When thinking about safe assets for retirement, bonds are often the first topic that comes up. But this is not their only application. In the following, we explore the most important aspects of investing in bonds.
Types of Bonds
Bonds come in many different flavors. These flavors have particular characteristics, so it is vital to understand their differences.
Buying a bond is synonymous with giving a loan to the bond issuer. While the bond matures, the issuer pays interest on the principal. At maturity, the issuer repays the principal. Of course, there is a catch to this: the issuer might not be able to make the payments. That’s why we want to understand who the issuer of our bonds is. The most relevant bond issuers are:
- U.S. Treasury Securities
- U.S. Federal Agency Securities
- U.S. Municipalities
- Corporate Bonds
U.S. Treasury bonds are backed by the full faith and credit of the U.S. government. Therefore, they rank among the safest assets in the world.
U.S. Federal Agency Securities are bonds issued by those U.S. federal agencies that have been authorized by Congress to issue debt securities. While the U.S. Treasury does not directly back these, they are considered moral obligations of the U.S. government. Examples of these agencies are the Federal National Mortgage Association (Fannie Mae), or the Government National Mortgage Association (Ginnie Mae).
U.S. states and local political entities, so-called municipalities, also often issue bonds. In the case of General Obligation Bonds (GOs), they are backed by the issuer’s full faith and credit. Most often, they are secured by a pledge of taxes and are therefore very safe. In contrast, Revenue Bonds are secured by revenue received for the operation of functions, e.g., water, sewer, bridges, or tunnels. One aspect that makes municipal bonds stand out is their tax treatment: For residents of the issuing state, interest income earned from investing in municipal bonds is generally exempt from Federal and state income tax.
Companies in need of additional cash may issue corporate bonds. Secured debt securities are backed by assets of the issuing corporation. In contrast, unsecured debt securities are only backed by the reputation, credit record, and overall financial stability of the issuing corporation.
Bond issuers cover a broad spectrum. The interest paid on a bond largely depends on the risk of default: the lower the risk, the lower the interest paid. To make it easier to compare risk between issuers, bond issuers often use rating agencies, most importantly Standard and Poor’s or Moody’s. In broad strokes, we distinguish the following:
- Investment Grade
Companies with a rating of BBB or higher are considered investment grade. Companies rated BB, or lower are known as junk grade. To avoid the negative connotation of this word, we also refer to these bonds as high-yield bonds.
The chart above illustrates how risk and returns relate to each other. U.S. Treasuries have the smoothest equity curve and the lowest downside – but also the lowest total return. On the other hand, high-yield bonds show significant drawdowns, but, at least during periods of economic growth, the highest total returns.
Another essential aspect of bonds is their maturity, which is the remaining period of receiving interest from a given bond. As we can see from the chart above, maturity has a tremendous influence on the characteristics of a bond: the longer the maturity, the higher the returns. This relationship makes sense, as the future appears riskier, the further we go ahead.
Bond Total Return
The volatility of bond returns might come as a surprise, though. Shouldn’t fixed-income securities create super smooth returns? They indeed do, but only if held from issue all the way to maturity. Most investors will keep their bonds for shorter periods. Doing so is possible because bonds are traded on exchanges, much like stocks, with their prices set through supply and demand.
The free market acts as an equalizer of sorts: two bonds with comparable risk should yield similar returns. Bond valuation allows us to compare bonds with each other by expressing their future cash flows in today’s dollars.
An example to illustrate this: In January 2008, BAA-rated corporate bonds were yielding around 6.5%. In October 2008, companies in need of new loans issued bonds at 9.5%. Due to this, bonds at 6.5% became unattractive. Consequently, the market traded the older 6.5% bonds at a discount to make up for their lower coupon rate.
We rarely purchase a bond at par. If we buy bonds at a premium or a discount, the coupon rate becomes (mostly) irrelevant. Instead, we experience the bond’s yield. We distinguish current yield and yield to maturity. Current yield is the simpler of the two; it is the interest received, divided by the price paid. This calculation leads to a central relationship: declining yields drive prices up.
With bond prices fluctuating, it becomes clear that the interest paid on a bond is only part of its total return. The remaining part stems from capital gains or losses. Interest rates peaked at about 15.5% for 10-year Treasuries in September 1981. Since then, interest rates have been in constant decline. Consequently, over the past (close to) 40 years, total bond returns were propped up with additional capital gains. A bond’s sensitivity to yield changes increases with its maturity. This explains the differences in volatility we noticed on the chart of bond returns by maturity above.
While bond yields have been declining for decades, this can most likely not continue in perpetuum. While negative yields are a reality in many countries, we still have to believe that at some point, bond yields will stop falling, or even rise again. If bond yields stop declining, the total returns of bonds will match their yields. With 10-year Treasury yields hovering around 2%, this is not an attractive outlook. Should yields start to rise, the total returns of bonds will be dragged down by capital losses incurred through dropping bond prices. Under those conditions, bonds with shorter maturity will do better than their cousins with longer maturities.
Bonds as a portfolio component
While living off your savings, it is crucial to keep the withdrawal rate within safe limits and independent from price fluctuations. A bond’s interest income may be withdrawn safely and without affecting the principal. This makes bonds an ideal component of retirement portfolios.
However, bonds are also a crucial part of almost any cross-asset portfolio, even while accumulating wealth. This is because bonds can help to dampen a portfolio’s overall volatility, and in doing so, lead to smoother returns for investors. However, not all bonds are equally suitable for this purpose.
The chart above shows the beta of various bonds to the S&P 50. We can see that high-yield or junk bonds have a positive correlation to the stock market. For this reason, high-yield bonds do not help manage portfolio volatility. In contrast, long-term U.S. Treasury bonds have a strong negative correlation to the stock market. This negative correlation counteracts stock market moves and helps a lot to lower portfolio volatility. The aggregate bond market, behaving very similar to 7-10 year U.S., has only a weak negative correlation, which still helps reducing portfolio volatility.
There are plausible explanations for this behavior. For companies with low credit rating, the bond yields relate to the economic cycle. In times of economic stress, the risk of company failure increases, which is reflected in rising yields. Rising yields lead to falling bond prices and a reduced total return. In times of economic growth, yields are likely to decline, leading to exaggerated performance. Combined, this leads to a positive correlation to the state of the economy and the stock market.
For high-quality bonds, the situation is different. In times of economic stress, investors seek to reduce their risk exposure. The so-called ‘flight to quality’ sets in, leading to increased demand in top-rated bonds. Due to the high demand, investors are willing to accept lower yields and higher prices. The result is a negative correlation to the stock market. As outlined before, this effect becomes more robust with longer maturities, which is why long-term U.S. Treasury bonds maximize this effect.
Investing in bonds
Just like with stocks, there are two general avenues for investing in the bond market:
- Picking individual bond series
- Funds, mutual or exchange-traded
Choosing individual bonds is an exercise very similar to picking stocks. However, we feel that the bond market is less transparent than the stock market, making this exercise more difficult than it should be. Also, bond portfolios should always be actively managed to maintain a proper structure of various maturities. Unless investors are looking for something particular, this might not be worth the trouble.
However, investors can also invest in the bond market using exchange-traded funds. All of these ETFs actively manage their holdings to make sure they stay within their stated objective. In 2020, a typical bond ETF charges an expense ratio of 0.15% or even less for this convenience. There is a vast selection of bond ETFs available, addressing the needs of most investors. For these reasons, using ETFs is our preferred method of using bonds.
We hope this post provided you a helpful overview of the bond market. Bertram Solutions offers comprehensive wealth management services to retail investors, specialized in quantitative analysis and active management. Please contact us to learn more.