We’re Bonding

Earlier in the year, I got an earful from my client “Donald”, complaining about the bond positions that we owned. He said that his friend “had stuff that was paying way more” than the fixed income assets in his portfolio. I explained that his friend owned risky bonds that I did not think were appropriate for him. He begrudgingly agreed, but I don’t think that he was too happy with me.

Flash forward to yesterday, when I spoke to Donald again. He was practically effusive in complimenting me about his bond positions, but admitted that he just didn’t get what had happened and why his portfolio had done well. This made me think that there are so many people out there who really don’t understand how bonds work, so from time to time, I like to “bond” with readers about bonds.

When you buy a bond, you are lending a given entity (the US Government, a municipality or a corporation) money for a given period of time. For the use of your money, the entity will pay you a stated amount of interest (the coupon). Once the bond is issued, your interest payment will remain constant. While many investors think of bonds as safe havens, they are often surprised to discover that bond prices can swing pretty dramatically and sometimes they can lose value. You probably have heard the phrase “bond prices and yields are inversely related” and then thought “what the heck does that mean?”

Bonds become more or less valuable based on the prevailing interest rate environment. As an example, let’s take a look at what happens to a bond when the Federal Reserve changes interest rates. If you purchased a government bond many years ago for $1,000 and it pays 8%, you will receive $80 per year. Today, an 8% interest rate is great, so your bond will be worth more. That means that as prevailing interest rates decrease, the price of your bond will increase---an inverse relationship.

You may not care about the fluctuation in your bond price of you plan to hold the bond to maturity, but if you are considering a sale prior to that time or if you own a bond mutual fund, the change in price can be painful, as many investors found earlier this year when interest rates spiked (and bond prices fell). Of additional importance is that not all bonds are created equal. When Donald called me about his bonds versus his friend’s higher yielding bonds, he thought he was comparing like assets, but that was not the case. In fact, Donald’s friend probably was tired of low yielding government bonds and instead invested in higher yielding bonds that carried lower ratings. Unfortunately, with higher yields also comes more risk.

Over the summer, concerns emerged that overextended homeowners and businesses would not be able to repay the loans they assumed, which meant that billions of dollars in bonds became vulnerable and the people who invested in risky bonds watched the values of their bonds lose money. All of the sudden the extra interest could not compensate investors for the losses in the bond values. Meanwhile, Donald, who owned “boring, low yielding” government bonds was the beneficiary of the problems, as worried investors redirected their risky bond investments into safer alternatives, and his bonds increased in value. After a number of months, Donald bonded with his stodgy fixed income holdings, and my extension, with me.