Bonding with Bonds

 Can you remember when bonds were cool? Come on, I know that you do… assuming that you were of investment age during the 1980s. I got my Wall Street start on an institutional fixed income trading desk in 1991, and back then, it was kind-of a big deal. Everywhere I went, friends, family members, and sometimes complete strangers would ask me to look at their investment portfolios. Before looking at the portfolio, I would usually provide the disclaimer that “I was a bond guy who knew very little about what was going on in the stock market.” However, once I looked at most of the portfolios, they were all heavily, if not completely, invested in bonds, save a few shares of Microsoft, Philip Morris, and Exxon. I have to admit, I wasn’t expecting it. However, when I had a closer look, I noticed, in an instant, that the yields on those bonds, most of them in the double digits, were far greater than any of the dividend yields on most stocks. It quickly dawned on me that those investments offered a far better risk / reward than what many stocks at the time had to offer. Stocks during the period leading up to the early 1990s were very volatile. A recession which straddled 1990 and 1991, combined with a 1980 recession and 1987’s Black Monday selloff added to the stress of stock investing. If you didn’t enjoy the unknown, you could have bought bonds… and many did. That seems like a long time ago, and much has happened since. Recently, bond yields have begun to look attractive for the first time in many years. Combine that with a volatile stock market and you may not be surprised that I am starting to get more and more questions about bonds. Given that, now might be a good time for a quick refresher on bonds. 

 What is a bond? 

 A bond is quite literally a loan made by an investor to a borrower. Borrowers can include companies, government treasuries, municipalities, and government agencies. To compensate the lender, the issue, or borrower will pay interest in the form of a coupon payment, and just like most loans, the borrower must pay back the borrowed amount, or principal. That end date is the maturity of the bond. 

A basic example 

As an investor, you purchase a $1000 bond from an issuer and that bond matures in 5 years and has a 2% coupon. For the next 5 years, the issuer will send you a $10 check twice a year for 5 years, at which time, you will get your $1000 back. In this simple situation in which you plan to hold the bond to maturity, the only risk you are taking is assuming that the lender will stay liquid enough to pay your coupons and return your principal at maturity. So, you are like a bank lending money to a company, and you are being compensated by receiving interest. 

 A bit of history 

Back in the day (sorry to say I remember that day) bonds actually had physical coupons which an investor would clip off and send away to be redeemed. In the example above you would have clipped a coupon twice a year, sent it in, then wait by your mailbox for your dividend check. It’s true. In that example, you would say that your investment yielded you 2%. That is $20/year divided by $1000 invested principal. 

What determines yield? 

Well, you must remember that you are lending money to an entity. If that entity, or borrower has a good credit rating and is not likely to fall on hard times, it would be considered a lower risk and would therefore pay a lower yield than a company which had more risk. Additionally, if the company were to put up some collateral (like a building) to back the loan, it would be less risky yet and it would offer a lower risk than a bond back by general obligation. This falls in the basic investing maxim of greater risk / greater return. Another determinant is maturity. Under normal market conditions, investors expect to be paid a time premium, whereby an investor will receive more yield for locking principal in for a longer period of time.

Where do you buy… and sell bonds? 

So far, we only covered a basic example in which you buy a bond directly from a company, though it generally does not happen that way. Bonds trade in an over-the-counter market which you can access through a broker/dealer or an investment advisor. When a company issues a new bond, it does so through a syndicate of broker-dealers and investors are likely to buy the bonds at par, or face value, which is typically $1000. One thing that we did not cover yet, is that you can sell your bonds prior to maturity. You can sell them to other investors through your broker/dealer. You can also buy already-existing bonds from other investors. Because you are trading in a secondary market, the prices of those bonds will change based on a number of factors, as follows: 

• Supply and demand. More demand will push bond prices higher and less, lower. Scarce issues (low supply) which are not readily available (low supply) will push a bond’s price higher while readily available ones will pressure prices lower.
• Credit quality. As mentioned above, credit quality determines what a company must pay in interest to borrow money. In most cases bonds are rated by rating agencies such as Moody’s and Standard and Poor’s. If rating agencies lower a bond’s rating, the price of the bond would decline, as it is riskier.
• Underlying bond market. Bonds are typically traded based on the US Treasury market, which is considered riskless, in that the US Government is not likely to default. As risk goes higher (ratings lower), the bigger the spread over similar maturity Treasuries. 

So now it gets a bit more complicated, so let’s use another example to clarify. Let’s say that an investor buys a 10-year maturity 2.5% coupon bond for $1000 in year 1. The investor buys the bond because 2.5% is a fair return for the risk at the time of the investment. Two years later the first investor wants to sell her bond in order to use her money to go on vacation. In the two years since the investor bought the bond, the Federal Reserve raised interest rates, meaning that it pushed up the Fed Funds Rate (as it has been this year), so now a fair return for that same investment might be 4%. The investor needs to sell the bond in the secondary market to a new investor. The new investor would not possibly invest in a bond that is paying a coupon of only 2.5% when bonds of that same maturity and credit rating are currently paying 4%. However, if the new buyer were able to buy the bond at a discount, it would make up for the lower coupon. In other words, the new investor can buy the bond for $875 at a discount and will, at maturity, receive the full $1000 face value back adding to the coupon of 2.5%. Now the total return to the new owner would be higher than the 2.5% coupon and vice versa, if the new investor paid a premium (more than $1000), the total return would be lower than the coupon. That total return is referred to as yield to maturity. So, the yield to maturity takes into account the coupon, time to maturity, and the price paid for the bond. That makes sense intuitively, right? Yield to maturity is an accurate way to determine the actual return of a bond and it is therefore important for a prospective investor to know a bond’s yield to maturity in order to compare it to other bonds or even to dividend paying stocks. Bond math is very specific, and to prove it I will share the formula for calculating yield to maturity. You can easily gloss over it, but it is important enough for me to at least show it to you.

PP = c*(1 + r)^-1 + c*(1 + r) ^-2 + … + c*(1 + r) ^-n + PAR*(1 + r) ^-n 

where: 

c = coupon payment 

r = yield to maturity 

n = years to maturity 

PAR = par value (usually 100) 

PP = purchase price 

If you are buying the bond, you simply plug in your purchase price and all the coupon payments and solve for r in the above equation. If you know the yield to maturity, you can simply replace r with it in the above equation to determine the price you will pay for the bond. I know this seems complicated, but in reality, your financial advisor or broker will calculate it for you. Once you know it, you can make apples to apples comparisons properly and determine if the bond in question, or any other bonds are the right investment for you. 

Why talk about bonds now? 

At the top of the newsletter, I talked about the attractive double-digit yields to maturity (now you know how that is calculated). But a lot has happened in those 30+ years. Most notable to bonds is the fact that bond yields have fallen steadily over the past 40 years. For example, 10-Year Treasury Note yields got as low as 0.5% in mid-2020! Imagine lending your money out for 10 years and only receiving ½ a percent in interest.

Great for borrowers, but not so good for lenders. What’s more, the S&P500 pays around a 1.7% dividend, which is far greater, and with that the potential to earn an additional +10% growth per year (based on the long-term average annual return for the index). Of course, that comes with a greater risk, as we have learned in the past 10 months or so. Check out the following chart which shows the steady decline in 10-Year Treasury Note yields over the past 30 years. Please note the following chart, which shows the S&P500 Index over that same period. 

Now let’s have some fun with markers, shall we? Though the S&P500 Index returned around +1023% during the period of this chart, you can see by the red arrows that it fell during certain periods, and in others, as denoted by the yellow arrows, the index traded sideways. In fact, if you look at the gold line you can get a high-level view of what your portfolio would have looked like over that period of time, assuming you invested in the S&P500 only. Still, if you had the luxury of socking away all your savings in 1991 you would have had a fantastic return. However, if you invested your money in 1991 and you needed it at any point during 2000 to 2013, you would have been very disappointed, because you would have either broken even on your investment or more likely, lost money. If, however, you bought a 10-year Treasury Note in 1991 and held it to maturity in 2001 you would have gotten a return of around 8.5%, with no risk (in finance we consider US Treasuries to be risk-free). In 2001 you would have received your full principal back from the Treasury (if you bought the bonds at par). If you didn’t need the money yet, you could have bought another 10-year Treasury Note for around 5% and locked that in until 2011. If 5% doesn’t seem like a lot, compare it to the S&P during that period in which you would have lost almost -5% in value... not before you suffered 2 nearly -40% losses in 2002 and 2009. If we factor in dividends, the S&P would have earned around +15%, however if you collected your treasury coupons which were 5% a year you would have collected a total of 50% on your initial investment (5% a year times 10 years). I can go on and on with this analysis and we could even mix and match maturities, which you can do based on how long you want to lock your money up. Need it in 2 years? Buy a 2-year Treasury Note, and so on. Of course, you can get even more yield if you buy corporate bonds, municipal bonds, etc., but with those comes additional risk, which is a whole other topic for a different newsletter. But hopefully you got the message. 

Conclusion 

I have surely filled your head with a lot to ponder. I have introduced, or re-introduced you to bonds, and I have showed you how they work at a very high level. Now let’s quickly turn our attention to the markets over the past year. Equity markets have been quite turbulent as inflation has picked up to levels not experienced in decades. To fight inflation the Fed has begun to raise interest rates at a pace which has also not been seen in decades. That monetary tightening can, and has in the past, caused recessions, which has put lots of pressure on stocks, causing painful losses. In the same period of time, we have witnessed bond yields rise to levels not seen in many years. Yields on 2-year Treasuries are above 4%, which are quite attractive if you are unsure of where the equity markets may go within the next 2 years. With a bond investment you know where your money is, how much it will earn annually, and when you will get your money back. Are you unsure about what will happen in the next 12 months? You can purchase a 1-year Treasury Bill and the US Treasury will pay you around 3.8% and you will get your principal back at maturity. 

In these volatile times for markets with the threat of a global recession looming, it may make sense to have a fresh look at bonds, especially considering that yields are the most attractive that they have been in at least a decade. I will end where I started. Remember how I was surprised at the beginning of my Wall Street career over how much money folks had allocated to bonds. When I look at portfolios today, I am often surprised at how little clients have allocated to bonds. Especially those clients who plan on needing their capital within the next few years.