Demystifying the Bond Market
July 23, 2020
Just like stocks, not all bonds are created equal.
There are a wide variety of bonds of varying quality and performance. Learning how and what they are is a huge advantage for income investors who are looking to diversify their portfolios for safety and consistent performance.
The bond market might appear to be a dark and mysterious part of the financial world and one that’s hidden from the average individual investor. But the reality is that with some tutoring and a bit of effort, getting to know bonds can unlock lots of yield now and gains in the years to come.
What Is a Bond?
To start, bonds are simply loans issued by governments and companies that pledge to pay principal and interest for a period of time. If interest rates are low, companies like to borrow money (i.e., issue bonds) to pay for expansion or upgrades, rather than use their cash.
Bonds differ from stock in that they are higher in the pecking order if things go south for a company. For example, if a company goes bankrupt, bond holders are first in line to get paid out of whatever remains in the company. Stock holders are near the back of that line.
Bonds can come with maturities (the length of the loan covered by the bonds) that can range from a day to as long as 100 years or more. The longer the maturity, the higher the interest rate, since there’s a greater risk of the company paying back the bond. Short maturities usually have lower rates than longer maturities.
The interest on the bond, referred to as the coupon, can be paid over different time periods.
Typically, coupons are paid semiannually, which is the case with most U.S. government bonds. But corporations and some foreign bonds can pay their coupons annually, 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, calculated based on some predetermined basis, such as a percentage of an index or an inflation rate.
And coupons can come with no current cash paid, which are known as zero-coupon bonds. 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 accrued interest or yield.
How Are Bonds Priced?
Bonds are quoted as a percent of par, which is the face value of the bonds. Traditional bonds have face values that are typically $1,000. And if they’re trading at 100 par, that means that the bond is priced at 100% of $1,000.
Most individual bond purchases start at around $10,000, but most serious orders run about $100,000 or more. This is why I like to use bond funds rather than recommending individual bonds. It means investors have a better chance of everyone getting the same investments at the same price. I can vet the bond portfolios, and I can see what the fund managers are doing, which makes it easier for most individual investors.
And as bonds come to the market and continue to trade, their prices will rise and fall (above par or below par). There’s an inverse relationship to the par value of the bond and its coupon.
Above par means that the price paid for the bond is higher than par, which brings the effective yield down. This happens as the bonds get closer to maturity. At maturity, 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 (at the lower established rate) by buying a bond at less than par, the difference between the price paid and the maturity will make up for more of the yield as the bond moves towards its maturity.
There is no intrinsic advantage or disadvantage to buying bonds above or below par since the effect is the same. 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, which is known as “calling away” the bond. 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’re 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 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 in 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.
Bond Ups and Downs
Bonds trade based on three major factors:
- Credit of the issuer
- Inflation and expectations of inflation over the life of the bond
- Competition from other investment and market opportunities
Credit is crucial. The credit of bond issuers, from the U.S. Treasury and the government of China to Ford Motors and Regions Bank, is either getting better or worse. The better the credit, the higher above par the bond price. And as the markets will price credit based on expectations, improving credit means rising prices.
Inflation valuations are about 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 subtracting for the impact of rising prices. So, basically, falling inflation means better bond prices (lower yields), while rising inflation means lower bond prices (higher yields).
Last up is opportunity risk. If other bonds or other assets like stocks or metals or cryptocurrencies are deemed to be more attractive, bonds will trade lower since there are likely fewer buyers. Consequently, if stocks or other assets are deemed to be greater risks, bonds can benefit with a growing base of bond buyers.
Now, not all bonds move in the same amount of price. The reason is simple. 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 shall be.
Easy Rules of Thumb
- For a bond with a one-year maturity, a 1% change in yield would make the price of the bond move by 1%.
- A five-year bond with that same 1% yield change would move by closer to 3%.
- A 10-year bond would move by some 7%.
- And a 30-year maturity would move by some 13% in price for a 1% move in yield.
So, if expectations are for bonds to do better in a market, longer maturities mean more price movement opportunity. But if the risk is for higher yields, then shorter maturity bonds are better buys.
One more thing: Bonds don’t all move at the same time in the same direction. For example, U.S. Treasuries move differently depending on maturities. Shorter maturities may go down in yield (up in price), while longer-dated maturities go up in yield (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 U.S. Treasuries.
So again, 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 about inflation and risk now and in the future, and buy the right bonds accordingly.
All My Best,
Editor, Income Investor’s Digest & Profitable Investing
Author, Income for Life