How Do Bonds Work?

2011 October 18
by Kyle Bumpus
from → Investing And Investments

Bonds are one of the most fundamental asset classes along with stocks, cash (and cash equivalents), and perhaps real estate. So important are bonds that most experts would argue it’s flat-out impossible to construct a reasonable, diversified portfolio without them. And yet, for being such a fundamental portfolio building block, bonds are surprisingly misunderstood.

How Do Bonds Work?

A bond is a contractual obligation for a company or government entity to repay the principal of a loan at a pre-determined future date along with regular interest payments at specified intervals. There are plenty of bonds with unique features that make this a somewhat oversimplified explanation, but essentially what happens when you buy a bond is that you become a lender in the same way the bank who underwrote your mortgage was a lender to you. When you borrow money to buy a home, you know what your monthly payment will be (or at least the formula used to calculate it if you took out an Adjustable Rate Mortgage) and how long you’ll have to pay it. So it is with corporate and government bonds.

Bond Interest Rates Versus Risk

Most bonds pay interest twice per year, although there is some variation, and the length of time a bond will pay interest until the principal is repaid is called the bond’s maturity. In general, longer-term bonds will tend to pay a higher interest rate than shorter-term bonds and lower-quality bonds will tend to pay a higher interest rate than higher-quality bonds. This is because longer-term bonds have more credit and inflation risk than short-term bonds. That is, you’re more likely to run into problems the longer you lend out your money because while it’s relatively easy to predict what might happen a year or two from now, it’s much more difficult to predict what might happen 20 years down the road. Thus, long-term borrowers have to pay a risk premium to convince investors to part with their money for such a long period of time.

Similarly, the credit quality of the borrower plays a big role in determining a bond’s interest rate. Treasury bond rates tend to be lower than corporate bond rates because they are considered to be less risky. Junk bond rates, naturally, have to be much higher in order to tempt investors. The flip-side, of course, is that there is a much higher risk of default (meaning you don’t your money back at all) the lower you go on the credit quality ladder. For this reason, most experts highly discourage owning anything other than treasury and high-grade corporate bonds.┬áMunicipal bond rates are a special case. They usually pay lower rates than other bonds with similar characteristics because their interest payments are exempt from federal income tax.

Note: I highly recommend you familiarizing yourself with the Morningstar Bond Style Box.

Bond Interest Rates Versus Bond Prices

One of the most confusing things to most people is that bond prices move inversely with bond interest rates. When interest rates go up, bond prices fall. When interest rates go down, bond prices rally. Why? Because if I own a bond paying 5% when prevailing interest rates are only 4%, there’s no way I’m going to sell it for what I paid. I’m going to jack up the price so that the effective yield to the buyer is going to be right at the prevailing interest rate of 4%! Similarly, if interest rates go up to 6%, nobody is going to pay face value for my 5% bond. I’m going to have to lower the price if I want to sell it. The measure of how sensitive a bond fund’s price is to fluctuations in interest rates is called its effective duration.

What Do I Recommend For Your Bond Portfolio?

In general, a short- or intermediate-term high-grade bond fund should form the core of your bond portfolio. The best bond funds will own only high-quality bonds, sport low expenses, and have an average duration under 6 years or so. For investors who don’t mind a tad more complexity, I recommend a two-fund fixed income portfolio┬ácontaining both a TIPS fund and a short- or intermediate-term nominal bond fund.

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2 Responses
  1. 2011 October 18

    Thank you for explaining the risk of bonds. After a 30 year decline in bond rates, bond prices are at historical highs and offer historical risks. I actually believe (other than the TIPS which you recommend) investors should consider not owning any bonds at this time. I have written an article titled “Sell Bonds and Buy Best Dividend Paying Stocks” for anyone interested at:
    http://blog.arborinvestmentplanner.com/2011/08/sell-bonds-and-buy-best-dividend-paying-stocks

  2. 2011 October 19

    I also heard and read where experts were recommending investors to sell bonds early September. But it turns out that was wrong decision as bond price took off recently. I think it’s always good to diversify your portfolio, which means you should also consider bonds in your long term investment. Thanks for explaining about bonds.

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