Night School: Bond Basics

At Clean Yield, we manage many “balanced” portfolios, which own stocks and bonds. Though stocks usually grab the headlines, bonds also have a critical role as the ballast in many portfolios.

What Is a bond?

A bond is a debt instrument that is issued by a government, company, or non-profit entity to raise money. Though there are many flavors and varieties, a plain-vanilla bond is a legal obligation for a borrower to repay an investor the original amount borrowed (face value) when the bond comes due (matures) in a specified number of years.

A bond usually pays a “coupon” rate of interest. The rate is set at issuance and is expressed as a percentage of the face value of the bond, which is priced at $100 and is usually issued in $1,000 increments. For example, a bond with a 4% coupon rate would pay $40 in annual interest (4% x $1,000).

Bonds are also called “fixed-income” securities, because the coupon interest rate is usually fixed at the time the bond is issued. In the old days, bonds were issued in paper form with “coupons” attached, and the coupons were literally clipped by the investor and taken to a bank to be exchanged for cash.

Once a bond has been issued, it is usually traded in the bond market, which is not a physical exchange but rather an electronic network of bond dealers.

Bond Math

A bond’s price in the bond market fluctuates based on supply and demand. There is an inverse relationship between the prevailing market rate of interest and a bond’s price. (Overall market interest rates are determined by several factors, which we’ll address in a future article.)

If interest rates in financial markets fall, the prices of already-issued bonds rise, because their coupon rates of interest are higher than those of newly issued bonds, making them more valuable.

The inverse is also true. If market interest rates rise, the prices of already-issued bonds fall, because newly issued bonds have higher coupon rates than those already issued. In both cases, prices reach an equilibrium where investors are indifferent toward buying a new bond or an old bond with similar maturity, quality, and yield characteristics.

If this is a bit confusing, you are not a-loan!

Credit Quality and Credit Ratings

The ability of a bond issuer to repay the face value at maturity is crucial. Several firms assess the credit quality of bond issuers and assign a rating to most bonds that are issued. Standard and Poor’s (S&P) and Moody’s are probably the most familiar firms.

“Investment-grade” bonds are considered to have a high probability of being repaid at maturity. They are rated by S&P from AAA to AA+, AA, and so on down to BBB-. Non-investment-grade (“junk” or “high-yield”) bonds have a greater risk of not being repaid at maturity. Junk bonds carry a higher rate of interest to compensate for this additional risk. S&P rates them from BB+ to BB to BB- and so on.

U.S. government and government agency bonds are considered investment grade. They’re popular, especially among large investors, because the large market for U.S. Treasury securities offers “liquidity,” or ease of trading without affecting the market price.

Bond Investment Strategies

The simplest bond portfolio strategy is “laddering,” which means spacing the maturity dates of a portfolio’s bonds in regular intervals, such as annually or semi-annually, over a number of years. This reduces the “reinvestment risk” of reinvesting the proceeds of a maturing bond at a time of unfavorable interest rates. Laddering is akin to “dollar-cost averaging” investing in stocks, by making regular purchases in order to avoid having to guess the ideal time to invest.

The Clean Yield Approach

We typically ladder a bond portfolio with U.S. government agency (or municipal or corporate) bonds that come due within five to seven years. U.S. government obligations are considered “risk free,” because the government can “print” more money if needed to repay maturing bonds. Since the government controls its own currency, it can create as much of it as it wants.

We do not, however, invest in U.S. Treasury obligations. U.S. Treasury bonds are general obligation bonds of the U.S. government largely used to fund the government’s massive military operations. We invest in agency securities instead, which provide funds for home mortgages or farming. In addition, we may invest in “green” bonds (those aimed at funding specific environmental or climate projects) or local municipal bonds, where available and appropriate for clients.

Conclusion

Bonds have historically been a vital component of a diversified portfolio. Bonds provide predictable income, and their market values often are not correlated with fluctuations in the stock market. This reduces a portfolio’s ups and downs and provides stability in periods of economic weakness and corporate profit downturns.

In another article, we will cover other aspects of the fixed-income marketplace, including how prevailing interest rates are determined and what the “yield curve” is (and why it matters).