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News & Views


UNDERSTANDING BOND MARKETS: WHAT THEY MEAN FOR TYPICAL INVESTORS

Thought Pieces | April 26, 2021


Investing in bonds is different from investing in stocks. Stocks represent
ownership in a company. This ownership is not one where you can tell management
how to run the company but rather a relationship where you benefit if the
stock’s price rises, plus you receive any dividends paid by the company.

If stocks represent ownership, bonds represent “loanership.” Bondholders are
loaning the company or the governmental entity money for a fixed period of time.
At the end of that time period, bondholders receive the face amount of the bond
back plus any interest paid on the bond during the period in which they own the
bond.

Most bonds issued by corporations have a $1,000 face value and pay interest
semi-annually. Other arrangements exist as well. For example, there are
zero-coupon Treasury bonds that pay no interest but sell at a discount to the
$1,000 that bond holders will receive when the bonds mature. The interest is in
the form of the difference between the discounted purchase price and the value
paid to bondholders at maturity. For example, a 20 year zero coupon Treasury
with an implicit 3% yield would sell for $553.68 and pay the bond holder $1,000
at the end of 20 years.

Inverse relationship with interest rates
The price of an individual bond moves inversely with interest rates. As interest
rates move higher, the price of a bond will decline in order to offer a yield
that is in line with the new higher interest rates.

Bonds with a longer time to maturity will be more sensitive to interest rate
moves all things being equal. This is due to the fact that more things can occur
the longer the time until the bond matures. These “things” can include interest
rate fluctuations, a change in the credit-worthiness of the bond issuer and a
change in the economy among other things.

Bond ratings
Independent ratings agencies provide ratings for bonds based upon the
credit-worthiness of the borrower. The U.S. Government has the highest AAA
rating. The rating of other governmental units and agencies might be lower,
however.

The main concern of a bond buyer, whether an individual investor or an
institutional buyer like a pension fund, is the ability of the bond issuer
(borrower) to eventually pay back the face amount of the bond and to make the
periodic interest payments spelled out in the bond indenture or contract.

For bonds with a lower ranking, raising the money they need will be more
expensive, usually in the form of a higher interest rate. The bond offering
could include other terms as well that push their costs up.

Bond mutual funds and ETFs
There are numerous mutual funds and ETFs that invest in various types of bonds.
There are both actively managed and passive index versions of both. As with
stock funds and ETFs, the benefit of using a managed account is that you receive
professional management and a degree of instant diversification across a number
of different bond holdings. Bond funds and ETFs can be both actively managed as
well as passively managed index products. Generally, actively managed bond funds
and ETFs will carry a higher expense ratio than their passively managed index
counterparts.

Types of bonds
There are any number of different types of bonds:

Government bonds
The U.S. Treasury issues a variety of bonds with maturities ranging from the
very short-term (known as Treasury Bills or T-Bills) to intermediate and
longterm bonds. The rates on Treasuries are often quoted in the financial press
and are a benchmark of sorts for investors.

Municipal bonds
These are bonds issued primarily by state and local governments. These can be to
raise money for the issuer in general, or tied to a specific project or entity.
Some of these bonds are backed by specific revenues the municipality expects to
earn and this is often considered a margin of safety for bondholders.

The main advantage of “munis” is that the interest earned is not subject to
federal taxes. This can make these bonds attractive to investors in higher
income brackets. They are, of course, not an appropriate investment for a
tax-deferred retirement account like an IRA.

Corporate bonds
These bonds are issued by corporations and are a legal obligation of the
company. Corporates will generally offer a higher rate of interest than
government bonds as they can be subject to the risk of default unlike the
government.

These bonds usually have value of $1,000 and pay interest semi-annually. They
may have a call provision which allows the company to call or redeem the bonds
early if they feel market conditions warrant. Some issues use convertible bonds
which allow the holder to convert the bonds into a specified number of the
company’s shares of stock.

Foreign bonds
Just as in the U.S., foreign governments and corporations issue bonds to raise
money. In addition to any ratings for creditworthiness, U.S. investors need to
be concerned about currency fluctuations relative to the U.S. dollar.

Bonds for individual investors
Individuals can buy bonds through their advisor or typically wherever they house
their other investments. Buying individual bonds may entail a transaction fee,
but will also be subject to a spread. This is the difference between what the
advisor paid for the bond and the price that they will sell them to you for.

For many individuals it is more efficient to purchase bond mutual funds or ETFs.
You get the benefit of professional management and you do not have to do the
research and due diligence on individual issues.

Bonds and rising interest rates
As mentioned previously, rising interest rates will cause the price of
individual bonds to drop. With individual bonds this is not an issue if the
bonds are held until maturity, although there may be some opportunity costs.
Bond funds and ETFs never mature so investors do need to do their homework to
determine how much a given fund will be impacted.

Summary
Investing in bonds is often misunderstood by many investors. Bond investors are
loaning the bond issuer money for a fixed period of time and in return expect to
receive the face value of the bond upon maturity and period interest payments.

Just as with individual stocks, many investors may be better off investing in
bond mutual funds and ETFs. They have the benefit of professional management and
a level of diversification among a number of issues.

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