Bonds are traditionally used for safety in a portfolio as a ballast to smooth out volatile stock returns. Traditionally, stocks and bonds are thought to move in opposite directions. In reality they don't always. During the Great Recession in 2008, the Federal Reserve implemented a program called Quantitative Easing to purchase bonds to increase market liquidity. This artificially increased bond prices which reduced interest yields, causing investors to invest in stocks because bond yields were not very attractive. The end result, stocks and bonds were both moving upward simultaneously. This happened again in March 2020 during the COVID-19 pandemic.
While there is a plethora of research and strategies available for stocks, there is a comparatively smaller set of analysis about bonds, and it is fairly dry and technical. Bonds are dull, bonds are boring. A bond is just a loan for Y years at X% interest. Bonds do not represent an ownership interest. You can think of a bond as an interest only loan with a balloon payment at the end. You can make much more money investing in stocks because there is no limit to how high a stock can go. In my humble opinion, some concepts about the stock market have been incorrectly projected onto the bond market. The concept of diversification is used to mitigate the risk that a single investment defaults and you are left with nothing. (i.e. Don't put all of your eggs in one basket.) You can diversify investments across company size, company type / sector, growth vs. value, credit rating, price / earnings ratio, bond duration, government / commercial issuer, you name it. Applying the concept of diversification to bonds results in a Total Bond Market Index fund that invests in all maturities, all credit ratings and both corporate and government bonds. This of course captures the average return for the bond market, and you want above average returns.
When holding stocks, you have no idea what that stock will be worth 1, 3 or 5 years from now, or how much money it will pay in dividends. If you knew how much a stock would be worth in the future, investing would be a snap, right? If you buy an individual bond, you know how much fixed interest it pays every six months (i.e. coupon payment), so you can easily calculate how much in dividends you will have in the future. If held to maturity, the price of your bond in the secondary market is irrelevant because once a bond matures, the principal (par value) is repaid and your bond ceases to exist. The only risk with buying a bond is if the bond issuer defaults (i.e. goes bankrupt) and doesn't repay the principal (par value). Since bond behavior is boring and predictable, there is a lot less risk investing in bonds versus stocks / equities.
While investing in long-term bonds with my dad, I noticed the bond price recycling over 12-18 month periods. My dad's account went up, then it went down, then it went back up again. Each time it reached a new high I asked my dad if he wanted to sell to lock in the profits. The first two times he said to "let it ride". On the third time we sold and went to cash. While the cash didn't lose value, we missed out on eight months of dividends while waiting for the price to go back down. Note to self, you need to watch your entry point for long-term bonds so you are not upside down when you need to take money out. Once we bought in near the 52-week low for long-term bonds the account nearly always showed a profit.
As a result of this experience with my dad's account, I decided I really liked long-term bonds because they paid good dividends and increased in value about 10% if you buy them near the 52-week low. I moved all of my bond holdings to Vanguard Long-Term Investment Grade Bond Fund (VWETX). While VWETX is taxable, I held it in my IRA account which is tax-deferred so I didn't have to worry about paying taxes on dividends each year, and it paid a lot of dividends. At that time I was about 40 years old and my portfolio was running between 75-80% stocks and 20-25% bonds.
How bonds make money
- Coupon payment (i.e. simple interest)
- Capital appreciation*
Most investors are already familiar with simple interest, which is a percentage of principal paid at fixed intervals. Capital appreciation (or depreciation) results from the movement of a bond's price in the secondary market. The calculation of a bond's price is dependent on the prevailing market interest rate (yield) in the bond market for the time to maturity and credit rating of the bond. * - A bond held to maturity does not have any capital appreciation (or depreciation).
Prevailing market interest rates for bonds of all durations (one day to 30+ years) form a yield curve. Normally interest rates for short-term bonds are lower than intermediate-term bonds and lower than long-term bonds to compensate for the risk of investors holding bonds for longer durations.
Bond prices are set by supply and demand. When a bond is issued a fixed coupon payment is set by the issuer. This is why bonds are called fixed income investments. This coupon payment is a certain percentage of the bond's par value (future value) and can be thought of as an interest rate. Because the coupon payment is fixed, the price of a bond increases when prevailing market interest rates / yields fall, and decreases when they rise. This is a mathematical certainty. Calculating bond prices can be somewhat complicated and I won't bore you with the details, however I have created a bond pricing calculator for you to visualize the value of a bond at different prevailing market interest rates / yields.
A bond can trade at a discount (under $1,000), premium (over $1,000) or at par value ($1,000). Let's look at an example of how this works. Suppose you purchase a 10-year bond with a $1,000 par value that pays 3% interest (coupon rate). This bond will pay dividends of $30 per year (coupon payment) for 10 years and $1,000 at maturity. If the prevailing yield (determined by the bond market) for 10-year bonds with an issuer of the same credit rating is 3%, then the price of that bond is the same as it's par value, $1,000. If the prevailing yield is 2.5%, then the bond will trade at a premium price of $1,105. If the prevailing yield is 3.5%, then the bond will trade at a discount price of $908. The chart below illustrates the bond price at different prevailing yields to maturity:
After holding that bond for a year the value of your investment will fluctuate. If interest rates fall to 2.5%, then your bond will be worth $1,040, and if interest rates increase to 3.5%, then your bond will be worth $962. Accounting for $30 in dividend collected for the first year, your total investment will be worth $1,070 if interest rates fall to 1.5%, and worth $992 if interest rates increase to 3.5% after the first year. If you hold this bond to maturity, you will receive $1,300 regardless of interest rate changes along the way. ($30 x 10 + $1,000) Note that there is no capital appreciation in this scenario.
Multiple individual bonds can be packaged as the investment basis for a bond mutual fund. The benefits of a bond fund are:
- Dividends are paid monthly or quarterly instead of once or twice a year for individual bonds.
- Bond funds tend to be more liquid (easier to sell) than individual bonds.
- Diversification among multiple bond issuers mitigates the risk of a single issuer defaulting.
- Set it & forget it - Bond funds purchase new bonds automatically as bonds mature.
Some investors create bond ladders with individual bonds to avoid operating expenses related to a bond fund. Investors stagger the maturity dates of individual bonds to generate fixed income at regular intervals. When a bond matures and principal is repaid, that principal is either spent or used to purchase a new bond for a future date. While avoiding operating expenses of a bond fund sounds attractive, individual bonds may take some time to sell prior to maturity in the secondary market and have a higher default risk. U.S. Treasury bonds are considered to be the "riskless" investment because the United States has only defaulted once making coupon payments in 1979 due to Congressional delays and a technical snafu printing checks. Investors later received their coupon payments with accrued interest. IMHO, a bond fund with an operating expense less than 0.10% is worth it. At the end of the day you can think of a bond fund as a bond ladder that never matures.
Volatility and Risks
I quantify risk as the amount of money you can lose in a portfolio, also known as drawdown. The longer the duration of a bond, the more volatile it becomes. The more volatile an investment is, the more money it can make or lose. (i.e. the higher the volatility, the higher the drawdown) To offset the volatility of stocks, bonds are typically used as a ballast to reduce the drawdown of a portfolio during stock market downturns.
Since prevailing interest rates / yields are determined by supply and demand in the market, long-term bond yields can actually be lower than short-term bond yields. This is called an inversion. An inverted yield curve has historically been a leading indicator for a recession, however a recession doesn't always follow.
In a falling interest rate environment, the value of a bond increases. When bond yields drop to near zero, and in some cases becoming negative, it would seem that bonds are not a good investment at low yields. However, because of capital appreciation there is the opportunity for significant profits in a declining interest rate environment. Here is a good article discussing the topic of bond convexity.
In a rising interest rate environment, the value of a bond decreases, however the coupon payments remain fixed. If held to maturity, the price of the bond in the secondary market is irrelevant as the future value of the bond remains constant. A loss can occur if bonds are sold while the prevailing interest rate is higher than when the bonds were initially purchased.
I am a huge fan of long-term bonds. As I mentioned before, bonds are boring and predictable. A lot of investors view bonds as a trade off between price and interest rate. I prefer to look at long-term bonds from a buyer's perspective, the lower the price the higher the interest rate. That's a win-win. Since bond funds trade within a range, it's easy to know when a bond fund is reaching an upper limit on price to know when it's a good time to sell.
Not all bonds are created equal
Both corporations and governments issue bonds of varying durations. (short-term, intermediate-term, long-term) Corporate bonds are issued by companies to raise money and are generally positively correlated with their stock price. Government bonds generally pay lower coupon rates than corporate bonds and are generally negatively correlated with stocks. Some government bonds are even tax-exempt which may result in an effective after-tax return that is higher than corporate bonds of the same duration. To illustrate the impact of different duration corporate bonds in a 60/40 portfolio, I have created the following backtest:
Note that as bond duration increases, the portfolio performance (CAGR) increases. However, this additional performance comes at the expense of higher drawdowns / volatility. You can view the drawdowns in the full 60/40 corporate bond backtest. This is due to the positive correlation of stocks to corporate bonds. When stocks do well, corporate bonds tend to also do well.
Contrast this with the impact of different duration U.S. Treasuries in a 60/40 portfolio:
Once again, as bond duration increases, portfolio performance (CAGR) increases. However, unlike corporate bonds, the longer the Treasury duration, the lower the drawdown. This means you get better performance and better drawdowns with longer duration Treasuries; this is a win-win. In addition, there are frequent time periods where a 60/40 portfolio of stocks / extended duration Treasuries outperforms a 100% stock portfolio! To be able to outperform a 100% stock portfolio, you need to rebalance when your asset allocation deviates 1% from 60/40. You can view the drawdowns in the full 60/40 U.S. Treasury backtest. This is yet another reason why I am a big fan of long-term bonds.