Today we talk about the topic that just about individual investor would prefer not to have, and as soon as I mention it many of you will skip to the next article on the page. The topic, however, is a vital component of portfolio construction and investing in general. The topic is bonds (I will also refer to as fixed income).
In its base form, a bond is a loan to either a company or government. When an investor invests in a bond, they are loaning money to the company or government that issued the bond. Lenders, or investors who buy bonds, do so with the expectation they will receive interest (coupons) and eventually receive the money they loaned back either in extra payments over time, or in a single payment at maturity.
Seems straight forward, but I think part of the reason bonds are so spurned by many investors is that to many, these investments seem to cause more trouble than they are worth. Most of us buy bonds because they are perceived as less aggressive than stocks, and yet sometimes bond prices can be quite volatile, and often appear to be in a loss position on investment statements. There are also an absurd number of types of bonds, and the subject can be very confusing, even to experienced investors.
First let’s address the loss position on the monthly or quarterly investment statement. We will start with a simple exercise. If a bond is purchased for $100, pays $5 a year in interest for 10 years, will mature at $100 at the end of the 10 years, but shows up on the investment statement in year three of ten at $95, did the investor lose money in the third year?
Well, applying some simple math, and assuming the investor sold the bond at the statement price in the third year, the investor invested $100, but by year three had received $15 in interest payments. If the investor sells the bond for $95, their total cash receipts in this exercise is $110, so $100 put in, $110 received back. It’s hard to describe this outcome as a loss and a professional investor would not view it as such, but I have seen many individual investors contending this type of resolution as a loss and then concluding bonds in general were unattractive. So, the first lesson in owning bonds is evaluate the total return in a bond, the total stream of payments must be considered, including the maturity or sales price if the bond is sold. Without understanding this concept, bonds will likely seem endlessly frustrating.
Another frustrating feature of bond investing is the sheer variety of bonds available. Government, tax free municipal, taxable municipal, corporate investment grade, corporate high yield, mortgage backed, and convertible are all types of bonds, and there are many more. Due to this endless variety, most investors in my experience will invest in bonds through some sort of mutual fund or pooled investment. Investing in bonds in this way adds another layer of complexity to investment process as in my opinion bond funds must be considered differently than individual bonds.
After many years interest rates (yields) on many bonds have finally become significant as a source of return, and with interest rates up substantially over the past year and a half, investors may be looking to bonds for the first time in a while as a source of potential return.
When I consider bond investments, I start with one factor that is vital to how I expect the bond or bond fund to behave while I own the investment. The factor is called duration.
Duration, made simple, is a number, stated in terms of time, which indicates how long an investor will have to wait to recoup their original investment in interest payments or maturities in a bond or bond fund. This factor will help indicate how much price volatility the bond investment may experience as interest rates go up and down during the period the investment is held. Higher duration bonds will typically be more volatile and lower duration less volatile. To me, it is impossible to evaluate a bond investment without using this metric and it should be available on most bond quoting systems of mutual fund research reports.
Understanding duration helps the investor implement decisions based on their expectations for interest rates in the future. Investors believing rates will trend higher will typically seek lower duration bond investments, and the opposite when they believe rates will go up.
For investors interested in reevaluating bonds in their portfolio now that yields have gone higher, duration will be important to understand as the due diligence is started, and with bonds in general providing higher yields, now may be a good time to get reacquainted with this asset class.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stock investing includes risks, including fluctuating prices and loss of principal. No investment strategy can guarantee a profit or preserve against loss. Past performance is not a guarantee of future results. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. This material may contain forward looking statements; there are no guarantees that these outcomes will come to pass.