Bonds for Beginners

There is plenty of info out there about bonds. But it can be a little bit confusing. So I’ve tried to distill the basics into useful information for investors.

What are bonds?

Basically, a bond is a debt obligation to the investor. Companies or governments issue bonds because they need to borrow money. Bonds have a maturity date at which time the bond issuer has to pay back the money to the investor. They also have to pay the investor a little bit more than they paid for the bond, typically in the form of a “coupon.”

Example

For example, say you buy a bond with a face value of $1,000, a coupon of 4% paid annually, and a maturity of 10 years. This tells you that you will receive a total of $40 ($1,000 x 0.04) of interest per year for the next 10 years (often paid semi-annually). You’d then receive $40 per year for 10 years. When the bond matures in a decade, you’d then get your $1,000 back.

Relationship to interest rates

When the economy is growing too fast, the Federal Reserve makes borrowing more expensive by increasing the interest rate, which means people and companies spend less, which discourages inflation. When economic growth slows, the interest rate is decreased so that borrowing will increase and there will be growth.

When interest rates are rising, the prices of older bonds will fall because investors will demand discounts for the older and lower interest payments. For this reason bond prices move in opposite direction of interest rates and bond fund prices are sensitive to interest rates. Bond fund managers are constantly buying and selling the underlying bonds held in the fund so the change in bond prices will change the NAV of the fund.

So bottom line: a rise in either interest rates or the inflation rate will tend to cause bond prices to drop.

Comparison to stocks

Unlike stocks, owning bonds give you no ownership rights in a company. So you don’t necessarily benefit from the company’s growth, but you won’t see as much impact when the company isn’t doing as well, as long is the company is solvent.

Because bonds tend to me much more stable than stocks, their primary role in a portfolio is to offset some of the volatility you might see from owning stocks. They also give you a stream of income, but note that most bond income is taxed at your ordinary income rate, rather than a lower qualified dividend rate of 0, 15, or 20 percent.

Basic Bond Terms

4 main things to consider

The main things to consider are (1) individual bonds vs. bond funds; (2) what type of bond (treasury/corporate/municipal, etc.); (3) what the bond’s credit risk is (chance of default); and (4) duration of the bond (short/intermediate/long).

1. Bond mutual funds (as opposed to individual bonds)

Bond mutual funds (and ETFs) hold hundreds of individual bonds. You can buy and sell them just like you would mutual funds holding stock. An individual bond will not lose value as long as the bond issuer does not default (due to bankruptcy, for example). However a bond mutual fund can gain or lose value, expressed as Net Asset Value (NAV), because the fund manager often sells the underlying bonds in the fund prior to maturity.

Bond funds can be specific in source and duration, such as a VSCSX (Short-Term Corporate Bond Index Fund) or broad, such as VBTLX (Total US Bond Market Index Fund) or BND (Total US Bond Market ETF). For a discussion on index funds vs. ETFs, click here.

2. Types of bonds

Treasury Bonds are the safest type, but lower yielding. They are issued by the US treasury in groups of three maturity ranges:

Bills have a range up to one year; Notes have a range between one year and ten years; Bonds have a range greater than ten years.

Municipal bonds are issued by states and localities. They tend to yield more than treasury bonds but less than corporate bonds. Under present federal income tax law, the interest income you receive from investing in municipal bonds is free from federal income taxes. In most states, interest income received from securities issued by governmental units within the state is also exempt from state and local taxes. This makes municipal bonds ideal for taxable accounts.

Corporate bonds are issued by corporations and are often callable. Since a corporation can default on it’s debts, corporate bonds are subject to credit risk and usually pay higher coupon interest rates over comparable term treasury maturities as compensation for this risk.

High yield bonds are corporate bonds with lower credit quality than top credits. These companies are at much greater risk of default than higher quality credits and, as a result, pay higher coupon interest rates than comparable high quality corporate bonds.

Treasury Inflation Protected Securities provide for inflation indexed income and inflation protection for the bond’s principal.

Zero Coupon bonds do not pay current interest. They are issued at a discount from par value and compound continuously at the coupon rate. The bond holder receives the full principal amount as well as the value that has accrued from interest on the redemption date.

3. Credit risk

Credit risk is a risk that the issuer of a bond may default, such as by bankruptcy. Also known as “default risk.” Bonds are rated according to the following chart.

Treasury bonds are considered the safest and least likely to default. Because of the strength of the U.S. economy, only a monumental downturn in the economy or, possibly, a very rare circumstance during a time of war would prevent the government from repaying its debts. Additionally, the government has power to tax in order to raise the money necessary to pay interest and principal on its borrowings

Municipal bonds are relative safe investments. Cities don’t go bankrupt very often, although it can happen (ex. Detroit, MI and and Stockton, CA).

Corporate bonds are the riskiest of the three. The upside is that the riskier the bonds, the more interest they will pay in exchange for taking on that risk.

There are different grades of bonds within each category. The following are historic default rates:

4. Duration

A bond’s maturity refers to the length of time until you’ll get the bond’s face value back. Changes in overall interest rates will have more of an effect on bonds with longer maturities.

Because bonds with longer maturities have a greater level of risk due to changes in interest rates, they generally offer higher yields so that they seem more attractive to potential buyers. The relationship between maturity and yields is the yield curve and looks like this.

So at any given moment, long-term bonds (10+ years) will pay more than intermediate-term bonds (5-10 years), which will pay more than short-term bonds (less than 5 years). So why opt for any thing less than long term bonds? Again, a longer-term bond carries greater risk that higher inflation could reduce the value of payments. For example, if you pay $10,000 for a long-term bond paying 3% annually, you are locked into that rate. Rates may increase such that in 5 years, long-term bonds pay 5%. But if you opted for the long-term bond at 3%, you’re locked in for another 5 years at that lower rate.

Should I even hold bonds?

From a very long-term historical perspective, long-term government bonds have earned an average 5.64% a year since 1926, while large-company stocks have gained an average 10.01% a year (assuming reinvested interest and dividends.)

So why even invest in bonds? Here are a few reasons:

(1) Holding bonds are a form of diversification and help limit exposure during inevitable down markets. Here is a snapshot of how $10,000 would have fared if invested at 10/9/2007 through the market’s low point on 3/9/2009. VTSMX represents a total stock fund while VBMFX represents a total bond fund.

As you can see, a 100% stock portfolio would have gotten creamed and taken a 55% loss, while a 70/30 portfolio would have mitigated losses by almost 20%. Of course, it’s fair to point out that the market then rebounded and hit all time highs, so buy-and-hold equities investors would have ultimately made out fine. But for those with an investing time horizon of five or ten years, or those in retirement drawing down their principal, an equities heavy portfolio would have caused some sleepless nights. Worse yet would be if a drop in stocks caused an investor to panic and sell low!

(2) Bonds actually outperformed stocks in 10 separate years since 1937. Typically, those periods coincided with stretches of terrible stock market performance, such as the period following the dot-com bust from 2000-2001 and the Great Depression.

(3) Conventional wisdom that increasing your allocation of bonds as you near retirement is sound. While it makes sense for a 21 year-old to hold 90% stocks, it would be ill advised for a retiree to hold the same allocation (assuming that they might actually need the money and would be affected if it dropped steeply in value). Remember the old adage, ‘if you’ve won the game, stop playing.’

So which bonds do I choose?

Larry Swedroe, the director of research for the BAM Alliance, says that historical evidence suggests investors may be better served by excluding corporate bonds from their portfolios, instead using CDs, Treasuries and municipal bonds as appropriate. One concern is that corporate bonds are too highly correlated with stock performance, both of which can nosedive together. Swedroe argues that if you desire a higher return from your portfolio, instead of adding credit risk that comes with riskier bonds, you should consider taking that risk with equities rather than with corporate bonds.

Conversely, financial expert Rick Ferri advocates for not only the inclusion of investment-grade corporate bonds but also lower-grade high yield bonds, on the basis of their diversification benefits and higher potential returns.

I tend to side somewhere between the two. As to ratings, based on historical data, bonds rarely outperform stocks. Their role is stability more than aggressive growth. So I would recommend holding highly quality bonds (Baa or better) and avoiding junk bonds. I do that because I don’t want the ‘stable’ portion of my portfolio to be volatile. However, I’m not against holding high quality corporate bonds, as they still have a relatively low default rate and can boost overall performance.

As far as duration, general wisdom dictates that short-term bonds are the place to be when rates are headed up. But that isn’t always easy to determine and short term bonds don’t tend to very yield much. Long term bonds are a bit risky as you risk getting locked in at a rate that doesn’t keep up with inflation. That’s why I tend to stay in the intermediate term, taking on less interest rate risk than you would with a long-term bond while getting a better rate than I might from a short-term bond. Another happy medium is a total bond fund.

International bonds are an option as well. Recent returns for international bonds have been better than US bonds (BNDX) which has renewed interest in international bond investing.

The better reason to consider international bonds is diversification. While in isolation a given foreign market might appear more volatile, including multiple markets can actually lessen overall portfolio risk. Additionally, for a long time, it was difficult to find international bond funds with a low expense ratio. But it’s become easier, and currently BNDX has an expense ratio of 0.20%. For more reading, click here.

The bottom line is that with the relative stability of domestic bonds, it may not be essential to test the waters into international bonds, but it can potentially provide a diversification benefit.

What to look for in a bond fund

A bond fund will list the percentage allocated to various types and grades of bonds. Be aware of this when comparing yields of different funds, so that you’re not comparing apples to oranges.

  • Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX) or the comparable ETF (BND) is a great starting place. As you can see, it’s well diversified in high quality bonds. Duration average 6.1 years, but as a total market fund, it holds all durations of bonds.

  • Tax exempt municipal bonds – If you are in a relatively high tax bracket, then it makes sense to hold tax-exempt municipal bonds in a taxable account. Basically, you make a trade off of a slightly lower yield for tax-exempt status. The benefit grows the higher the tax bracket you are in.

Here is the best calculator to determine if holding tax-exempt bonds makes sense for you. You will need to know the yield for each fund. Use the “SEC yield” (a fund’s hypothetical annualized income as a percentage of its assets) to determine the rate that each fund pays.

If it makes sense, then a great starting point would be Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares (VWITX). As you can see, there are fewer AAA rated bonds, but also few high risk bonds.

Also, look into whether your state offers a federal and state tax exempt bond fund. For example, California offers VCAIX.

Bonds in Tax-Advantage Space?

Traditional thinking is to hold bonds in tax-advantaged accounts, only placing bonds (municipal bonds for those in a high tax bracket) into a taxable account if there wasn’t sufficient space in tax-advantaged accounts, or if your tax-advantaged accounts offered poor fund choices (ex. high expense ratios).

But there are those who disagree. The White Coat Investor argues for Bonds in Taxable. He recognizes that bonds are taxed as ordinary income which suggests using tax-advantaged space, and that municipal bonds that might be used in a taxable account yield less than other bonds. BUT, he points out the huge value of shielding your highest yielding assets (stocks) in a tax advantaged account. Letting stocks grow without tax drag in, for example, a Roth IRA, can have a benefit beyond that of the tax savings from putting bonds in taxable. Read his article for specific examples.

For what it’s worth, he has a point! I personally hold municipal bonds in my taxable account. But because it’s not a great idea to only hold municipal bonds, I hold a total bond fund and TIPS bonds (which are tax-inefficient) in my tax-advantaged account.

Summary

  • As in most things, diversification, moderation, and a long-term view are the best approach. For bonds, this means holding at least some meaningful portion of bonds in your allocation (20%+ or more) as you near retirement and choosing a diverse selection of bonds, or better yet a bond fund.
  • Holding bonds of intermediate duration or a total bond fund are both safe bets.
  • International bonds provide a diversification benefit but are not entirely necessary.
  • High income investors should consider holding municipal bonds in taxable accounts. When in doubt, do the math yourself!

For a more detailed look at bonds, check out:

 Investing in Bonds for Dummies