercial paper is a short-term zero coupon bond, issued by corporations and municipalities, typically with a one- to six-month term.
  • Treasury Bills are like commercial paper, issued by the federal government.
  • US savings bonds are zero-coupon bonds for the public. You may have some tucked away from your bar mitzvah, quinceañera, or wedding. Don’t forget to cash them in.

Why do interest rates change?

That’s the stuff of Phd dissertations. Here’s a simple model:

  • Think of just two government interest rates — short-and long-term.
  • The Federal Reserve Bank’s (aka “the Fed”) primary tool to control inflation and minimize unemployment is to adjust short-term interest rates.
  • The Fed lowers or raises the short-term interest rate when it wants to stimulate or decelerate the economy or restrain inflation. Raising rates tend to dampen future inflation (by slowing the economy) while lowering rates tends to stimulate economic growth (by making it cheaper to borrow).
  • Long-term interest rates derive from expectations about the Fed’s future intentions for short-term rates, plus a premium for incurring more risk because of the longer time period.
  • Other rates — mortgages, corporate bonds, car loans, etc. — tend to roughly move in line with the rates of government bonds with similar maturities.

How risky are bonds?

They’re usually safe (until they’re not).

The interest and principal repayment of a bond is contractually guaranteed and if not paid in full and on time, a legal claim will be initiated by the lenders.

If the borrower declares bankruptcy, bondholders typically have priority over other claimants so they are likely to receive some value when it is resolved. And, secured bondholders (i.e., those with an asset pledged as collateral), have priority over other bondholders. But it can be a messy, contentious, and expensive process.

In one notorious example, an American hedge fund tried to seize an Argentine naval vessel docked in a Ghanaian port to compensate them for defaulted Argentine government bonds that they owned. In the end, the hedge fund got their money and earned an outsized return.

In another crazy story, Hertz went bankrupt in the early days of the COVID pandemic and its bonds were thought to be worthless. Instead, investors appear to have recouped more than 100% of their initial value as the economy rebounded. Go figure.

These are two examples when, in a twisted sense, bonds do have more fun.

Besides Argentina and Hertz, other examples of troubled bonds that have been in the news include:  Greece, Puerto Rico, Detroit, Toys R Us, and Sears.

How does investing in bonds compare to stocks?

Historically, bonds have offered lower returns than stocks. Over the past 100 years or so, stocks averaged 10% annual returns and long-term bonds averaged 6%. Inflation and short-term bonds each averaged about 3%.

To compensate for the lower returns, bonds also offer less risk — when they decline in value, their dips are generally smaller than with stocks. This is why it often makes sense for an investor’s portfolio to be a mix of stocks and bonds — typically, nearly all stocks when you have a long time horizon (i.e., you’re young) and a higher percentage of bonds as your time horizon shortens (i.e., you’re getting old) and you want to dampen your investment risk.

How do you buy bonds?

Investors can buy individual bonds but it’s not a good idea. Transaction costs can be significant, the choices are overwhelming, and there’s typically less liquidity if you need to sell them. Instead, invest through a mutual fund and leave the trading decisions to the pros. It’s just too hard to sort out on your own.

There’s a wide variety of bond mutual funds to suit any investor’s goals:

  • Long- and short-term
  • Tax-exempt and taxable
  • Investment grade and high yield
  • Government and corporate
  • International

Because bond yields are so low, it’s extra important to pick a fund that keeps its expense ratio very low. Otherwise, you’re giving away too much of the already meager returns to the fund manager. A low-cost bond index fund is the best choice.

What kind of returns should you expect?

Bond mutual funds report something called a “30-day SEC yield.” It, more or less, is the annualized return of the bond fund over the past 30 days, net of fees. You should be able to google this term, along with the bond fund’s name or ticker and see the current 30-day yield. Note that it changes every day and is not a guarantee of future returns.

To give you a sense of current rates of return (in June 2021), Fidelity and Vanguard each offer similar US intermediate term bond funds and their yields are both ~1.3%. Longer term bond funds currently yield closer to 3% (but they’re more volatile).

What’s a good benchmark bond to track?

If you want to follow just one bond to get a sense of interest rates, use the 10-year US Treasury bond:

  • It’s widely traded, closely tracked, and reported in the media.
  • Home mortgage rates are loosely tied to it.
  • Other countries’ 10-year government bond rates also are reported so you can easily compare if you’re curious.

The 10-year US Treasury bond is currently yielding ~1.5%.

Most of the time, bonds are boring and that’s just how you want them to be. They’re supposed to provide ballast when the investment seas are choppy.

Questions?  Get in touch

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