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Demystifying Bonds

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Starting with the basics, bonds are usually issued in amounts of $1,000 per bond (called par or face value), which represents the amount the investor has lent to the issuer.  The coupon is the interest rate the issuer pays on the money borrowed, and it’s typically paid semi-annually to the holder of the bond.  A bond has a maturity, which represents the date that the face value must be paid back to the investor by the issuer.  Since an investor can hold a bond to maturity and thereby receive the face value of the bond, investors often think a bond’s value doesn’t change over time.  In fact, bond prices fluctuate daily, albeit usually in a much smaller range than stocks.  Changes in price are mostly driven by two factors, which represent the key risks for any bond: interest rate risk and credit risk. 

Credit risk is the risk that the issuer of the bond will default, i.e. fail to pay either interest when due or the face value at the maturity date.  All bonds with fixed rate coupons have interest rate risk, which is the risk that the price of the bond will fall because interest rates have gone up.  For example, if an investor buys a 10-year U.S. Treasury bond with a coupon of 5% for $1,000, she will receive $50 annually while holding the bond.  If a year later interest rates have risen, and the U.S. is issuing new bonds with a coupon of 6%, the price of her 5% bond will drop because no one will be willing to pay $1,000 for a yearly payment of $50 when they could use that $1,000 to buy a new bond and get $60 annually.  If it were a 2-year bond instead of a 10-year bond, the price would drop less because the buyer would suffer the lower annual payment for only one year rather than 9 years before the bond matured and the $1,000 par value was paid.  So, a “shorter” bond, such as a 2 year bond, has less interest rate risk than a “longer” bond, such as a 10 year bond.  Because of this, buyers of longer bonds need to be compensated for shouldering this greater risk, so longer bonds usually pay higher rates of interest. 

A U.S. government bond is considered to have only interest rate risk, but essentially no credit risk.  However, all other issuers of bonds, including corporations, states, municipalities, etc. have the risk that they will suffer financial difficulties which will make them unable to pay the interest and principal when due.  These issuers must pay a higher rate of interest to compensate the buyer for this credit risk.  The difference between the U.S. Treasury rate and the rate other issuers must pay is called the “credit spread”.  That spread varies greatly depending on the perceived credit worthiness of the issuer.

On September 30, 1981 the 10-year US treasury bond reached a peak yield of 15.84%!  That marked the end of a 30-year bear market and the start of a 36-year bull market that may have ended on July 5, 2016 (we’ll only know for sure with several years of hindsight), with the 10-year treasury bond yielding 1.37%.   During this long downtrend in rates, there have been interludes when rates rose, but these have usually been brief (usually a year or less), and always followed by moves to new lows in rates (see the graph below).  The average annual return for intermediate bonds (bonds maturing in 3 to 10 years) during this bull market has been more than 7%!

For use of the interactive chart, please click here.

As I write this, the 10-year bond yield is 2.96%, which represents more than a doubling in yield in the last 21 months.  The foregoing interest rate history is important because it means that many of today’s investors have never experienced an extended period of rising interest rates.  So, if we’re entering a period of rising interest rates, what does that mean for how we manage the bond portion of client portfolios and what does that mean for bond returns? 

We utilize several strategies to reduce the damage rising interest rates could inflict on portfolios.  Trying to guess where interest rates will go next month or next year is not one of those strategies.  We think it’s a fool’s errand to try to predict interest rates, so it is not part of our strategy.  On the other hand, we can readily identify risks.  The risks of higher interest rates have been pronounced for the last several years based on the simple observation that interest rates have reached record lows from which there is little room to drop further and vast room to rise. Thus, we’ve been willing to position portfolios with shorter maturities than normal in recognition of the asymmetric risk/reward profile at recent rate levels.  In the long run, we think it makes sense to focus on credit risk as the area where we can add the most value in fixed income because we believe we can analyze whether we are being adequately compensated for the credit risk of a given borrower.  In the current environment, credit spreads on most traditional bonds are unusually narrow, which leads us to minimize credit risk by emphasizing high quality bonds in client portfolios.  The operative word is “traditional” bonds because we are finding opportunities in less well-known bond instruments. 

We are diversifying bond portfolios into non-traditional areas when we can minimize interest rate risk and receive appropriate compensation for credit risk.  Examples include pools of Insurance Linked Securities (ILS), which are floating rate instruments with virtually no interest rate risk.  Furthermore, they don’t entail any credit risk; instead they carry natural catastrophe risk because some or all of bond principal is paid out when insured natural disaster losses are unusually high.  These risks are random and totally unrelated to the credit cycle, so these bonds are a terrific diversifier in bond portfolios.  Another example is “direct lending” funds.  These funds pool very large numbers of small business and consumer loans originated on-line.  These loans typically have little interest rate risk because the loans have very short maturities and partial principal repayments are made monthly or even daily.  While credit risk is present, the efficiency of the lending process means the lender can be compensated for the risk with double-digit interest rates (before credit losses), while still allowing the borrower to pay a cheaper rate than would be paid using traditional sources, such as credit cards.

Rising interest rates create a headwind for bond returns, but bonds still play a vital role in portfolios by generating income and reducing portfolio risk through diversification.  A well-designed strategy can minimize the damage from rising rates and allow clients to reap the benefit of the higher income that flows from those increased rates.