Let’s unwrap bond investing by starting with a familiar example: an IOU. When a friend borrows money from you and gives you an IOU, they promise to pay you back the borrowed money plus interest later. This simple concept is at the heart of bond investing.
How Bonds Work
When you buy a bond, you’re essentially lending money to another entity. This entity can be a government or a corporation. In return, they promise to repay your investment with interest. Think of it as an IOU on a much larger scale.
Government, Corporate, and Municipal Bonds
Now that we understand the principle of bond investing, let’s look at the various types of bonds.
Government Bonds: These are considered low risk because governments are unlikely to default on their debt. After all, if the government can’t pay us back, they can just print more money. However, this safety comes at a cost – government bonds generally offer lower yields compared to other types of bonds. Government bond rates fluctuate, but they affect all other bonds and the stock market and are often called the “Risk-Free Rate”.
Corporate Bonds: Companies issue corporate bonds to raise capital and fund projects. Since companies carry more risk than governments, they offer higher interest rates to attract investors. This means that corporate bonds provide higher returns compared to government bonds, but they also come with a higher risk of default, which means we do not get our IOU back.
Municipal Bonds: These are issued by state or local governments to fund public projects. Municipal bonds can be tax-exempt, meaning the interest income is not subject to federal income tax, making them an attractive option for certain investors.
Risk and Reward
In the world of investments, risk and reward go hand in hand. More risk means more reward, the key is to find the right balance that aligns with your investment goals and risk tolerance. To measure the risk of a bond, investors look at the company’s credit rating, the business version of a credit score.
Risk Classifications: Bonds are rated by credit agencies based on their risk of default, which is when the company cannot pay the investor back. Higher-rated bonds are less likely to default but offer lower yields. Lower-rated bonds, on the other hand, carry a higher risk of default but provide the potential for higher returns. Credit ratings range from AAA down to D, and anything in the A’s is considered investment grade.
Key Performance Indicators (KPIs)
Bonds come with several useful measurements for us to look at.
Yield to Maturity (YTM): YTM represents the total return an investor can expect if they hold the bond until it matures. It accounts for the bond’s current price, coupon rate, and time remaining until maturity. YTM is a useful metric for comparing the potential returns of different bonds. Because YTM includes several variables, it is the best measure of expected return.
Current Yield: Current Yield is a simpler metric calculated by dividing the annual interest payment (coupon) by the bond’s current market price. It provides a quick estimate of the bond’s annual return but does not consider the bond’s total return at maturity.
Tax Equivalent Yield: Some bonds, like the previously mentioned municipal bonds, are tax-exempt, meaning the interest income is not subject to federal income tax. The tax equivalent yield helps to compare the after-tax return of tax-exempt bonds to taxable bonds. Due to municipal bonds being tax-free, investors may prefer a lower-yielding municipal over a higher-yielding corporate bond as it may translate to more spending power for investors as less is taken out in taxes.
Why We Care
Bond investing plays a crucial role in financial markets and can have a significant impact on the stock market. Here’s why:
Risk-Free Rate: The risk-free rate is usually equal to the 3-month U.S. Treasury bill, which is considered “risk-free” because it’s backed by the U.S. government. The risk-free rate is an important component in the calculation of the cost of equity which is used to calculate a stock’s expected return and its fair value. As interest rates rise, the fair value of stocks declines, hence the relationship of stocks and bonds.
Interest Rates: Bonds and their interest rates have an inverse relationship. When interest rates rise, bond prices fall, and vice versa. This is because as interest rates increase, newly issued bonds offer higher yields, causing the prices of existing bonds to drop. Imagine two bonds, both cost $100. Bond A pays a coupon of 5%, bond B pays a coupon of 2%. Since everyone would only buy Bond A, the face value of bond B would have to decrease from $100 to wherever the market is willing to buy. On the other side of this investment is an entity that must pay you the interest, so higher rates negatively affect stocks as they have to pay more in interest expenses on their debt and bonds. Due to the behavior of stocks and bonds relating to interest rates, they often move in opposite directions.
Our Strategy
Today, we are at an interesting juncture in the economy, the “Yield Curve”1 or measure of return at different maturity dates, is currently inverted. This means that short term bonds are returning more than long term bonds, a reflection of the short term struggles the economy is facing. This is reflected in the “10-2 year spread”2, which is the 10 Year U.S. Treasury bond minus the 2 Year U.S. Treasury bond. Historically, inverted yield curves have foreshadowed every U.S. recession. Currently the yield curve is -0.70% inverted, which is the most inversion in over 40 years. Due to this and other factors, we have shifted our strategy to favor Government bonds and highly rated investment grade Corporate and Municipal bonds, typically AA or higher. We are also now seeing bonds yielding upward of 5% and are taking advantage of both the high short-term yields and locking in long term yields for consistent cash flows.