Bonds: You’ve Got Questions, We’ve Got Answers.

Bond Series Part 1

Bonds are arguably the most misunderstood component of a traditional investment strategy.

On the surface, they seem like a straightforward and boring investment. However, there is a surprising amount of complexity in the mechanics of a bond portfolio. Despite being larger than the stock market, the bond market is generally less transparent and less liquid. Let’s put it this way, there’s a reason why you don’t see bond prices running across the CNBC screen by the minute. Working with a professional investment manager can help investors navigate these complexities, and perhaps more importantly, prevent investors from making money-losing mistakes. 

What are bonds?

Bond investments are essentially loans – as the buyer of a bond you are the lender and the bond issuer is the borrower. Your loan (bond investment) gets paid back in full at some stated maturity date (or the call date if the borrower has the option to refinance early). While waiting for the repayment, you collect pre-determined interest payments (coupons). Simply put, your rate of return is essentially “fixed” (hence the term “fixed income”) at the time of purchase. Because the principal and interest payments are predictable, a prospective return can be imputed, called Yield to Maturity (and Yield to Call, if applicable). The Yield to Maturity is essentially the return an investor will earn when they purchase a bond and hold it until maturity. Only if we sell at an inopportune time or if the borrower had trouble paying the lender (bond owner) back, would the investor “lose” money, or get a lower return than expected. Ultimately, this traditional “lender/borrower” arrangement is why bonds are viewed as lower risk investments than stocks.

Learn More Bond Interest Rates Demystified: When and Why Safe Doesn’t Feel Safe Anymore

How do interest rates affect bond prices?

As a result of a large increase in interest rates in 2022, we have had more client questions about this. Like stocks, bonds are regularly traded between investors, and what an investor is willing to pay for a bond will change based on the current level of interest rates. The change in what an investor is willing to pay for the bond is what is ultimately reflected on your brokerage statements from month to month.  This, however, does not in any way change the return that was expected when the bond was originally purchased. It is simply an adjustment to the price to reflect what the current level of interest rates would be for newly issued bonds. While it is true that money can be permanently lost in bonds, we feel that we can either avoid or mitigate the risks that typically cause this to occur.

Learn More Bond Interest Rates Demystified: When and Why Safe Doesn’t Feel Safe Anymore

How do you lose money in Bonds?

There are two primary causes for permanent bond losses that we seek to avoid: 1) the borrower is unable to fulfill its obligation to pay back principal and/or interest (a default); and 2) the bond investor chooses an inopportune time to sell the bond (rather than waiting until maturity to get the full principal back). In the following sections, we will talk about these two “losing strategies” and how we seek to avoid them as investment managers.

While we simplify the nature of this topic for discussion, building a portfolio tailored to your investment goals can be complex. To learn more about how NPF can help you with your bond investments, or with any questions or comments, please feel free to give us a call.

Learn more in Part 2 of our bond series: Bond Interest Rates Demystified