What All Investors Should Know About The Life Cycle of a Bond
Your bond portfolio's return depends on everything from interest rate swings to defaults. Here's what to watch for.
Shakespeare's "neither a borrower nor a lender be" is good advice for maintaining harmony with friends and family. But if everyone followed it, investors would lose out on an entire asset class: Bonds.
Bonds allow individual investors to be lenders. Companies or governments, which issue the bonds, are the borrowers. The money generated from bond sales pays for roads, airports, factories and the start-up costs for all manner of innovative products. Bonds also happen to benefit your portfolio. Referred to more formally as fixed income, they are an essential part of a balanced stable of investments.
Bonds are less volatile than stocks, and they're far less likely than stocks to go to zero. They typically — but don't always — trend in a different direction from the stock market, providing balance in your portfolio. And they provide income that non-dividend-paying stocks do not.
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They're not as simple as that, though. From issuance to maturity, a number of things can impact a bond's return, and it helps to be familiar with those dynamics, whether you plan on buying bonds yourself or getting your exposure through a mutual or exchange-traded fund.
First things first: When interest rates fall, bond prices rise. And when rates rise, bond prices fall. It's all about demand. When new bonds are issued at lower yields, they're less attractive to investors than higher-yielding bonds already on the market, so existing bonds that pay more interest get bought — and vice versa.
Investors can get cranky when rates rise and they see their bond holdings fall in value (this is supposed to be the safe part of their portfolio, after all), but regularly replenishing a portfolio with new, higher-yielding bonds will eventually cushion those losses, and then some. In this way, "bond prices are self-healing," says Collin Martin, the head of fixed-income research and strategy at the Schwab Center for Financial Research.
The ins and outs of bonds
A key difference between stocks and bonds is that while stocks are perpetual — for the most part, you can buy and hold them forever — bonds mature. That means the borrower pays back your principal and your ownership ends. To maintain your portfolio, you need to buy a new bond.
In many cases the bond has a set term, such as 10 years. If you hold the bond to the end, you get the payment you expected. The interest rate the bond pays is called the coupon, and many bonds pay a fixed rate. Other bonds have rates that vary, pegging payments to a widely used benchmark such as the United States federal funds rate.
The longer the term of the bond, the more sensitive its price is to interest rate moves. The measurement of a bond's sensitivity to interest rate moves is called duration. The number is an estimate, typically expressed in years, of how long it will take a bond investor to get paid back.
A longer duration means the bond's price will move more when interest rates move. A duration of 6, for example, implies that if interest rates rise by one percentage point, the price of a bond will fall roughly 6%; the price will rise by a like amount if rates fall one point.
Things get a little more complicated when the issuer of the bond has the right to pay it off early, or "call" the bond. The issuer might have just one date when it can call, or it might have multiple chances. Typically, the issuer pays the bondholders a penalty (a "call premium") for calling the bond before it reaches maturity.
This creates "call risk" — which you'll find most often in a declining-rate environment when borrowers want to retire bonds paying a higher rate of interest and replace them with cheaper debt.
Everything that happens to a bond along its life cycle impacts its yield, or the return relative to the price of the bond. Consequently, there is a lexicon of yields to get to know:
Current yield is the bond's annual interest payments as a percentage of the bond’s current price. If a bond’s price drops below its issue price, the current yield increases. If the bond is trading above its issue price, the current yield is lower than the coupon rate when you bought the bond.
Yield to maturity is the return an investor will get by holding the bond to maturity, as long as the borrower makes all the promised payments and the investor is able to reinvest those payments at the same rate of return.
Yield to call calculates the return for the investor if the company calls the bond on a specific date before maturity. A bond that allows the issuer multiple opportunities to call it has multiple yield-to-call returns.
Yield to worst sounds yucky, and it is. If there are multiple call dates, yield to worst is the yield attached to the call date that gives investors the worst possible return.
So far, everything we've talked about assumes the borrower pays you back. If it's the United States government that issued your bond, that's safe to assume. But if you're buying corporate bonds — issued by companies — there's a risk that you won't get your money back at all. That's called credit risk. As an investor, you're paid for taking that risk by the difference in interest between what's considered the risk-free rate on a U.S. Treasury note or bond and the rate paid by your bond.
Ratings agencies that evaluate bonds, borrowings and debt assign grades to them — and the riskiest bonds are considered non-investment grade, or high-yield bonds (for their premium yields). Colloquially, they're called junk bonds, and they are rated below triple-B by Standard & Poor's. As interest rates tumbled after COVID-19, so too did defaults on high-yield bonds, according to S&P. But defaults on high-yield bonds have returned to more normal levels of roughly 4.5%.
"The default risks are not negligible, so that puts a fair bit of onus on you as an investor to be gauging exactly what’s happening with the company," says Robin Marshall, director of fixed-income research at FTSE Russell, an index and analytics company.
All of this is a lot to keep track of. For many investors, funds that hold bonds may be a better choice than individual bonds themselves. Funds typically disclose the average duration of the bonds in their portfolio — meaning an investor can see which funds are most sensitive to interest rate moves — and also give an idea of the credit quality of their portfolio by disclosing the percentages of bonds in each ratings category.
Baird Aggregate Bond (BAGSX), a member of the Kiplinger 25, the list of our favorite no-load, actively managed funds, is a good investment-grade, intermediate-maturity fund with a duration of 6 years. Its expense ratio is 0.55%, and it yields 3.9%. Vanguard High-Yield Corporate (VWEHX), another Kip 25 fund, has traditionally taken a more conservative approach to the junk-bond market than its peers. With expenses of 0.22% a year, it yields 5.6%.
Note: This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.
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