Dec 22, 2022
Bond Series Part 1
You’ve Got Questions, We’ve Got Answers.
Bonds are arguably the most misunderstood component of a traditional investment strategy. On the surface, they seem like a relatively 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 more opaque and can be less liquid. There’s a reason why you don’t see bond prices by the minute running across your news screen. Working with a professional investment manager can help investors navigate these complexities and perhaps more importantly, prevent investors from making money losing behavioral mistakes.
What are bonds?
Bond investments are essentially loans – as the bond investor you are the lender and the issuer of the bond is the borrower. Your loan (bond investment) gets paid back in full at some stated maturity date (or call date if the borrower has the option to refinance early), and you collect pre-determined interest payments (coupons) along the way. Your 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. The investor would lose money if sold at an inopportune time, or if the borrower had trouble paying the lender (bond owner) back. Ultimately, this traditional “lender/borrower” arrangement is why bonds are viewed as lower risk investments than stocks.
How do interest rates affect bond prices?
We have received several inquiries from clients this year about their bond portfolios as interest rates have risen over the course of the year. 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. This, however, does not in any way change the return that was expected when the bond was originally purchased. It is simply lower than what one could get from a new bond investment today. 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.
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 series, 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