Start 2019 With a Better Grasp of Bonds
January 03, 2019
For many investors, the bond market might appear to be a dark and mysterious part of the financial world, and one that is kept away from the average individual investor. But the reality is that with some tutoring and a bit of work, getting to know bonds can unlock lots of yield now and gains in the years to come.
To start, bonds are simply loans issued by governments and companies that pledge to pay principal and interest for a period of time.
The can come with maturities, meaning the time until the loan is paid off, that can range from a day to as long as 100 years or more.
Typically, interest (or “coupons”) is paid twice a year, (as is the case with most US government bonds, but corporations and some foreign bonds can pay their coupons in other intervals, including once a year (annually), or quarterly, or even in some cases monthly.
Coupons can come in various forms, as well. Coupons can be paid at a fixed percentage of the face value of the bonds, or they can be paid on a floating basis—meaning they’re calculated based on some pre-determined basis such as a percentage over an index or an inflation rate.
And coupons can come with no current cash paid, in which case the bonds is known as a zero-coupon bond. These bonds are sold and traded at a discount to their final maturity amount, and the difference between the price paid and the final maturity paid equals the accreted interest or yield.
Bonds are quoted as a percent of par—par meaning the face value of the bonds. Traditional bonds have face values that are typically $1,000 or $100., If a $1,000 bond is trading at 100 par, that means that the bond is priced at 100 percent of $1,000.
And as bonds come to the market and continue to trade, their price will rise and fall above par or below par. Above par means that that while the coupon is stated, the price paid for the bond brings the effective yield down. This happens as the bonds get closer to maturity or at maturity, when they will only pay the face value. So, anything paid above par is reduced from the yield during the life of that bond.
Bonds also trade at a discount to par. Again, even though you would be paid the fixed coupon, by buying a bond at less than par the difference between the price paid and the maturity will make up for a lower yield as the bond moves towards its maturity.
There is no intrinsic advantage or disadvantage to buying bonds above or below par—it’s all about buying the bonds based on their yield to maturity.
Yield is the return on the bond to the investor. Yield is calculated by looking at the current price above or below par, then adding all of the coupons over the life of the bond and then the final coupon and principal payment at maturity. This is what is known as yield to maturity, and is the most common means of quoting bonds.
Next is yield to call. Some bonds can be bought back at an agreed price by the issuer before the maturity in a process known as calling away. The impact is that if a buyer paid a premium price over par and the bond is called away before maturity, the effect would be a lower yield.
This means that when looking at bonds, you need to know if they are callable, and at what price. Then you look at the effect on your yield if the bonds were called before their maturity. This is then the yield to the call, and a big part of how bonds with calls should be traded and evaluated by investors.
The final means of evaluating yields on bonds is the current yield. This is much the same as how stocks are evaluated. The coupon amount is divided by the current bond price and the result is the current yield. This might be helpful when looking at current cash being paid on the initial investment—but bonds should always be evaluated and bought based on the true yield to maturity or to the call price and date.
Bonds trade based on three major factors: the credit of the issuer, the expectations for inflation over the life of the bond and the relative competition from other investment and market opportunities.
Credit is crucial. For bond issuers—from the US Treasury to the government of China to Ford Motors—credit is always fluctuating. The better the credit, the higher the bond price. And as the markets will price credit based on expectations, improving credit means rising prices.
Inflation is next—and one must consider both the current rate as well as the expected rate over time to maturity. The higher the rate of inflation, the lower the effective real yield is after accounting for the impact of rising prices. So, in a market here in the US or elsewhere, falling inflation means better bond prices while rising inflation means lower bond prices.
Last up is opportunity risk. If other bonds or other assets, including stocks, are deemed to be more attractive, bonds will trade lower naturally, with fewer buyers. Consequently, if stocks or other assets are deemed to be greater risks, bonds can benefit from a growing base of bond buyers.
Now, not all bonds move the same way. For one thing, the longer the maturity of the bond, the longer the opportunity for credit and inflation to impact those future payments of coupons and principal.
This means that as yields rise or fall, the longer the maturity of any given bond, the bigger the price moves will be.
Now, here’s an easy rule of thumb. For a bond with a 1-year maturity, a 1% change in yield would make the price of the bond move by 1%. A 5-year bond with that same 1% yield change would move by closer to 3%. A 10-year bond would move by some 7% percent. And a 30-year maturity would move by about 13% in price for a 1 percent move in yield.
So, if expectations are for bonds to do better in a market, longer means more price movement opportunity. But if the risk is for higher yields, then shorter maturity bonds are better buys.
Another factor to consider is that bonds do not all move at the same time in the same direction. For example, over the past year US Treasuries have moved differently depending on maturities. Shorter maturities have gone further up in yield—down in price—while longer-dated maturities went up less yield and down in price.
This means that investors are making different assumptions over different periods of time in terms of credit, inflation and opportunity risks for US Treasuries.
So, when buying bonds, you need to think through what you expect the bond and the issuer to do during the life of that bond. Think of inflation now and in the future, risks opportunities now and in the future, and buy the right bonds accordingly.
But with inflation in the US market remaining low, with the core Personal Consumption Expenditure Index below 2%, inflation expectations remain low. And competition for investor cash from volatile stocks is lower, making bonds more attractive. Plus, credit conditions for the bulk of the corporate bond market remains positive, with only lesser credit issuers running into challenges. And the same is true for the municipal bond market’s issuers. All of this helps for credit to remain generally positive.