The subject of bonds and the bond market is one of the least understood by investors. Yet it is one of the most popular areas of investment today, especially among individual investors. After bad experiences in the stock market and rising bond market yields, that’s understandable, but those who don’t understand what they are getting into – often substituting extrapolation of recent performance for actual understanding of how bonds work – are vulnerable to what could be bad experiences in the bond market, hardly just recompense for the prudent pursuit of less risky returns.
These remarks apply directly to United States Treasury bonds and mostly to US based investors. The same principles apply to other bonds, except that credit risk is an additional consideration in those cases. As quintessential sovereign bonds, Treausuries are considered free of credit risk and in a sense the purest of bonds by virtue of being limited to interest rate and inflation risks. Principal and interest dollars are virtually certain to be paid as promised, the future value of those dollars themselves is the main issue.
In general a “bond” is a financial security that is really nothing more than a carefully structured IOU. When you “buy” a bond, you are making a loan. The seller of the bond (the borrower) agrees in advance to repay the amount lent (“principal”) plus an additional amount of rent (“interest”) for the use of the money for some predetermined period of time. A simple example would be, say, a $100 bond at 4% interest that “matures” in one year. You pay $100 for the bond, and then one year later you receive $104 back. An analogous bond of ten year maturity might pay you $4 in one year, $4 the next, and so on, until at the end of the tenth year it pays the same $4 in addition to the original $100 amount lent. An actual US Treasury bond usually would pay $2 twice a year. Because the amount of rent (interest) is stipulated in advance, bonds are often referred to as “fixed income” investments.
One of the things that makes this simple concept formidable to new investors is the jargon often used in bond-land. The term “bond” generally refers to a fixed income security of any duration, short to long. But turning to the specific, a short term “bond” is often called a “bill”, and an intermediate term bond (say, ten years) is often called a “note”, reserving the term “bond” for a long term … “bond”. This is particularly the case with the US Treasury market. Yes, it’s confusing … you usually have to draw inferences from context.
It might seem counterintuitive at first, but the short and long term ends of the bond market (TBills and TBonds) are very different animals and fulfill distinctly different roles in an investment portfolio. Think of a bond as a teeter-totter with price on one end and interest rate on the other. The interest rate and price are like reciprocals of each other, when one goes down the other must go up. To make this concrete, reconsider our first example of a one year $100 bond. The interest rate is 4%, so you get back $104 dollars at the end of the year. But suppose the day after you buy it, market interest rates double to 8%. Your bond still only pays $104 at the end of one year (remember that’s “fixed”). Meanwhile, anyone wishing to buy a one year bond can now get one at 8% interest. That means in order to be consistent with the new 8% rate the market price of your bond must now be around $96 – down from the original $100. Notice we have something new here … the value of the bond – despite its “fixed income” nature – changed. Interest rate up, market value down. This is the main thing that makes the bond market, well, “interesting”.
The longer the duration of the bond, the longer the price end of the teeter-totter is. Because the arithmetic is simpler, for this purpose, let’s use as our example a bond that, instead of paying interest once a year, compounds (reinvests) it until maturity and then pays it all in one lump sum (this is called a “zero-coupon” bond). A bond bought today for $100 that pays 4% annualized at the end of ten years would have to pay (1.04)^10*100 or about $148 at maturity. But since the amount paid back is fixed, it makes more sense to look at it from the opposite direction, assuming the repayment stays $100 and that the amount originally paid changes. Looked at that way, a bond that pays $100 in ten years @ 4% interest is worth about $67.56 today. The same instrument @ 8% interest is worth about $46.32 today. So a ten year zero-coupon bond is worth 67.56/46.32 or 45.8% more if the prevailing market rate is 4% than if it is 8%. For still longer term bonds, even small interest rate changes mean big price changes.
The shorter the duration of the bond, the shorter the price end of the teeter-totter is. As you approach zero, the price fluctuations disappear. Very short term Treasury bonds (bills) may have a lifetime of only ninety days … very little price change even for large interest rate changes. This is how “money market” funds work – they’re very short duration bond funds intended to keep their current value steady in normal market conditions. They were originally invented to resemble putting your money in an interest-bearing bank account.
The upshot of all this is that as interest rates rise, you are better off in the short duration bonds. As rates rise, so does your yield. If interest rates fall, however, your yield goes down. This is where long term bonds come in. As rates fall, the price of your bond rises … and the longer the bond, the greater the rise. Conversely, if rates rise, the decline can be large, too. Long bonds are nothing like the relatively tame investments many investors imagine them to be.
Long bonds are nevertheless useful in an investment portfolio even in periods of generally rising interest rates (though you may want to have a smaller allocation), because they have a tendency to zig when other investments zag. This smooths out what would otherwise be wild surges and crashes in the value of your nest egg as a whole, reducing your risk – for example in the event you have an unexpected expense, forcing you to sell while those other investments are down, or tempting you to sell when markets are in a panic and the world seems about to come to an end – and generally making it easier to sleep at night.
Many investors invest in bonds without actually ever buying one as such, instead buying shares in a pooled “fund” that in turn does the actual buying, owning, and selling of bonds. This is simpler in important ways, because you don’t grapple with issues like your bond maturing, paying you back, and then having to buy a new bond in order to remain invested. The fund takes care of that, continually maintaining a portfolio of bonds of a (usually) set duration. But the basic characteristics of the bonds – including the relationship between prevailing rates of interest and the current market value of the bonds – are passed along to investors in the funds. So if you invest in a short term bond fund, the price fluctuations due to changes in interest rates will be small. If you invest in a long term bond fund, they will be large.
So short and long term bonds are not only not similar, but in a way, opposites. Over a full rate cycle, the nominal return on a mix of them will be net positive, but during the intervening zigs and zags their different characteristics complement each other and help smooth out large fluctuations in your portfolio.