Ch. 8:  Intro to Bonds

Chapter 8:  An Introduction to Bonds

8.0 Introduction

            Bonds are boring, but useful.  Like a spatula or something.  When you are young, you probably won’t allocate much of you net worth into bonds (and you might own one spatula).  But as you age, the relatively safe nature of bond investing will make the bond-investing more appetizing.  Let’s learn.

8.1 What is a bond?

            In the past, we discussed two general methods firms can use to raise capital.  If a company issues stock (equity financing), the firm is selling off pieces of itself so that it may use the cash to finance projects.  The company does not promise anything specific to the investors, but the investor is subject to future profits that the firm may earn.

  Alternatively, firms may issue bonds (debt financing).  In this case, the firm is literally just borrowing money and promising to repay it in the future at a set maturity date.  To lure investors, the firm will pay interest.  These components—the maturity date and the interest rate—are agreed upon prior to the transaction being made.  Thus, bond investing is generally more stable than stock investing. 

            Bonds that are sold directly by the borrower to the investor are traded on the primary market.  For instance, when I take-out a loan at my local bank to buy a house, this is a transaction occurring on the primary market, but the bank may then sell my mortgage to a larger financial institution.  Trades that occur between investors take place on the secondary market.  Just about all bonds can be re-sold again and again.  This is important.  If you buy a bond that has a maturity date twenty years from today, that doesn’t mean you must wait twenty years to see any money.  You can sell your bond at any time.  Thus, most bonds are quite liquid. 

            There are lots of bonds.  LOTS.  At the time of writing, there were $53T worth of bonds held in the United States alone.[1]  Why?  Just about everyone issues bonds.  Small businesses, big businesses, local government, state governments, etc.  Bonds serve an important function by connecting those that want to save (investors) with those than need money now (borrowers).  The interest rate on these bonds is a function of the demand for bonds (the savers are the buyers) and the supply of bonds (the borrowers are the sellers).  Bonds can be short-term (30 days or less) or long-term (30 years or more).  Bonds can be low-risk (such as US governmental bonds) or high-risk (“junk bonds”).  Bonds  Some bonds have many payments (i.e. coupon bonds), some only have one payment (zero coupon bonds).  Bonds are far more heterogeneous than stocks; thus, one bond investor could be an extreme risk-taker, while the other is a 90 year-old investing in the safest bonds in the world. 

            With so many bonds available, it’s no surprise that wise investors will find value in bond investing.  When you are young, you can withstand significant risk, so you might not own many bonds since one can usually whet their risk whistle in the stock market (say that five times fast).  But as you age and your risk tolerance declines, you will likely transition more of your stockholdings into bonds. 

8.2 Why are Bonds Risky?

            Suppose I loan a friend $100, who promises to pay me $110 in exactly one year.  This is a simple bond with a set interest rate (10%) and specific maturity date.  While you may not use the word “bond” in such transactions, the term is appropriate. There is some risk that your friend never pays you back—this is called default risk.  Your friend may default on their payment for many reasons.  Perhaps you get into an argument and your friend never speaks to you again.  Maybe your friend will get eaten by a bear.  Or maybe you both forget about your deal.  Who knows?

            Different bonds have different levels of default risk.  Essentially every national government issues bonds to finance public projects.  If you buy a bond issued by the French national government, you can be pretty certain you will receive payment.  But if you buy a bond issued by Mexico, there is a greater risk of default.  If both France and Mexico offered a 3% interest rate on bonds, no one would ever buy the risky Mexican government bonds.  Thus, the interest rate on risky bonds will be higher.  At the time of writing, French government bonds were paying a 2.8% annualized return, while a Mexican government bond was paying 9.6%.[2]  To be clear, default risk is only one factor that determines interest rates, but it is an important one to consider.  When you invest in bonds, you can generally expect that bonds promising higher interest rates are riskier.

            For investors that want very low risk, they can invest in bonds that have a low probability of default.  One popular option for American investors is to invest in US government bonds.  US government bonds have basically no default risk, so they are appropriate for investors looking to earn a little bit of interest while taking on minimal risk.  Because the US government borrows soooo much money, there are plenty of US government bonds available to purchase on the primary and secondary markets.

            In addition to default risk, bonds are subject to interest rate risk.  This is a tricky little subject, so pay close attention.  Suppose that all risk-free bonds are presently trading at an interest rate of 4.00%.  Alex buys one of these bonds today, spending $1,000 on a bond that will mature in one year, paying him $1,040.  Immediately after buying the bond, interest rates rise to 5%.  If Alex holds his bond to maturity, this change in interest rates will have no direct impact on him.  But what if he tries to sell his bond?  Now that investors can earn a 5% return, they are unwilling to pay $1,000 for Alex’s bond that is paying a measly 4%. Alex’s bond has lost value. 

            Thus, as interest rates change, so do the value of all bonds.  This unpredictable feature of bond investing is called interest rate risk.  There is always an inverse relationship between interest rates and bond values:  When interest rates rise, the value of previously issued bonds falls.  When interest rates fall, the value of pre-existing bonds rises.  In 2022, rising interest rates led to severe reduction in bond valuations; thus, bond investors had a bad year (bond index funds lost about 10% during this year). 

            There’s a third and final source of risk for bonds—inflation rate risk.  Suppose the current interest rate for risk-free bonds is 2.5% and inflation is 1.0%.  If you own loads of bonds that pay 2.5%, you will, effectively, become poorer if inflation rises above 2.5%.  Think about it.  If you own a bond that will pay $10,000 in 20 years, that $10k is worth more when inflation is low.  Because inflation is unpredictable, so too are the value of bonds.  When inflation rises, the interest rate on your bond does not change.  As a result, the inflation-adjusted value of your bonds falls.  Thus, the unpredictability of inflation serves as a source of additional risk for bonds. 

  A person that wants to (nearly) eliminate their exposure to inflation risk might consider buying i-bonds (i.e. “series I savings bonds”), which are US government bonds with interest rates that rise and fall based on inflation.  When inflation rises, the interest rate on the i-bonds increases, and when inflation falls, the interest rate is adjusted down (but never below 0%).[3]  To fully realize all interest earned from an i-bond, you must hold the bond for at least five years.  If you redeem an i-bond after holding it for more than one year, but less than five, you will lose the last three months of interest accrued by the bond.  And you’re not allowed to cash-in the bonds in the first year of ownership at all.  This lack of liquidity in the first year makes i-bonds unsavory to most young investors, who usually can’t afford to “lock-up” money for a full year.  Nonetheless, in times of high inflation, these bonds are tempting.  In 2022, high inflation resulted in i-bonds paying an annualized interest rate of 9.62%, making these bonds very popular.  In 2022, my wife and I bought $20,000[4] worth of these bonds, which are earning a not-so-great 5.27% interest at present.  No ragrets.  I’m 38 years old and need a bit of bond exposure and can handle the liquidity, so this is a reasonable asset for me to hold. 

8.3 Investing in Bonds—Bond Index Funds

            In previous chapters, we discussed methods for investing in stocks.  I recommended stock index funds, which allow investors to fully diversify while paying very low fees.  Index funds enable the investor to earn market-level returns with no idiosyncratic risk.[5]  Bond-investing is quite different.  There are so many different types of bonds and diversification doesn’t necessarily lead to reduced risk.  For example, a person holding only US governmental bonds is taking a far safer approach than an investor that is buying government bonds from all over the world.  If you get very rich, there might come a point where you take a complicated approach to bond-investing.  I’m assuming you ain’t.  The recommendations provided are for investors that plan to use bonds as a low-risk investment.

  As discussed, the bond market is heterogeneous. As such, the efficient market hypothesis probably doesn’t apply.  Nonetheless, actively managed bond funds still underperform passively managed funds (largely due to fees).  So, bond index funds will suffice for most investors.  Bond index funds, as you would probably guess, are investment vehicles that are passively managed and hold lots of bonds.  Since the management is passive, bond index funds have low fees. 

As shown above, one can invest in a bond index fund that has US bonds, international bonds, or both.  Whether you should invest in international bonds is probably a question that doesn’t have a particularly meaningful answer.  More diversification is good, so, all else equal, you might opt for a world bond fund (or choose to buy both a US and international bond fund).  Unfortunately, it’s unlikely you’ll have many good bond index funds in your 401(k) or other employer-offered tax sheltered account.  So, if you want to buy bonds, you might have to buy something actively managed that levies high fees or only hold bonds in a brokerage account.[6]  Or, if you have a target date fund available in your tax-sheltered account, you can get all the stocks and bonds you need inside one account—more on this in chapter 9.

  You might look at the table above and wonder why anyone would invest in bonds.  But this was an atypically bad ten-year period for bonds.  Interest rates from 2004 to 2021 were very low, meaning that bond interest rates were also low.  And the huge increase in interest rates in 2022 led to sharp declines in valuations for pre-existing bonds.  But remember, most invest in bonds to earn a safe return.  In times of recession, stock index funds typically perform poorly, while bond index funds do okay.  This is indicated by the graph below, which shows the correlation between stocks and bonds.  During recessions (shown in gray) the performance of stocks and bonds is usually negatively correlated, meaning that their values move in opposite directions.  Investors that need to control risk can use bonds to offset the losses that stocks incur during market declines.  And they can do so without totally sacrificing return.  Bonds normally outperform other safe assets like savings accounts and CDs, so a person seeking safe returns will likely find use for bonds.

Correlation, bonds and stocks

Bond index funds aren’t a necessary part of your investing future.  Rather than buy such a fund, you could invest in long-term individual bonds.  For example, if you need a safe return on investment, you could buy i-bonds or other US government bonds.  Some (older) investors build a bond ladder, in which bonds mature incrementally creating a predictable inflow of income.  For example, you could start buying 30-year bonds every month starting at age 40.  When you reach age 70, you receive a bond payout every month.  Unless the US government defaults on its bonds, you have manufactured a way to generate predictable income.  And one doesn’t need to buy bonds for 30 consecutive years for this to work.  A 60-year old could buy bonds that mature in one month, two months, etc.  But it’s not for me.  This is a thing.  I’ve never seen anyone do it, but it’s a thing.  The opportunity cost is too high.  One could have instead investing in stocks (much higher return than government bonds) or a bond index fund (usually slightly higher return than US government bonds) and simply withdraw money when cash is needed.  

8.4 Conclusion

                 How much of your portfolio should be allocated to bonds?  There is no perfect answer to that question, and to develop an informed opinion, one would need to deeply understand a person’s financial situation.  Certainly, age is a major factor.  Younger investors, who can stomach more risk, may reasonably choose to hold no bonds.  Older investors, who may not have the capacity to handle risk, may choose to allocate the majority of their portfolio in bonds (or other safe investments).  Chapter 9 will consider these topics in detail.

End Notes

[1] US Fixed Income Securities Statistics - SIFMA - US Fixed Income Securities Statistics - SIFMA

[2] This is the return for bonds that will mature in 10-years.  Source:  www.worldgovernmentbonds.com

[3] Interest rates are only adjusted every six months.  Thus, i-Bonds do not completely eliminate inflation risk.

[4] The purchase limit is $10,000 per year per person.  My wife and I each bought $10K worth in 2022.

[5] If that sentence doesn’t make sense, read the previous chapters.  These are important details.

[6] In Chapter 9, we will learn about the tax structure of investments.  Because of the way bonds are taxed, it’s usually better to hold any bonds you own in a tax shelter. 

Key Terms

Bond Index Fund: Passively-managed asset that contains a wide variety of bonds.

Bond Ladder:  An income producing system where many bonds are bought with maturities occurring at regular intervals.  For example, a person could buy one bond that matures at the end of next month, one bond that matures at the end of the following month, and so forth.  In doing so, the investor (usually a retiree) has created a system where they regularly receive cash, as if they were a worker earning a regular salary.

Debt Financing:  Raising funds by selling bonds.

Default Risk:  Inherent risk of owning a bond.  Specifically, there is always a chance that a bond issuer will fail to make promised payments.  Some bonds have low risk (e.g. US government), some bonds have high risk.

Equity Financing:  Raising funds by issuing stock.

i-Bonds:  US government bonds that pay interest based on the current inflation rate.  When inflation rates are high, the interest rate on the bond is high. 

Inflation Risk:  Inherent risk of owning a bond.  When inflation rises, the value of future payments fall.  Since inflation is unpredictable, so to is the value of future payment(s) that you will receive for you bond.

Interest Rate Risk:  Inherent risk of owning a bond. 

Maturity:  The point at which a bond ends and the bond issuer must make a final payment.  Some bonds only have one payment (at maturity), while other bonds have many payments (e.g. mortgage).

Primary Market:  The market in which newly-issued bonds are sold to investors.  The saver is directly connected to the borrower. 

Secondary Market:  The market in which a previously-issued bonds are sold to other investors.  If you buy a bond on the secondary market, you are not loaning money.  Rather, you are just buying a bond from another investor

Practice Problems

1.       I buy an i-bond and it sell it three months later.  Explain how this situation is handled (if it's possible at all).

This is simply not possible.  One much hold an i-bond at least one full year before redemption.

2.       I buy an i-bond and it sell it three years later.  Explain how this situation is handled (if it's possible at all).

Since you held the bond more than one year, but less than five years, you will be allowed to sell but will forfeit the last three months of interest-earned.

3.       I buy an i-bond and it sell it ten years later.  Explain how this situation is handled (if it's possible at all).

This is a-okay.  You will be allowed to redeem all interest-earned since you held more than five years.

4.       I own a bunch of typical bonds that I bought a few months ago.  Suddenly, interest rates fall.  If I decide to sell my bonds now, will I earn a profit?  Explain.

Good news.  When interest rates fall, the value of pre-existing bonds rises.  If your bonds are paying, say, 6%, and newly-issued bonds are only paying 4%, your bond will now sell at a premium.

5.       I own a bunch of typical bonds that I bought a few months ago.  Suddenly, inflation rises.  Is this good or bad news for me?  Explain.

Bad.  The inflation-adjusted value of my bond is now lower since the payments I received in the future will have less buying power.

6.       Explain why diversification in the bond market does not always lead to reduced risk.

Bonds are extremely heterogeneous.  If you are holding lots of safe bonds in your portfolio, diversification (into riskier bonds) can lead to a riskier overall portfolio. 

7.       A small business decides to issue bonds so that it may expect to a second location.  This type of fundraising is called _________ financing. 

Debt.

8.       I buy a bond from a small business. The bond matures in 15 years.  Is this bond subject to default risk?  Interest rate risk?  Inflation risk?  Explain.

Yes, all three!  Default risk because the business could fail and I would not receive payments.  Like any bonds (except i-bonds), my bonds are subject to interest rate risk and inflation risk.  If interest rates or inflation rise, my bond will be less valuable.

9.       When you buy an i-bond, are you interacting in the primary or secondary bond market?

Primary.  I-bonds cannot be resold.  So any purchases of i-bonds require direct lending to the federal government.

10.  I buy a secondary-market bond issued by McDonald’s for $4,000.  Will McDonald’s use my money?  Explain.

McDonald’s doesn’t get my money.  Since this bond is sold on the secondary market, my purchase merely transacts money from myself to another investor.