Bonds, Part I
As the Covid-era (It was an era, right? Because it certainly felt like it!) looks as if it is coming to an end, our country has been opening back up, and things have been returning to business as usual. But is it ‘business as usual’ in the markets? It certainly hasn’t felt that way, especially for bond investors as of late.
Historically, bonds have provided diversification and insulation from market risk. This is because there has been a negative correlation between stocks and bonds; when stock prices rise, bond prices decrease and vice versa. Consequently, investing in both stocks and bonds provided a natural shock absorber to market volatility —losses in one investment were offset with gains in the other, which is why the 60/40 asset allocation (60% stocks and 40% bonds) was popular with so many investors for so long. However, in 2022 thus far, stocks and bonds have been declining alongside one another, which has made bonds and other fixed-income investments feel less “safe” than they have in the past.
What does this mean for bond holders? Well, we feel that the correlation between stocks and bonds is an anomaly and do not expect it to persist. As for interest rate increases, investors may find themselves wondering how to benefit from the advantages of holding bonds — such as portfolio diversification, capital preservation, steady income stream, and favorable tax treatment — while minimizing the opportunity cost from increased interest rates. Read on to learn about the role bonds serve in portfolios and how increased interest rates may affect them.
The Basics of Bonds
A bond is essentially a loan made to an entity by an investor for a pre-determined period at a fixed annual interest rate. They are issued by federal, state, and local governments, and corporations. Accordingly, there are three basic types of bonds: U.S. Treasury, municipal and corporate.
Bonds produce income in the form of coupon payments, typically paid semiannually. The coupon rate refers to the stated fixed annual interest rate as a percent of par value. For example, a 5-year 5% coupon bond will pay $50 per $1,000 bond per year (5% of $1,000), or $25 semiannually and on the maturity date, the par value ($1,000) will also be repaid to the bondholder – thus over the lifetime of the bond, if you held it to maturity, you would receive $1,250.
For many, exposure to bonds has never been about maximizing returns. Instead, in addition to providing diversification to their portfolios, bonds can provide capital preservation; a reliable, steady income stream; and even favorable tax treatment.
A bond rating is a grade given to a bond by a rating service that indicates its credit quality and riskiness, which significantly influences the price and coupon rate offered. Risk and interest rate have an inverse relationship. So, all else equal, the riskier the bond, the higher the interest rate the bond will carry, and the safer the bond, the lower the interest rate the bond will carry. The main types of risks associated with bonds include interest rate risk, credit risk and reinvestment risk.
What’s all the fuss about Municipal Bonds?
Municipal bonds, “Munis,” are issued by governmental entities to raise money for public works projects like roads, schools, and other infrastructure. Interest on most Munis is free from federal and state income tax, and investors who are residents of the municipality issuing it may also be exempt from state or city taxes on their interest income. Retirees and highly-compensated executives may also look to add Munis to their bond portfolios because of the tax-free income they provide. Munis are a good balance of risk and return between corporate and treasury bonds. Though Munis typically provide lower returns than most corporate bonds, they do come with a lower level of risk. At the same time, they generally offer better returns than treasury bonds, though the higher return comes at a slightly higher risk. These qualities make Munis an attractive option for investors in high tax brackets. Something to keep in mind with Munis is that while the interest is generally tax-free, capital gains from selling a bond, if any, would still be taxable.
The Federal Reserve, the “Fed” & their role in our economy
The Federal Reserve System, the “Fed”, is the central banking system of the United States. The Fed was founded in 1913 by Congress following several financial panics. During these panics, people raced to banks to withdraw their funds, and many banks failed because they didn’t have enough reserves to meet the people’s demand for liquidity.
The Fed has grown and evolved during its 100+ years in existence, and it is now tasked with providing the nation with a safe, flexible, and stable monetary and financial system. It has an explicit dual mandate from U.S. Congress: to keep inflation under control and support maximum employment. To this end, it has two main tools at its disposal: setting the target federal funds rate and open market operations. Without action from the Fed, our economy could be in serious distress like the financial panics of the late-19th and early-20th centuries!
The federal funds rate is the interest rate banks charge each other to lend Federal Reserve funds overnight. This affects the the cost of borrowing for businesses and consumers, so the Fed uses the federal funds rate to help grow or slow the economy. If the federal funds rate is decreased, it lowers the costs for businesses and consumers to borrow money which increases spending and helps spur the economy. On the flipside, with inflation skyrocketing like it is today, we’re seeing the Fed start to pull up the emergency brake and increase the federal funds rate, which makes it more expensive for businesses and consumers alike to borrow money and thus curtails spending and borrowing.
This year, for the first time since 2018, the Fed has raised the target federal funds rate – not once, but twice: by 25 basis points on March 17th and by another 50 basis points on May 5th. The hike in May was the largest hike in more than two decades! We expect it to continue raising rates for the next year or longer as it tries to cool down demand and weaken inflation without triggering a recession. Chair Jerome Powell states the Fed’s “intent is to discourage spending just enough to bring down inflation,” and adds that he doesn’t think it will be “straightforward or easy.”¹ CME Group has a FedWatch² tool that is based on the Fed Funds target rate and market expectations of where the Fed Funds rate is heading, segmented by date, and currently (as of 6/6/22) when looking at the furthest projected date (July 2023), it has the market favoring a target rate of 3.25% – 3.50% by next summer. For context, rates were 0.06% in June 2021.
Rising Interest Rates: Higher Coupon Rates for New Bonds & Reduce Value of Existing Bonds
What do rising interest rates have to do with bonds? Well, bond prices and interest rates are negatively correlated. This means when interest rates go up, bond prices go down, and when interest rates go down, bond prices go up. Simply put, bonds are valuable to investors because of their promised yield – which is tied to interest rate at the time of purchase. When interest rates go up, potential yield of new bonds increases and therefore bonds with lower interest rates are less valuable. The rates earned on bonds have less appeal as rates rise. More specifically, consider that bond value is determined by finding the sum of all the cash flows (the semiannual coupon payments) and the par value of the bond (the amount that will be repaid to the bondholder at maturity) During periods of rising interest rates, bond issuers that were offering 5% bonds must issue 6% bonds to remain competitive among other bond issuers. In addition, investors holding a 5% bond at the time of an interest rate increase will now experience a lower total return (coupon payments + par value returned at maturity) than the newer 6% bonds. If an investor wanted to sell the existing 5% bond, they would likely be forced to sell at a discount due to the increased rate hike – because why would anyone buy your 5% bond at full price when they could also purchase a 6% bond for the same price? The answer is — they wouldn’t.
Also, the yield to maturity plays a part in the risk of the investment. Investors who hold bonds to maturity ultimately should not be bothered by market fluctuations, as their investments would be affected only in the event of a sale prior to maturity. In general, investors holding long-term bonds are subject to a greater degree of interest rate risk than those holding shorter term bonds. But with risk comes reward, and to entice buyers, the riskier longer-term bonds will typically pay more.
When receiving your statements and seeing your bond portfolio is ‘down,’ the value reflected is the fair value of the account, an accounting practice known as mark to market³, which involves adjusting the value of an asset to reflect its value as determined by current market conditions, so if you’re an investor holding individual bonds to maturity, these values are not entirely applicable to you and you should not lose sight of your long-term investing goals. You will still be receiving your coupon payments and the par value at the maturity of your bond (assuming the issuer does not default, which is a realistic risk only in certain higher risk, higher yielding bonds), thus in a sense your bond portfolio will not be ‘losing’ any value and will be satisfying its exact purpose.
We believe bonds are an important – and often underappreciated – part of financial planning. While investing in bonds (or reading about them, like this blog post for example) isn’t nearly as exciting as meme stocks or cryptocurrency and they won’t make you rich overnight, they also won’t make you broke overnight either. High-quality, investment-grade bonds are considered stable investments and help contribute to a well-diversified portfolio while providing a steady stream of income.
Over the next few weeks, I’ll be writing more about the role bonds play in portfolios, including tools you can use to get the most out of bonds. Stay tuned for pieces about bond ladders, a strategy that can be utilized to help reduce reinvestment risk and Series I savings bonds, a low-risk savings product protected from inflation.
² CME Group
³ Mark to market (MTM) is a method of measuring the fair value of accounts that can fluctuate over time such as assets and liabilities. Mark to market aims to provide a realistic appraisal of an institution’s or company’s current financial situation based on current market conditions.
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