Bond Investing Unwrapped Simpler Than You May Think

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.  

WEBSITE DISCLAIMERS & DISCLOSURE

Business Continuity and Succession Plan Disclosure Statement

Andrew Hill Investment Advisors, Inc. (“AHIA”) maintains a Business Continuity and Succession Plan (“BCP”) that has been developed with the goal of protecting the health and safety of our employees and maintaining continuity of service for our clients. Our Plan is designed to ensure that we are prepared to operate through significant business disruptions, so that our clients can access their accounts without significant interruption under most circumstances.
Key elements of our BCP include the following:

  • Critical data from our computer systems is backed up daily to geographically remote, secure facilities.
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If your account requires servicing during a significant business disruption and we are unable to assist you, please call Fidelity Investments at 1-800-523-1203 and a dedicated team member will be able to assist you. It is impossible for us to anticipate every potential problem that may occur, but we believe our BCP will enable us to conduct business in the event of a variety of possible business disruptions. We review and test our BCP at least annually and it is subject to modification based on changing circumstances and assessment of need.

As a fiduciary, AHIA has certain legal obligations, including the obligation to act in client’s best interest. AHIA seeks to avoid a disruption of service to clients in the event of an unforeseen loss of key personnel, due to disability or death. To that end, AHIA has entered into a succession agreement with The Colony Group, LLC, effective May 24, 2019. AHIA can provide additional information to any current or prospective client upon request to Andrew D.W. Hill, President at 239-777-3188 or [email protected].

Andrew Hill Investment Advisors, Inc.
Privacy Notice

Andrew Hill Investment Advisors, Inc. (“AHIA”) believes it is essential that we maintain the privacy of the nonpublic personal information provided to us and that we obtain in connection with providing our products and services to clients.  AHIA views protecting its customers’ private information as a top priority subject to the requirements of the Federal Gramm-Leach-Bliley Act.  AHIA has instituted policies and procedures to ensure that client information is kept private and secure. 

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AHIA reserves the right to change these Privacy Principles, and any of the policies or procedures described above, at any time without prior notice. However, clients will be promptly provided with a current copy of our privacy notice upon material changes or upon request.  Active clients will receive a current copy of our privacy notice at least annually. These Privacy Principles are for general guidance and do not constitute a contract or create legal rights, and do not modify or amend any agreements.   If you have questions about this privacy policy, or if you wish to amend or rescind your written instructions with us at any time, please call us at (239) 777-3188.