WHAT IS A BOND?
A common way for governments and corporations to borrow money is to issue a bond at a stated interest rate for a specified amount of time. The interest rate is determined by market forces such as supply and demand, which in turn are influenced by factors such as inflation expectations and creditworthiness of the borrower.
Most bonds are fixed-rate loans, meaning the interest rate paid does not fluctuate during the loan period. For instance, suppose the Government of Canada issued a bond with a 4% coupon (the interest rate paid by the bond) for a period of five years. This bond will pay the following fixed cash flows to the owner of the bond assuming a $100 principal value*:
*The convention is to pay half the stated coupon every six months
THE RELATIONSHIP BETWEEN YIELD AND PRICE
Interest rates have risen rapidly during 2022 and many fixed income investors have seen significant losses in their bond portfolios. The key to understanding the inverse relationship between price and yield is that a bond’s coupons are fixed, whereas prevailing economic conditions are continually changing.
For instance, if the economy is expanding and inflation rising, investors will demand higher interest rates on any new loans they make. That’s because investors want to protect themselves against the possibility that inflation rises higher and persists longer than expected. Therefore, any newly issued bonds will have to come with a higher coupon (interest rate). What happens to the price of bonds previously issued?
If a bond’s coupon rate is no longer competitive with prevailing market rates, it’s price will fall to the level that provides a yield that more-or-less matches other securities with similar features and risks (i.e., the law of one price). Since the coupons are fixed at initiation, the only way to get a higher return is to pay a lower price.
Regardless of the path of interest rates, a bond’s market price will eventually converge to its redemption value, which is why so many people see individual bonds as appealing.
A COMMON MYTH ABOUT BONDS
We sometimes hear from clients that because bonds always return their principal upon maturity (assuming no default), it makes them safer than bond funds, which never mature. We disagree.
By focusing primarily on the return of your principal:
- You might be ignoring inflation risk by anchoring in nominal values
- Your bond portfolio is likely under-diversified
- By always holding to maturity, you might miss better investment opportunities that could arise
If there was no inflation (i.e., money held its value over time), the growth of your portfolio in dollars would be a good measure of your investing success. But the value of the dollar is continually eroded over time by inflation. So, it’s not how much money you have that counts (a nominal measure), its how many loaves of bread, so to speak, that your wealth can purchase (a real measure).
Inflation is one of the biggest risks with fixed income investing because a bond’s cash flows are usually fixed. If you bought a bond thinking inflation would average 2% per year for ten years, it’s a big problem if inflation averages 5%. Growing $100 into $1,000 after ten years might sound phenomenal, but what if inflation reduced your purchasing power from 20 loaves of bread (at $5 each) to 10 loaves of bread (at $100 each)? Not so good!
Bond investors can mitigate inflation risk by owning several bonds with staggered maturity dates. That way, you are regularly re-investing principal repayments back into the market at current market interest rates, which reflect current inflation as well as investors’ perceptions of future inflation risks.
If you agree that you need to own more than one bond to diversify your inflation risk, then you must also agree that by doing so you are effectively managing your own personal bond fund that never matures! So why not just own a bond fund? It’s likely cheaper to manage, but there are also other advantages.
The portfolio manager of a bond fund can shift their allocation between government and corporate sectors as well as up and down the credit-quality spectrum. The manager might shift assets to the government sector to reduce risks late in an economic cycle if they perceive the risks of a recession are rising. They might, on the other hand, purchase lower-rated corporate bonds in the depths of a recession. That’s because when investors are in the grip of fear, high-yield bonds (like all risky assets) tend to trade at prices significantly lower than their fundamental values.
Bonds are usually the safe part of investor portfolios. Their safety is due to the contractual payments their issuers are required to make to investors. In exchange for the lower risks taken (compared to equity holders), bond investors must accept lower return potential.
Bond investors also take on the risk that inflation erodes their modest return potential. Owners of corporate bonds take on the additional risk of bankruptcy.
We believe investors should hold diversified bond portfolios that manage these risks and that also take advantage of opportunities as they arise.