Steve TeSelle, CFA, CFP ™
January 2003
Most of us have an idea that bonds provide good diversification to stocks. If pressed, however, we probably have a little trouble explaining exactly how bonds work. I feel this way about my car: I know it gets me from one place to another, but don't ask me for any details on what goes on under the hood. My goal here is to describe some key points about bonds; I'm not trying to provide a comprehensive manual. All I want to do is explain why interest rates and bond prices move in opposite directions, and highlight the importance of the issuer.
According to the official bond market vocabulary, bills have a maturity of up to two years, notes have a maturity of two to ten years, and bonds have a maturity beyond ten years. For simplicity, I'll refer to bills, notes, and bonds as bonds. Maturity has nothing to do with hormones; it simply means when both the last coupon payment and the face value of the bond are paid to the investor.
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The key point to remember about bonds is that yield (expressed as an interest rate) and price move in opposite directions. You can think of the teeter-totter from your playground days. One side goes up, the other side goes down.
A bond has a face value, say $1,000, and it pays a coupon, typically every six months. Let's say the bond pays a 3% coupon, or $30, every six months. That translates into a yield of 6.09% (due to compounding). No matter what happens, unless the payer on the bond defaults, the bondholder gets $30 every six months. Let's say this is a five-year bond, so at the end of the five years, you get the last coupon payment and the face value of the bond.
So how much would you pay for this bond? Well, if you looked around the bond market and found that five-year interest rates were around 6%, you should be willing to pay about $1,000, the same as the face value. But let's say interest rates suddenly fall to 5%. Interest rates may have changed, but the coupon payments and the face value of the bond haven't changed. The bond still pays the $30 coupon every six months, so you should be willing to pay a little more than $1,000 for the $30 coupons and for the $1,000 you get at the end of five years. If you paid only $1,000 for this bond, you'd be getting a 6% yield when other bonds in the market are offering only 5%. If you pay about $1,045, then you'd get a yield of about 5% on your investment. That's why interest rates and bond prices move in opposite directions.
Sticking with our example, if you had bought the bond before interest rates
fell, you would have paid $1,000 for about a 6% yield. Then interest rates fall,
and the price of the bond increases. Now your total return consists of the $60
in coupon payments for the year, about 6%, and the $45 increase in the price
of the bond, about 4.5%. Your total return is more than 10%.
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The size of the coupon payment does not affect the yield we expect from investing in any particular bond. As we saw from the example, the price that investors are willing to pay for a bond adjusts up or down to reflect the interest rates in the overall market. The coupon payment does, however, affect how volatile the price of the bond is as interest rates go up or down in the future.
Let's compare our $30 coupon bond with a $60 coupon bond. If interest rates
are about 6%, we're willing to pay $1000 for the $30 coupon bond and $1255 for
the $60 coupon bond. Now interest rates fall to 5%. The yields on the bonds
fall to 5%, so the prices rise to $1045 and $1310, respectively. The $30 coupon
bond rises 4.5%; the $60 coupon bond rises 4.3%. The bigger the coupon, the
lower the fluctuations in price due to interest rate changes.[top]
Some folks have told me that they don't have to worry about fluctuations in bond prices because they buy bonds and hold them until maturity. While it's true that you don't have to worry about daily fluctuations, I think you're fooling yourself if you think you're unaffected by what's happening in the market.
Let's say you buy a five-year bond. It's going to give you coupon payments and then a final payment at the end of five years. But let's say interest rates rise steadily during the five years. Why do interest rates rise? Usually, because of inflation. So if you priced your bond every day, you would see it steadily losing value, because inflation erodes the value of the future payments that you receive. You can either price your bond every day and realize that the bond is losing value, or you can ignore what's happening around you and end up with less valuable payments in the future. Either way, inflation has eroded the value of your investment.
You might argue that interest rates could rise and then fall again, because
the Federal Reserve has successfully fought off inflation, or that inflation
and interest rates remain steady throughout the life of the bond. True, if inflation
is never a factor, then you can ignore the pricing gyrations that occur in the
market. I'm just not willing to close my eyes and hope that inflation is never
a factor.[top]
When the US government issues bonds, people think it highly likely that they'll be repaid. Investors bear very little risk of default, so they don't charge extra for the possibility that the US government won't honor its bonds.
In the 1970s, US banks thought foreign countries were equally safe. After all, countries don't go bankrupt, only companies do. The banks subsequently went on a lending spree and found out that, by golly, countries can default on debt.
Other issuers are states, cities, and companies. There is a whole industry that rates how likely any of these entities are to repay their debt. Generally, the higher the interest rate or yield associated with a bond, the higher the likelihood that the bond won't be repaid. The category of bonds known as high-yield, or junk, carries a high yield because the companies backing those bonds may not be able to come up with the money to repay the debt. There's a decent chance that the company will default and the investor will be forced to accept some lower payment than he or she originally expected.
Bonds issued by companies should always carry a higher interest rate than bonds
issued by the US government because not only can companies go out of business,
but they can't impose taxes to repay their bonds. How much higher the interest
rate has to be depends on factors like the economy and how optimistic investors
are. When things are bad, investors tend to want a bigger interest rate cushion,
or spread, to compensate for the perceived risk. When all is well, investors
tend to accept a lower spread.[top]
Bonds really aren't that difficult to understand once you get the hang of it, and once you know a little of the vocabulary. If you're interested in learning more about bonds, so you can use words such as convexity and duration at dinner parties, Frank Fabozzi has written a good book or two on everything you could possibly want to know about bonds.
If this piece has given you all you care to know about bonds, then consider
yourself incrementally informed. To return to the car analogy, you now know
a little about what's happening under the hood. Happy driving.
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I'll be price and you be yield...Oops! I think our bond just defaulted.
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