A Primer On Bonds

Jason Kirsch
Investment Insecurities
18 min readMar 27, 2017

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While many investors are attracted to the competitive nature of the stock market, the bond market deserves ample attention as its sheer size dwarfs that of equities. Data from the Bank of International Settlements[i] shows that the size of the worldwide bond market is about $82 trillion. In comparison, the worldwide stock market has an average value of $64 trillion[ii]. Due to its size, bond market activity can have tremendous implications for both the stock market and the general economy.

The size of the bond market can be explained by two factors: issuing debt allows companies to borrow more than 100 percent of their value of equity and the bond market includes government-backed securities while the stock market does not. For instance, if the federal government and/or municipalities need money, they can raise taxes or issue bonds but they can’t issue stock.

What Exactly Are Bonds?

Bonds are contractual agreements between a lender and borrower with a set timeframe. A bond purchaser loans a specific amount of money called the principal to the issuer. At the end of the period or the maturity date, the issuer pays back the principal. During the life of the bond, the issuer might pay the buyer periodic interest payments, known as coupons, which are almost always paid semi-annually. Since bonds often pay fixed coupons, they are referred to as “fixed income” instruments.

As you can imagine, bond buyers are interested in figuring out if and when they will be paid back and how much they will receive. The maturity date and other information regarding the specific issue can be found in a legal document called an indenture. If a bondholder holds on to the security, they will be repaid the principal at the maturity date (assuming the lender doesn’t default).

We recently discussed reasons why stocks are great investments. Now we’ll shift our attention to the bond market to determine whether bonds are good investments and what the decisions of bond investors implies for the stock market.

Differences between Stocks and Bonds

Stocks and bonds are two entirely different types of securities. At the core, bonds eventually terminate while stock shares can last indefinitely. While corporations are not required to issue dividends to stockholders, bond issuers are legally required to pay bondholders the interest mentioned within the indenture. When a bond issuer fails to pay interest, it is said to be defaulting. Cases of default are usually settled in court after years of legal system torture. While shares of stock are always issued from public companies, bonds can come from the United States government, municipalities or corporations.

The federal government borrows money by issuing fixed-income instruments called treasury securities. Treasury bills are loans that mature within one year, treasury notes mature in two, three, five and ten years and treasury bonds mature up to 30 years in the future. Since treasury securities are backed by the full faith of the United States, they are believed to have no risk of default (the U.S. Government can print more money when it likes). In fact, many investors consider treasury bills a risk-free asset because they not only have low default risk but, also, limited risk of future changes in interest rates or inflation. However, while treasuries might have a low risk of default, considering them risk free is a mistake. If these securities are highly demanded, investors bid up their prices thus reducing the return on the investment for potential buyers. When this happens, treasuries might fail to pay enough interest to keep up with inflation.

Corporate bonds are riskier than treasuries because its payments are reliant on the stability of the company. The most stable companies are currently solvent, meaning they generate enough cash to pay their debt. Solvency largely depends on whether cash flow is stable or not. If a firm regularly generates little cash, it might find it difficult to muster up enough to pay interest.

Another issue to consider is the company’s current amount of debt. The more outstanding debt a company has, the larger their total interest obligations and therefore the larger the required cash flow to prevent default. The amount of debt a company takes on might also provide insight to not only the ability of the company to pay down their debt, but also to management’s decision-making abilities.

Interest Rates, Inflation and Bond Prices

Bonds don’t have to be held until maturity. In fact, investors often sell them prior to their expiration date on the market. But, unlike a stock where cash flows are uncertain, bondholders know exactly how much cash they will receive in the future. This is assuming, of course, that the issuer does not default.

Investors value bonds, by projecting future cash flows and then discounting them back to the present. Because cash flows are fixed, a bonds value is largely based on factors that affect the rate at which investors discount these fixed coupons, the main ones being: the risk of default, the actual level of interest rates, the markets expectation of interest rates and expected inflation. Assuming the risk of default is non-existent, the value of a bond fluctuates when there is a change in inflation or interest rates.

Inflation is a bond’s greatest enemy. Since cash flows are fixed, an increase in prices directly reduces the purchasing power of future coupon payments. To prepare for inflation, investors factor their expectations into bond prices. However, if inflation is greater than expected, bond prices fall as the value of the fixed-coupons declines. While expected inflation might deflate bond returns, unexpected inflation can cause widespread fear in the market.

Now, let’s discuss interest rates. To comprehend the relationship between bond price and interest rates, you must understand the concept of the yield. The term “yield” refers to the return on an investment when the cost of acquiring the investment is taken into consideration.

Inflation aside, bondholders want to lend for the highest rate possible and bond sellers want to borrow for the lowest rate possible. When interest rates rise, lenders (investors) are able to lend at higher returns and will choose to do so. Existing bonds paying lower interest rates will not be worth as much because investors can alternatively lend money at the current higher rate.

Since bond payments are fixed, a reduction in prices directly increases the return per bond. Therefore during periods of rising interest rates, prices of existing bonds with lower coupons will fall and their rate of return or yield will rise to equal that of similar bonds that are currently being issued.

How Bond Prices Affect Stock Prices

Interest rates and bond yields also affect stock prices. The stock market generally performs poorly when interest rates are rising and bond prices are declining (bond yields increase). This relationship is attributed to many factors, such as:

· Rising interest rates reduces consumption by raising the opportunity cost of spending (saving becomes more valuable in relation to consumption).

· When bonds are providing high returns, the opportunity cost of buying stocks increases as investors can generate adequate return while avoiding volatility and risks that come with owning stocks.

· Rising interest rates increase the cost of mortgages, which puts downward pressure on the price of real estate and demand for construction. A reduction in construction demand has historically hurt corporate profits because many industries sell to construction companies.

· For traders, rising interest rates increase the cost of leverage, diminishing profit margins, which puts downward pressure on stock prices (less demand and liquidity).

Company’s Save Money by Issuing Bonds

Changes in interest rates don’t only affect bond buyers, but also bond issuers. Since the general level of interest rates directly affects the cost of issuing new bonds, companies might be more inclined to raise funds through debt during periods of low rates. However, regardless of the level of interest rates, the decision whether to raise funds through issuing debt or equity is carefully considered. Even in periods of higher rates, companies might prefer to issue bonds.

Regardless of interest rates, the cost of issuing debt is often less expensive than the cost of issuing equity. Furthermore, issuing bonds can lower a company’s taxes. Interest paid on borrowed money can be realized as an expense and can be deducted from pre-tax income, thus lowering overall corporate taxes. This principal is known as the interest rate tax shield. Stockholders don’t share this savings, as dividends paid are not tax deductible. In fact, there is an extra dividend tax applicable on distributions, resulting in double taxation on earnings (once on a corporate level and once on dividend distribution).

While not always a deciding factor, interest rate driven tax savings can make a substantial difference to after-tax income in large corporations. Because of this, it is standard practice for corporations to determine the cost of borrowing as the current interest rate minus the tax savings attributed to future interest payments.

Default Risk

As discussed, bond investors are interested in determining if and when they will be paid back, and by how much. To determine a best estimate to answer this question, investors focus on the interest rate, maturity date, and company issuing the security. On websites such as Yahoo Finance, investors can easily determine the interest rate, maturity and coupon rate.

To determine the financial stability of the firm, we can look at its credit rating and other fundamental metrics to determine its ability to pay interest over the lifetime of the bond. In addition, investors might want to note whether the security includes call provisions[1], convertible options[2], and/or insurance.

Determining the chance of being repaid requires ample analysis. Luckily for us, there are companies that provide assistance. Credit rating agencies exist to provide bond investors with a system that helps investors make more informed decisions. While rating systems differ from firm to firm, most follow a universal structure. For example, bonds issued from companies that are considered non-risky are classified as investment grade and have a credit rating of BBB or higher. Bonds issued from companies that are considered risky are rated BB or lower and are classified as junk. Note that the name shouldn’t represent whether the bond is a good investment. A junk bond that trades at a low price, or is considered junk for the wrong reasons might have lower risk than an investment grade bond trading at a high price.

The three most notable rating agencies are Standard & Poor’s, Fitch, and Moody’s. These powerful firms had built a stellar reputation amongst institutional investors and their triple-A rating is still considered invaluable to blue chip companies. However, the recent market crash tested the credibility of these agencies and damaged their once-stellar reputation. Even when the crises seemed evident, Moody’s and Standard & Poor’s issued top ratings to financial instruments that eventually went toxic.

Today, the big 3 credit rating agencies are still trusted, as the market seems to operate with a short memory. The chance that these rating agencies conducted business in a dishonest manner has not derailed the fact that the financial system cannot function without them. However this is not shocking. The same companies that are being judged by rating agencies are the ones that pay them in the first place — a conflict of interest if there ever was one.

The Credit Spread

In addition to helping investors determine a company’s risk of default, the credit rating system provides a framework that explains how investors are responding to default risk. By analyzing the difference in yield between bonds with different credit ratings (comparing similar bonds with equal maturities and provisions), you can determine how much return investors require per unit of default risk. The additional return required for investing in risky bonds is called the default risk premium. Investors can analyze the default risk premium through plotting the credit spread.

As you can imagine, investors generally require higher yield for taking additional default risk. This premium not only sets prices for the bond market, but also plays a big role in setting the premium investors require for purchasing equities. Since equities have more inherent risk than bonds (uncertain cash flows and no principal repayment), stock investors determine their required rate of return for holding stock based on the yield of both non-risky and risky bonds.

Figure 10 shows the credit spread, or the difference in yield between risk free and risky bonds. Note that investors generally compare the difference in yields between treasuries and BBB rated bonds, as the market considers anything less as having a material risk of default.

As you can see, credit spreads grow during market panics when investors become more cautious and risk averse[iii]. When this occurs, demand for low risk bonds increases, prices rise, and yields fall. Correspondingly, demand for high-risk bonds decreases, prices fall, and yields rise. The result, a larger credit spread.

Eventually, cautious behavior puts downward pressure on stock prices as they are considered more risky than bonds. Freed up capital transfers into less risky investments, such as treasury bonds, which puts further downward pressure on treasury yields, widening the credit spread even more.

But, large credit spreads don’t last long (Figure 10). Initial fear causes investors to demand lower risk bonds but, eventually, investors bid up the price of entities with higher risk. While there are many factors at play that contribute to this phenomenon, complacency amongst investors is the most logical answer.

As demand for lower risk instruments increases, yields decrease and investors begin to search the market in hopes of finding adequate returns. This can mean that investors either put money back into the stock market, alternative assets or higher risk bonds (usually a combination of all three). Thus, complacency or the act of reaching for returns acts as a natural correction that prevents the credit spread from becoming too loose.

When investor’s begin to demand higher risk bonds (junk bonds), prices increase and yields decrease. Today, junk bond returns are at a historic low, reflecting complacency in the market[iv] (figure 11). At such high prices, junk bonds are more risky than they have been in the past.

Interest Rate Risk and Maturity

Aside from the risk of default, bond investors are also threatened by the chance of increasing interest rates. Let’s say we have determined that the chances of being paid back our original investment are high, as would be the case when investing in treasuries. Now, we must determine when we will be paid back and if the fixed interest payments we receive will compete against future issues.

As interest rates change, so does the value of outstanding bonds. This interest rate risk becomes more substantial as the time until maturity increases because there is more time for rates to extensively change. Therefore, short-term bonds generally have less interest rate risk than those with longer maturities.

On top of the direct relationship between maturity date and interest rate risk, the interest an investor receives in payments determines how sensitive the bond is to changes in interest rates. A bond that pays a high interest rate can combat rising interest rates better than a bond that pay a low rate.

A bond’s duration measures its price sensitivity to changes in interest rates and takes into account its maturity and stated interest rate. The higher the duration, the more volatile the bond and the more sensitive it is to changes in interest rates.

While a bond’s maturity informs investors when they will receive the principal payment, duration informs them of the risk inherent in the security due to future changes in market bond yields. Because duration factors in interest payments, it is a superior measure of interest rate risk. For bonds that mature on the same date, a higher paying coupon often means lower durations and less risk because the bondholder has already made more of their money back through interest payments. For bonds maturing on different dates, those with longer time until maturity will have higher durations (assuming coupon rate is the same).

The Yield Spread

To determine how the market is responding to interest rate risk, investors study the spread between bonds of different maturities. Most often, investors compare the two most popular bonds, the treasury bill and the thirty-year treasury bond. These bonds work well not only because they are popular, but also because they are alike in almost every way, except length till maturity.

For Illustration Purposes Only

The Bond Market Isn’t Just For Bondholders

The bond market, more than the stock market, gives investors a comparison of returns for investments of different risk. This is because, in practice, investors determine the value of non-risk free bonds by attaching a specific premium to that of the rate on treasury bills. Since investors require compensation for taking risk, risky bonds will offer a higher return than those of lesser risk.

In addition to using treasuries to assign a value to risky bonds, investors use bond yields (of both risk-free and risky bonds) to determine their required premium for investing in stocks. Because of this, the bond market has powerful implications on both the stock market and the national economy.

The Yield Curve

The best indicators are ones that don’t measure what investors are expecting to do but, rather, what they are actually doing. In the bond market, these are the yield curve and the credit spread. In fact, these indicators are so powerful that they have each predicted many of the previous recessions[v]. While the credit spread implies how investors are responding to risk, the yield curve measures the market’s expectations for future interest rates and inflation.

The yield curve shows the “term structure of interest rates” or the relationship between yield and maturity dates. Most commonly, the longer the maturity, the higher the yield as investors generally require compensation for taking extra maturity risk. This normal condition would create an upward sloping yield curve as shown on the left side of figure 13.

In special circumstances, one might see a yield curve that is downward sloping (as seen on the right side of figure 13). This is called an inverted yield curve and shows that long-term yields are below those of short-term. Imagine lending out money for thirty years and being paid less interest than on a three year loan?

There are a number of reasons why this occurs. One is that the market is currently experiencing well above average inflation and investors expect it to drop and, two, the market expects the Federal Reserve to lower short-term interest rates in the future. The market might expect the Federal Reserve to lower short-term interest rates when they believe banks will begin to tighten their credit lending (signaling a weak economy). This would mean that the easy access to credit often seen during a bull market is expected to end.

It is important to understand that the yield curve’s Y-Axis (vertical axis) represents bond’s yields, not the level of interest rates set by the Federal Reserve. Because yield reflects supply and demand in the bond market, it reflects how fixed-income traders respond to changes in future expected interest rates and inflation.

Normally, fixed income traders view short-term rates as a function of the Federal Reserve’s policies and long-term rates as a function of the strength of the general economy. Therefore, when traders expect the general economy to weaken they will also expect the Federal Reserve to lower rates and will take advantage by buying long-term bonds (decreasing interest rates will increase long-term bond prices more so than those of short-term). Increased demand for long-term bonds lowers long-term yields, flattening and potentially inverting the yield curve (as seen prior to the 2007–2008 credit crisis).

This scenario is only the case assuming inflation expectations remain constant. The market usually expects inflation during periods of growth. Because inflation erodes the value of future coupon payments, investors require greater yields on long-term bonds, as more coupon payments will be affected by future inflation (interest rates aside). An increase in required return is seen by declining prices of long-term bonds. Alternatively, investors expect less inflation when growth is expected to slow. A reduction in erosion of the value of future coupons causes investors to bid up the prices of long-term bonds, as they require a lower return.

Since economic growth is dependent on easy access to credit, it is easy to see why the yield curve is considered one of the strongest indicators, having predicted the past seven recessions[vi]. However, many argue that the current market environment undermines its predictive power.

Since interest rates are currently remarkably low (near zero), the Federal Reserve can’t really lower them any further. Since it is unlikely rates will reduce, a flattening or inverted yield curve seems unlikely, as it may only occur from unprecedented factors such as high-expected deflation[3].

Why Long Term Investors Shouldn’t Invest In Bonds

I don’t suggest long-term investors invest in bonds because their yields are currently low and they have historically underperformed equities. While bond values may not fluctuate as much as stocks, they will make you less money in the long run.

The “Golden Era” for bonds occurred in the early 80s.

While discussing stocks I argued that the reason why bonds have historically underperformed equities (and by a great margin) is because stocks realize intrinsic growth and bonds don’t. Long-term investors don’t want to hold an investment that doesn’t realize growth unless it pays high interest.

However, investing in bonds can occasionally be a profitable endeavor in the short term. With exception to a few brief periods from 1980 to 2010, bond investors did very well for themselves[vii] because bond yields steadily declined (figure 15) and prices increased, generating a nice gain for bond holders. However, today, yields are near a half-century low and, in this environment, I don’t see how long-term investors can earn adequate return by investing in bonds.

I am not saying that every investor shouldn’t expose themselves to bonds. Instead, I am trying to make the point that long-term investors can accomplish their goal of outperforming the market while preventing forced selling by investing in stocks alone. But, notice how I say “long-term investors.” Investors who have a shorter time horizon and those that are in need of assured periodic income might be best off maintaining a portion of their portfolio in bonds because they aren’t able to handle large price swings that occur with stocks.

Key Takeaways

· Bond holders are interested in figuring out if and when they will get paid back and how much they will receive.

· Treasury bills are considered by many investors to be risk free. However, while they may have no risk of default, high demand can push down yields to trail inflation. Therefore treasuries may not be risk free when yields are low or inflation is high.

· Inflation directly devalues bonds by reducing the value of each future interest payment.

· Rising interest rates directly put negative pressure on bond yields.

· Investors look to credit rating agencies to determine default risk for bond issuers regardless of them having a less than perfect track record.

· The bond market, more than the stock market, gives investors a comparison of returns for investments of different risk. The two best indicators are the credit spread and the yield curve.

· The credit spread reflects how investors are responding to default risk and is an important metric for all investors, including those who only invest in stocks.

· The yield reflects how investors are responding to maturity risk and is just as important as the credit spread. In fact, the yield curve has predicted the past seven recessions.

· Historically, bonds have been poor investments. While they can perform well in the short-term, long-term investors can accomplish their goals by investing solely in the stock market.

[1] A call provision allows the issuing company to recall its bonds on a specific date.

[2] A convertible bond is one that is able to convert into common stock.

[3] Some experts believe that the U.S. economy is heading in the direction of deflation. While the Fed can battle inflation by raising rates, it might be unable to combat deflation. Deflationists believe that recent quantitative easing might have reduced its power over the markets, leaving the fed little power to fight deflation.

[i] Bis.org,. (2014). Debt securities statistics. Retrieved from http://www.bis.org/statistics/secstats.htm

[ii] World-exchanges.org,. (2010). Statistics | World Federation of Exchanges. Retrieved from http://www.world-exchanges.org/statistics

[iii] Barth, J., Li, T., & Phumiwasana, T. http://apeaweb.org/confer/bei08/papers/blp.pdf. Retrieved from http://apeaweb.org/confer/bei08/papers/blp.pdf

[iv] Aneiro, Michael. “New Record Low For Average Junk Bond Yield: 4.9%.” Income Investing RSS. Barrons, 17 June 2014. Web. 19 Feb. 2015. <http://blogs.barrons.com/incomeinvesting/2014/06/17/new-record-low-for-average-junk-bond-yield-4-9/>.

[v] Nguyen, T. (2014). THE YIELD CURVE AS A LEADING INDICATOR ACROSS COUNTRIES AND TIME: THE EUROPEAN CASE. University Of New Hampshire. Retrieved from http://scholars.unh.edu/cgi/viewcontent.cgi?article=1209&context=honors&sei-redir=1&referer=http%3A%2F%2Fwww.bing.com%2Fsearch%3Fq%3Dyield%2Bcurve%2Bpredict%2Bpast%2B7%2Brecessions%26FORM%3DAWRE#search=%22yield%20curve%20predict%20past%207%20recessions%22

[vi] Rudebusch, Glenn D. “Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve.” Journal of Business and Economic Statistics 27.4 (2009): 492–503. Federal Reserve Bank of San Fransisco. The Federal Reserve, 1 July 2008. Web. 19 Dec. 2014. <http://www.frbsf.org/economic-research/files/wp07-16bk.pdf>.

[vii] Dimson, Marsh and Staunton, Credit Suisse Global Investment Return Yearbook 2011, p.9.

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Jason Kirsch
Investment Insecurities

I'm Jason Kirsch, CFP(R) and founder of Grow. Im on a mission to inspire my gen to take positive action and improve their lives. Chk us out online.