Investing in Bonds

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Overview

Most investors consider broken: @dict-bonds a safe asset providing a steady income. This income stream protects portfolios against excessive volatility and avoids the liquidation of volatile holdings in retirement portfolios.

Before blindly relying on this income stream, investors should understand the nature of their investment. 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. This transaction typically spans several years, and there are many variables to consider, all of which might change over time.

Of particular interest is the current environment of low interest rates and the possibility of seeing interest rates rise in the future. Such development would change the behavior of bonds and significantly impact portfolio construction moving forward.

ProsCons
Bonds can provide low-volatility income streams and counteract stock-market volatility.Bonds are sensitive to changes in interest rates and may underperform moving forward.

Types of Bond Market Investments

There are many ways to invest in bonds. Investors can choose between buying individual bonds or investing in bond funds. Bonds differ by their issuer’s credit rating and place of residence, and the duration until maturity.

Individual Bonds

Similar to stocks, it is possible to invest directly in individual bonds. However, we feel that the bond market is less transparent than the stock market, making the exercise of selecting appropriate bonds more difficult than it should be. Further, bond investors should always manage their portfolios to maintain a proper structure of various maturities, e.g., through broken: @dict-laddering. And finally, bonds are often not very liquid, leading to wide broken: @dict-bid-ask-spread creating significant friction with every trade.

In contrast, investors can select from a vast menu of actively managed Exchange-Traded Funds (ETFs), addressing many different investment objectives. In 2021, typical bond ETFs charge an expense ratio of no more than 0.5%, and often significantly less. In our opinion, the improved liquidity and the simplified handling of ETFs are well worth this management fee. Consequently, ETFs are our preferred method of investing in bonds, and we do not consider buying individual bonds for this book.

Bonds: Total Return by Issuer

Bond Market Funds

Bond Issuers

As outlined above, investors buying a bond are essentially giving a loan to the issuer. But what if the issuer defaults on these payments? This possibility needs to be factored into the bond’s price and yield, with lower quality issuers paying higher yields. The most relevant bond types are:

  • U.S. Treasuries
  • U.S. Agency Bonds
  • U.S. Municipal Bonds
  • U.S. CDs
  • Corporate Bonds
  • Non-US Sovereign Bonds

broken: @dict-us-treasuries are backed by the full faith and credit of the U.S. government. Therefore, they rank among the safest assets in the world. These bonds come with maturities ranging from 4 weeks (Treasury Bills) to 30 years (Treasury Bonds). Because uncertainty rises with longer maturities, bonds with long maturities pay higher yields than those with shorter durations.

U.S. Federal Agency Securities are bonds issued by those U.S. federal agencies that Congress has authorized 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 broken: @dict-fannie-mae (Fannie Mae) or the broken: @dict-ginnie-mae (Ginnie Mae).

U.S. states and local political entities, so-called municipalities, also broken: @dict-muni-bond. 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.

Banks and credit unions often offer bonds in the form of broken: @dict-bank-cd (CDs). These products provide an interest rate premium over savings and money market accounts in exchange for customers leaving a deposit untouched for a predetermined time.

Companies in need of additional cash may issue broken: @dict-corp-bond. Assets of the issuing corporation back secured debt securities. 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 broken: @dict-credit-rating-agency, most importantly broken: @dict-sp-rating or broken: @dict-moodys-rating. In broad strokes, we distinguish the following:

  • Investment Grade
  • High-Yield

Companies with a rating of BBB or higher are considered investment grade. Companies rated BB or lower are known as junk grade. The market often refers to these bonds as high-yield bonds to use a word with a more positive connotation.

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 of the spectrum are high-yield corporate bonds. These bonds provide the highest total returns during periods of economic growth. However, they are tightly linked to the economy and behave almost like stocks with significant drawdowns in times of recession.

The following table lists some ETFs representing the various bond types:

Bond TypeRepresentative ETFs
Aggregate U.S. Bond MarketAGG, BND, SCHZ, SPAB
Aggregate U.S. Treasury BondsGOVT, FLGV
1-3 Year Treasury BondsSHY, SPTS, SCHO, VGSH
3-7 Year Treasury BondsIEI
7-10 Year Treasury BondsIEF, SPTI, SCHR, VGIT
10-20 Year Treasury BondsTLH, SPTL, SCHQ, VGLT
20+ Year Treasury BondsTLT, EDV, TBF
U.S. Agency BondsAGZ
Investment-Grade Corporate BondsIGIB, LQD, QLTA, SCHI, SPBO, VTC
High-Yield Corporate BondsHYG, JNK, USHY, HYLB
Treasury Inflation-Protected SecuritiesTIP, SCHP, SPIP
Bonds: Total Returns by Maturity

Factors that Move the Bond Market

Interest Rates

Bonds are fixed-income securities that provide an income stream through regular interest payments. This should result in returns smooth as glass, without the bumps in the road we expect from stock market investments. However, this is only true for investors buying a bond and holding it to maturity. As many bonds come with remaining maturities of 10 years or more, investors are likely to exit their investments before the bonds mature. Such an early exit is possible because bonds trade on secondary markets. And much like stocks, their prices are set through supply and demand.

This free market acts as an equalizer of sorts: In a rational world, two bonds with comparable risk and remaining maturity should yield similar returns. But bond transactions span long periods, and market conditions likely change in that time. Assume that company A issues a 15-year bond at an interest rate of 3%. Five years later, company B (with a similar credit rating) issues a 10-year bond at an interest rate of 5%, rendering company A’s bonds rather unattractive. Because the interest payments, the coupon rate, cannot be changed, the only way to market bonds from company A is to lower their price. Through trading at a discount, company A’s yield to maturity falls in line with the yield paid by bonds from company B.

broken: @dict-bond-valuation describes the mathematical relationship between bond prices, remaining maturity, coupon rate, and the market interest rate. A few important takeaways:

  • Bonds rarely trade at their par value. Most often, they trade at a premium or a discount.
  • A bond’s coupon rate and current yield describe future cash flows, not the asset’s total return.
  • Long-term investors should mostly watch out for the yield to maturity.
  • Bonds with longer remaining maturities typically pay higher yields.
  • When interest rates rise, bond prices fall.
  • The longer a bond’s remaining maturity, the higher its sensitivity to interest rate changes.

The chart above shows the total return of U.S. Treasuries with varying maturities. The graph clearly shows how total returns and volatility both increase with longer maturities.

Bonds: Total Return and

A consequence of fluctuating bond prices is that interest payments are only part of a bond’s total return. The often forgotten other part is capital gain. The chart above shows the total return for AGG, an ETF tracking the aggregate bond market. We can see how the interest payments result in a very smooth return. Also, we see that the ETF has incurred capital gains. The existence of these capital gains implies that interest rates declined over the years shown in the chart. In this example, capital gains account for only about a quarter of the fund’s total returns. For ETFs investing in bonds with longer maturities, e.g., TLT, capital gains may account for a significantly larger fraction of the total returns.

Bonds: Yield Comparison

Monetary Policy: Recessions and Inflation

We have established that bond returns are tightly linked to market interest rates. These interest rates are controlled through the broken: @dict-monetary-policy by the broken: @dict-federal-reserve-bank. However, the Federal Reserve Bank only sets one of these rates: the broken: @dict-federal-funds-rate. This is the overnight rate at which banks and credit unions lend reserve balances to other depository institutions.

Because the Federal Reserve Bank directly sets the Federal Funds Rate, this rate has sudden steps and jumps. But this rate only describes the interest on overnight deposits. Bonds have longer maturities than that, starting with three months for Treasury Bills. Consequently, these bonds’ secondary market rate follows with some delay, which also smoothes the curve.

The Federal Reserve Bank aims to shape the nation’s monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices. In a nutshell, we can expect the following actions:

  • To fight unemployment and support economic growth, the Federal Reserve Bank will lower interest rates.
  • To fight inflation, the Federal Reserve Bank will raise interest rates.

The chart above illustrates how market yields for various maturities and credit ratings have kept declining for the past decades. This trend aligns with the broken: @fred-federal-funds-rate since peaking at 19.1% in June 1981. We first reached near-zero interest rates in 2009, and over this period, bond returns were artificially bolstered through the addition of capital gains.

In 2014 the European Central Bank adopted broken: @dict-negative-interest-rates, and Japan followed in 2016. It is unclear if the U.S. will follow that lead, but this falling rate regime cannot continue in perpetuity. At some point, bond yields have to stop declining and maybe even rise again. Once that happens, capital losses will drag the total bond returns below the market rate. With broken: @fred-10-year-treasury-rate in 2021, this is not an attractive outlook. Under these conditions, bonds with shorter maturity will outperform their cousins with longer durations.

Inflation poses a particular risk to holding bonds. We have seen how rising interest rates drive down bond prices. In addition to that, the bond’s real return also suffers because the bond’s fixed interest payments fail to keep up with rising consumer prices. broken: @dict-tips (TIPS) are designed to solve that issue. The principal of these products is adjusted with the consumer price index, effectively counteracting inflation. Consequently, interest payments become variable as the product’s fixed coupon rate applies to an ever-changing principal.

Bonds: Treasury Return While VIX is Low

Stock Market: Flight to Quality

The Federal Reserve Bank is not the only force that influences yields. The jagged shape of bond yields over time shows that another power must be at work here: market supply and demand. More specifically, the phenomenon of broken: @dict-flight-to-quality. During bullish periods, investors gravitate towards stocks as these promise to capture the highest returns. But when market uncertainty increases and volatility rises, investors are looking for safer alternatives. U.S. Treasuries are among the safest assets in the world and, unlike holding cash, offer positive returns. While investors pile into Treasuries, they drive up the prices paid for these bonds. Because bond valuation dictates the relationship between prices and yields, higher prices result in lower yields.

Bonds: Treasury Return While VIX is High

The result of this effect is a negative correlation between U.S. Treasuries and the stock market. Because longer durations typically provide higher returns, this effect is more pronounced for longer-term bonds. The two charts above show this effect. While the broken: @dict-vix ranges at or below its 1-month moving average, the returns from U.S. Treasuries are primarily flat. But when the VIX runs above its 1-month moving average, the Treasury returns turn decisively positive. The following table quantifies this effect:

{"caption":"10 - 20 Year U.S. Treasuries vs. VIX since 1990","header":["VIX Regime","Accumulated Time","Annualized Return of U.S. Treasuries"],"rows":[["VIX below 1-Month Average","23.6 years","1.5% / year"],["VIX Above 1-Month Average","7.7 years","25.4% / year"],["Average","31.1 years","6.9% / year"]]}

It is worth noting that U.S. Treasury returns respond more to stock market volatility than stock market returns. This behavior confirms the observation that fear and uncertainty are the main drivers of market returns. We expect this effect to continue, even in an environment of rising rates. The underlying assumption is that the Federal Reserve Bank adjusts its monetary policy carefully enough for U.S. Treasuries to continue having a slightly positive return.

The meager returns in times of low stock market volatility also demonstrate that bonds might no longer be a good asset to buy and hold. The conditional returns show the advantages of active management, while the outlook of poor future bond returns defines the necessity.

Bonds: Beta to S&P 500

Bonds as a Portfolio Component

As with any asset class, investors should not consider bonds in isolation but in the context of a portfolio. Bonds serve the following purposes:

  • provide a safe income stream that may be withdrawn without affecting the principal
  • compensate portfolio volatility that stems from stock market investments

The income stream from bonds is, unfortunately, diminishing while bond yields continue to fall. In 2021, 30-year U.S. Treasuries yield less than 3%, and it is unclear what the future brings. While rising rates seem like good news for bond investors, this will lead to bonds trading at a discount and investors losing principal.

The negative correlation between stocks and bonds is more likely to hold in the future. It is crucial to notice that not all bonds are equally suitable to dampen a portfolio’s broken: @dict-volatility. The chart above shows the broken: @dict-beta of various bonds to the S&P 500. We can see that high-yield or junk bonds have a positive broken: @dict-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.

Combining these two views, we arrive at the following conclusion:

  • holding bonds becomes less attractive, should we return to an environment of rising interest rates
  • bond-heavy portfolios are no longer synonymous with safe returns
  • active management helps to benefit from the negative correlation between stocks and bonds