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Understanding Bonds


Investing in Bonds

Understanding Bonds - Investing in Bonds; picture of a company contract for par value of sixteen dollars and two thirds for 100 shares for investor portfolio

Investing in bonds is a popular alternative to investing in the stock market for many new investors. Their perception is that it is easier and safer than the stock market and they are under the general impression that their money is guaranteed. This is not necessarily the case and can cause the beginner investor considerable distress when their bond portfolio underperforms.

Just like there is some background studying that needs to be done to understand the stock market, there likewise is some background studying that needs to be done to understand the bond market.

A bond is simply a financial contract whereby an investor lends money to the federal government, an agency, a municipality or a corporation. The bond has a serial number and contains the terms and conditions of the contract, which includes the amount loaned, the interest payment terms and the date at which the money will be returned.

The terminology for bonds is straight forward and can easily be understood by stock investors. Buying and selling bonds is a simple process and a lot of online stock brokers also provide a bond brokerage service.

Adding bonds to an investment portfolio is a popular strategy by stock investors. The performance of bonds is usually poorly correlated with the performance of the stock market. This means that when the stock market underperforms it is common for bonds to outperform, thus bonds help to reduce the volatility of the returns from a portfolio consisting only of stocks.

Bonds are popular with stock brokerage accounts and with retirement accounts such as IRAs. There are many reasons why stock investors buy bonds and they range from receiving an income payment to investing safely in the short-term. Some stock investors utilize bond investing strategies in the same way as they do with their stock investing. Indeed some investing strategies combine corporate bonds with stocks.

Understanding Bonds - Investing in Bonds; picture of a pen pointing at prices printed in the financial newspaper for investors to select for their portfolio

For stock investors who prefer not invest directly in bonds there are a vast variety of funds which specialize in bonds. There are also mutual funds which are designed specifically for retirement investing which are known as Target Date Retirement Funds which combine stocks and bonds.

The common bond categories stock investors include in their portfolios are Treasury bonds, Municipal bonds and Corporate bonds. While bonds are low risk, there are some risks with bonds that investors should be aware off.

Treasury bonds are virtually guaranteed and in addition to their safety, treasury bonds are not callable, thus a Treasury bondholder will continue to receive their coupon payments until maturity with no risk of early recall. Also treasury bonds have a tendency to appreciate in value during economic recessions as opposed to stocks which typically decline in value during recessions.

While the out-performance of treasury bonds during economic recessions is appealing, in the long-term they underperform stocks by a fair margin. Stocks tend to average around 10% or more over the long-term while treasury bonds tend to average around 5%.

Municipal bonds are popular for their tax advantages, but they are slightly more risky than treasury bonds.

Corporate bonds tend to be more popular with experienced and active investors as they are more risky, but they also provide the higher long-term returns. However the long-term return from corporate bonds is only about one to two percent more than treasury bonds.

Junk bonds provide a couple of percent more return than corporate bonds but these are at a higher risk of default with a lot of volatility and the long-term return is still less than that from stocks.

Bonds come with a variety of returns, risks and volatilities and depending on the investor's goals can provide more diversification than a stock only portfolio.

Bond Terminology

Understanding Bonds - picture of lots of writing in dark brown on a white background saying bond terminology in large font capital bold letters with more words like issuer and maturity

The terminology used with bonds is consistent amongst the various categories of bonds such as treasury bonds, municipal bonds and corporate bonds. These terms are discussed as follows:

Bondholder

The bondholder is an individual person or an institution such as a bank, insurance firm or mutual fund which currently owns the bond.

Issue Date

The issue date is simply the date that the bond was first issued.

Face Value

The face value is the dollar amount of the bond and is the amount which will be repaid to the bondholder at maturity. The face value is also referred to as par value or the principle.

Coupon Rate

The coupon rate, also known as the coupon yield is the interest rate specified in the bond contract and is usually a fixed percentage, but some bonds have a variable component built into the interest rate. Good examples of variable rate bonds are Treasury Inflation-Protected Securities (TIPS) and I Savings bonds.

Coupon Payment

The coupon payment is the cash payment a bondholder receives. Most bonds make a payment twice a year (every six months). The term 'Coupon' comes from the old days when bonds were issued in paper certificate form and the bond had a series of coupons attached which the bondholder would use to claim their interest payment (one coupon generally gave a six month interest payment).

Nowadays most bonds are issued in electronic form and all interest payments are made electronically. Not all bonds make coupon payments. With bonds such as treasury bills the interest is not realized until the bonds maturity. With Savings bonds the interest is not realized until the bond is redeemed.

Zero-coupon Bonds

These are bonds which do not pay a coupon payment but instead the interest is accrued and is paid out at maturity. This means that at maturity, the bondholder receives both the principle and the accumulated interest over the life of the bond. Savings bonds issued by the U.S. Treasury use this concept.

Maturity

The maturity of a bond is simply the date that the bond ceases (such as March 2020). At Maturity the face value plus any accrued interest is paid to the bondholder.

The maturity is usually quoted as the length of time from the date of issue until the termination date.

Example: A bond issued in March 2010 and matures in March 2020 is referred to as a ten year bond.

The maturities can be as short as a few weeks and can be as long as 30 years.

Marketable Bond

A marketable bond is a bond which can be transferred to another investor (which means that the bond can be sold). Not all bonds can be transferred - such as Savings bonds.

Bonds which are sold after they are issued are generally referred to as used bonds. They are normally sold to a bond dealer who in turn makes them available for repurchase. Thus a bond investor has the choice of whether to a buy a new bond (a bond that is being issued) or they can by a used bond.

Bond Price

Just like stocks have a stock price, marketable used bonds have a bond price. These used bond prices are available from bond dealers and they have a Bid and Ask price. To buy a bond, the investor pays the Ask price and to sell a bond, the investor receives the Bid price. Thus an investor can buy and sell bonds just like stocks.

Bonds are quoted in a dollar amount based on $100 of face value.

Example: A bond with a face value of $1,000 is quoted as 110.28/111.33. Buying this bond will cost $111.33 per $100 of face value, which means the purchase will cost 10 x 111.33 = $1113.30 for the $1,000 bond.

Bond Value

The bond value is simply the purchase cost of a marketable bond, which is the Ask price multiply by the number of $100 increments being purchased.

Example: For a bond quoted as 110.28/111.33 the bond value is 10 x 111.33 = $1113.30 for a $1,000 bond.

Bond resale Value

The bond resale value is simply the dollar amount received if a marketable bond were sold.

Example: For a bond quoted as 110.28/111.33 the resale value is what the investor can currently sell their bond for (which is the Bid price). The resale value is 10 x $110.28 = $1102.80.

Callable Bonds

These are bonds which have a call option specified in the bond contract. This means that the issuer can terminate the bond and repay the face value to the bondholder. The term option is simply a feature of the bond specification and has nothing to do with exchange traded options (do not confuse this with an options contract).

A bond can only be recalled by the issuer if the bond contract specifies a call option. Issuers normally exercise their call option when interest rates drop and they can issue new bonds at a lower interest rate.

Some bonds may have a put option specified in the bond contract. With a put option the bondholder has the right to return the bond to the issuer and receive back their principle. The most common use of the put option feature is with U.S. Savings Bonds (which the U.S. Treasury refers to as redemption).

Thus a call option gives the issuer the right to cancel the bond and a put option gives the bondholder the right to cancel the bond.

Convertible Bonds

Some corporate bonds have an option where the bond can be redeemed to the issuer in exchange for shares in the issuing company. The bond specifications state whether the bond is convertible and what type of stock will be obtained (usually common stock but some bonds will convert to preferred stock).

The bondholder has the option of converting and most investors will convert when the stock price is sufficiently attractive. Once an investor converts to stock they are now stockholders and no longer bondholders (also they cannot convert back to bonds).

Current Yield

While the coupon yield is the bonds yield based on its face value, the current yield is based on the purchase price of a used bond. The current yield is important to buyers of used bonds as the purchase price is likely to be different to the bond's face value.

The purchase price of a used bond is the Bid price multiplied by the number of $100 lots.

Example:A bond quoted at 93.45/93.98 would cost $93.98 for every $100 of face value.

If the investor buys $1,000 of face value, then the purchase will cost 10 x 93.98 = $939.80.

If the coupon payment were $50 per year, the current yield is 50 / 939.80 x 100% = 5.32%

Yield to Maturity

The yield to maturity is usually calculated based on the interest being reinvested. The current yield is based the coupon payments being used as income while the yield to maturity is based on the interest being reinvested thus making use of the compounding effect. The price used is the purchase cost.

The calculation for yield to maturity is quite complex and is best done with a financial calculator.

Yield to Call

The yield to call is the same complex calculation as yield to maturity with the interest reinvested, except that instead of the bond being held to maturity, the time until the bond can first be recalled is used in the calculation.

Bond Insurance

Some bonds are issued with insurance which covers the bondholder in the event that the issuer defaults. Insured bonds are more common with municipal bonds as these bonds are largely sold to individual investors.

The insurance is more likely added when the municipalities are not selling sufficient bonds or they are issued for public works and the bond security is dependant on revenue generated. Even though the default rate for municipal bonds is very low, the insurance still helps increase the individual investors' confidence that the bond is a safe investment. In reality there is always the risk that the insurance firm itself runs into financial difficulty.

CUSIP

Both U.S. stocks and bonds have a unique identification code referred to as the CUSIP which stands for Committee on Uniform Securities Identification Procedures.

The CUSIP code consists of nine characters and includes letters and numbers, and is used with the settlement procedures. The first six characters identify the issuer. The next two characters identify the actual bond issued or the stock class for stocks.

The last character is a check digit that is calculated using a formula. The purpose of the check digit is to act as means of checking that the first eight characters were entered correctly. If any of the first eight characters contained a typing error, then it will produce a different check digit, thus allowing for the typing error to be picked up.

Buying and Selling Bonds

The retail investor generally buys and sells their bonds through a bond dealer

Understanding Bonds - Buying and Selling Bonds; picture of a computer keyboard for investors with a green key saying buy and a red key saying sell

When investors buy Bonds they are primarily bought from a bond-dealer. Investors cannot directly buy from a dealer and they are required to transact through a broker. Thus the broker purchases the bond from a bond-dealer on behalf of the investor.

Experienced bond investors might have a direct access brokerage account where they can access the electronic bond markets directly in the same manner as stock traders access ECNs (Electronic Communications Networks).

These investors buy their bonds directly from an electronic market (just like stocks on an ECN). This by passes the bond-dealer (who is also known as a broker-dealer). Investors often get confused between brokers and broker-dealers. Essentially they are two different businesses, but they can be operated by the same company.

Bond Dealers

A bond dealer is similar to a used car dealer - they both buy with the specific intention of reselling. Bond dealers buy bonds and resell them at a marked up price. This results in a Bid price and an Ask price.

Buying and Selling Bonds:

  • When an investor buys a bond from a dealer they pay the Ask price. This is similar to buying a used car at retail price.
  • When an investor sells a bond, they are selling the bond to a dealer and receive the Bid price. This is similar to trading in an old car for which the owner receives the trade-in price rather than the retail price.

Both the bond dealer and the used car dealer make their money from the difference between the buy and sell prices.

Bond Brokers

A broker is the firm which locates a dealer to buy from or sell to in order to fulfill an investor's order and typically charges a broker commission for their service.

Brokers and Broker-Dealers

Thus a broker and a dealer make their money in two completely different manners. A company can operate both a broker business and a dealer business. As such it is possible that an investor ends up buying a bond from the same company as their broker.

If the company operates as both a broker and a dealer they are referred to as a broker-dealer. If they only operate as a broker then they are referred to as a broker and if they only operate as a dealer they are referred to as a dealer.

Banks also tend to operate a bond dealer business and may also operate as a bond broker.

Some brokers specialize in bonds while others are stock brokers that also deal with bonds (and usually other markets such as commodities and currencies).

Buying Bonds

Newly issued Treasury bonds and Savings bonds can be bought directly from the U.S. Treasury. This requires opening an account with them through their website TreasuryDirect.gov and all bond purchases made are paid for with funds from a nominated bank account. The bonds are held with TreasuryDirect and there is no need for a bond broker.

Treasury bonds purchased through TreasuryDirect are bought at market price which is determined through an auction process. Thus the investor effectively buys with a market order and the price paid is not known until their order is filled. Paying the market price for treasury bonds is in effect the same as a stock investor who places a market order to buy stocks.

TreasuryDirect also allows investors to place a limit price order for treasury bonds, but limit orders must be placed through a bond broker or bank. Using a Limit order to buy bonds through a broker is exactly the same as using a limit order to buy stocks - the order may or may not be filled. When using a broker to buy newly issued treasury bonds, the bonds are held in an account with the broker and not with TreasuryDirect. When using a bank, the bonds are held in an account with the bank.

Retail investors can buy US Treasury bonds

directly through TreasuryDirect

Similarly, Savings bonds can be bought through a bank rather than through TreasuryDirect and they will be held in an account with the bank. Savings bonds are aimed at the general public and they do not require any investing knowledge to purchase them.

Used treasury bonds can only be purchased through a bond broker as TreasuryDirect only sells new issues.

Both newly issued and used municipal bonds and corporate bonds are purchased through a bond broker.

Investors can buy individual bonds or they can buy a bond fund such as a Mutual fund.

When bonds or bond funds are purchased through a stock broker then these are held in the same account as the investor's stocks.

A full-service bond broker may get a better price for a bond, but they tend to want to manage the portfolio for an annual fee and charge a higher commission. Using a full-service broker may suit some investors, but if they are not comfortable buying bonds themselves then the easiest way for a stock investor to gain exposure to bonds is to buy a bond fund, especially an ETF.

Selling Bonds

Savings bonds do not have a maturity like most bonds and cannot be sold. They can be redeemed any time after one year from the date of issue. A penalty applies if they are redeemed within fives years and the penalty is that the investor forfeits the last three months of accrued interest.

Example: If an investor redeems a Savings bond after 24 months they receive the principle and the first 21 months of accrued interest. Also Savings bonds stop accruing interest after 30 years but they are not automatically redeemed - the investor must redeem the Savings bond themselves.

Treasury bonds (including bills and notes) can be sold before maturity. If they are held in a TreasuryDirect account then the investor must first transfer the bond to a brokerage account. In the past, treasury bonds held with TreasuryDirect could be sold through SellDirect, but this service is no longer available.

Once the treasury bonds have been transferred to a broker they can be sold just like selling stocks.

If the treasury bonds were purchased through a broker then they can simply be sold through their broker. The same applies to any municipal bonds or corporate bonds purchased through a broker.

The Bond Market

The bond market is basically an over-the-counter market rather than the centralized stock markets like NYSE or NASDAQ. The bond market nowadays is still similar to the NASDAQ OTC BB market; expect that the bond market has now extended with bond trading platforms in a similar fashion to the Electronic Communication Networks (ECN) which trade in parallel with NYSE and NASDAQ.

NYSE now has their own bond trading platform for corporate bonds called NYSE Bonds, which is based on the NYSE owned ARCA trading platform used with the ARCA ECN. The NYSE Bonds platform has an order book (Level 2) which shows the Bids and Asks for each bond traded on their system. Most of the Bids and Asks are from bond dealers, but with NYSE Bonds effectively being an ECN, they allow individual investors and traders to place limit orders into their order book via a direct access broker.

Thus stock investors and traders with a direct access broker can place limit orders into NYSE Bonds order book in exactly the same way they do with the ECNs for their stocks.

There are several other bond trading platforms similar to NYSE Bonds which cover the Treasury bond market and the Municipal bond market. The only downside with these platforms is that they do not necessarily include all bond dealers and thus the best Bid and best Ask may in fact not be the best prices currently available.

The Risks with Bonds

Bonds are generally safe investments - but there's no money back guarantee

Understanding Bonds - The Risks with Bonds; picture of an investors tablet laying on a wooden table with writing saying finance and inflation and loan debt

Bonds are amongst the safest of investments. Excluding junk bonds, the risks are generally much lower than that of stocks and are considerably lower than commodities such as oil, gold and currencies.

While bonds are considered fairly safe, there are still some risks associated with them. The risks come in two forms - the risk of loss and the risk of the bond not performing as expected.

The risk of loss is primarily due to the bond issuer defaulting on their obligations. The default can be that the issuer does not make all their required coupon payments or in the worst case the default is that the bond principle is not returned at maturity. The risk of default varies depending on the bond type and the bonds maturity.

The other risk with bonds is that the bond does not perform as expected. While a bond may have been a good deal when it was issued, interest rates do change and when new bonds are issued in the future with higher coupon rates, the resale value of the existing bond drops and also the bondholder is now receiving am interest rate that is less than the new rate.

Another risk bondholders' face is that the credit rating of their bond is reduced which in turn lowers the resale value of their bond. Also some bonds face a liquidity risk; this is where a bond cannot be sold as there is no demand for that bond or that the resale price is extremely low due an extremely wide Bid-Ask spread.

The various risks that bondholders face are discussed as follows:

Interest Rate Risk

The interest rate of bonds is largely linked to the inflation rate as determined by the consumer price index (CPI).

The value of used bonds is predominantly dependant on the interest rate of newly issued bonds. When the coupon rate of newly issued bonds increases, any older bonds will have their value adjusted to reflect the new coupon rate.

Example: An older bond with five years to maturity makes a coupon payment of $50 per year with a face value of $1,000 and new bonds are issued which pay $70 per year with a face value of $1,000.

The market will adjust the value of the old bonds so that they have the same returns as the newly issued bonds over the five year period.

New bonds:Five years of coupon payments = 5 x 70 = $350

Old bonds:Five years of coupon payments = 5 x 50 = $250

The market will likely pay around $100 (350 - 250) less for the old bonds.

The reason the old bonds are revalued is straight forward. For a bond investor, why pay $1,000 for an old bond paying $50 per year when they can simply buy a new bond paying $70 per year. Anyone trying to sell an old bond will have to lower their expected price so that it provides the same return as the newly issued bond.

Should the interest rate for newly issued bonds be lower than that from older bonds, then the value of an older bond increases.

Example: An older bond with eight years to maturity makes a coupon payment of $50 per year with a face value of $1,000 and new bonds are issued which pay $30 per year with a face value of $1,000.

New bonds:Eight years of coupon payments = 8 x 30 = $240

Old bonds:Eight years of coupon payments = 8 x 50 = $400

The market will likely pay around $160 (400 - 240) more for the old bonds.

The value of older bonds is very sensitive to the interest rate of newly issued bonds. The value can even be affected if the new bonds are issued by another issuer with the same credit risk. Ultimately bond investors look for the best returns for a certain credit risk.

When actually selling a bond, the resale value will be lower than the bond value since the bondholder will have to sell to the Bid price and effectively loses out on the dealers Bid-Ask spread.

Inflation Risk

Apart from interest rate risk, the bondholder also faces another type of risk which is inflation risk.

Inflation effectively reduces the future spending power of money. Thus $1,000 today is worth less in ten years time as inflation increases the costs of everything that can be bought. In other words, $1,000 buys more today than what it will in ten years time.

The future yield of a bond may well be

less than the future inflation rate

Inflation Risk

If inflation is running at 3% and a bond is paying 5%, then the investor is increasing their wealth by only 2% per year and not 5%. The risk the investor faces is that the inflation rate in the future might increase above the 5% that the bond is paying.

If inflation increased to 7%, then the investor's future return is actually negative 2%. This is because the price of everything in the future is now increasing at the rate of 7% per year but the bondholder is only increasing their wealth by 5% per year.

While the bondholder has the option to sell their 5% bond and buy a higher yielding bond, unfortunately the resale value of their 5% bond will have dropped and the investor will have to bear the capital loss.

Of course if inflation were to drop in the future, then the investor will receive a double bonus - the inflation adjusted yield increases and the bonds value increases.

Thus inflation is a risk all bondholders face and the shorter the maturity then the lower the inflation risk. This is one of the reasons why longer term maturity bonds pay higher interests rates - to entice investors to take on the future inflation risk.

Liquidity Risk

Understanding Bonds - The Risks with Bonds; picture of a blue cube for investors with large white writing on it saying wait, buy and sell for risk management

The liquidity risk comes in two forms.

The first is the risk that there is no demand for the bond should the bondholder decide to sell. While this is not a problem if the investor holds their bond until maturity, it is a major problem if the investor wants or needs to sell their bond - they simply cannot sell their bond. Normally, treasury bonds are extremely liquid but some corporate bonds can be quite illiquid.

The second risk is when there is a bond dealer who is willing to buy the bond, but due to the bonds unpopularity the bond dealer will only offer an extremely low price in order to cover themselves in case they cannot resell the bond. Thus the investor ends up selling their bond for significantly less than what it is realistically worth.

A bond may be popular when the investor purchases the bond, but in future the bond might be unpopular. The future is unknown and there are numerous events that can take place which may make the bond undesirable.

The liquidity risk is basically the Bid-Ask spread offered by the bond dealers. High demand for a bond produces a fairly narrow spread (something around 0.5%) but low demand for a bond can see spreads of 5% and higher. While this is not a problem for investors buying newly issued bonds and holding them till maturity, for investors buying second hand bonds and then selling then, this can cost them 5% or more for a low demand bond. The Bid-Ask spread is not constant but varies over time with the popularity of the bond.

Callable Risk

Bonds that have a call option specified can be recalled at set dates as specified in the bond contract. As a general rule, bond issuers who specify call options do so in order to take advantage of possible lower interest rates in the future. Thus when the issuer gets the chance to issue bonds at a lower rate; they will certainly exercise their call option rights and recall their higher interest paying bonds.

Unfortunately for the investors they lose their high coupon rate bonds. They can always buy the newly issued bonds at the lower interest rate, but they will always lose out on their returns.

Thus with callable bonds the risk is always that the bonds are recalled when it does not suit the investor. If interest rates rise then naturally the bond issuer has no intention of recalling their now relatively low interest rate bonds. Again the investor losses out as their bonds are now yielding less than that of the new bonds which unfortunately lowers their resale value.

Default Risk

The default risk is the risk of loss and is primarily due to the bond issuer defaulting on their obligations. The default can be that the bond issuer does not make all their required coupon payments or in the worst case the default is that the bond principle is not returned at maturity.

The bond issuer may stop the coupon payments

and may not repay the principle at maturity

The risk of default varies depending on the bond type and the bonds maturity.

The safest bonds are treasury bonds which are effectively guaranteed. The investor is assured by the U.S. treasury that they will receive all of their coupon payments and that their principle will be returned at maturity.

The next safest bonds are municipal bonds issued by municipalities. The risk of default is extremely low.

Then there are municipal bonds issued by non-municipalities such as universities, airports and hospitals. These are at a higher risk of default as they are reliant on the revenue generated to meet their bond obligations. The risk is significantly reduced when these bonds are issued with insurance.

Corporate bonds of investment grade are also depended on their financial position and are at a higher risk of default.

The highest risk bonds are speculative grade bonds which are more commonly known as junk bonds and the risk of default starts to become quite high.

The credit rating of bond issuers helps investors to make an informed decision with regard to the risk of default that they are taking on. With the exception of treasury bonds, all the other bond types are given a credit rating by the credit agencies. As a general rule, most of the defaults which occur are with speculative grade bonds (junk bonds).

Credit Ratings Risk

Most bonds are assessed for their credit risk by one or more credit agencies based on the bond issuers' financial strength. However the financial strength of an issuer can change in the future and this introduces another risk for the bondholder - the credit rating itself might drop in the future.

The problem a lowering in credit rating causes is that the resale value will drop as the bond will now be perceived to be a higher risk bond. As the perceived risk increases, investors naturally demand a higher yield to compensate for the added risk. Unfortunately for the bondholder this means the resale value drops so that the current yield is increased to a level the market is willing to accept.

The Bond and Stock Portfolio

The allocation of bonds and stocks

Understanding Bonds - The Bond and Stock Portfolio; picture of three blue cubes stacked on three red cubes depicting growth, conservative and aggressive investing staegies

One of the main reasons stock investors incorporate bonds into their portfolio is diversification. Different asset classes such as stocks, corporate bonds, treasury bonds and municipal bonds each have their own performance characteristics. While these asset classes are all cyclical they do not necessarily cycle together.

The Correlation between Stocks and Bonds

The performance of the stock market is largely tied to corporate earnings, which in turn is depended on the strength of the economy as measured by the Gross Domestic Product (GDP).

The performance of treasury bonds is linked to the inflation rate. What makes treasury bonds perform strongly is when the inflation rate drops. Older bonds paying higher interest rates are now worth more and they pay higher coupon payments compared to newly issued treasury bonds with low interest rates.

The performance of municipal bonds is also linked to the inflation rate but the correlation is not as strong. This is because individual investors largely dominate this market and they tend to be more focused on the tax benefits rather than the returns. Whereas treasury bonds are largely dominated by intuitions who are constantly seeking to maximize their returns.

The performance of corporate bonds is tied to both the inflation rate (Feds Funds rate) and the financial health of the companies which issue the bonds. There is a general link with the strength of the economy, but it's not a direct link as with earnings. In a weak economy, corporate profits typically fall, however this does not necessarily mean that the financial position of companies will deteriorate. Some bear markets actually see corporate bonds performing strongly and even if they do underperform, they still significantly outperform stocks in bear markets.

To sum up, when the stock market is performing poorly, bonds tend to perform well and when the stock market is performing strongly then bonds tend to underperform.

Including Bonds in a Stock Portfolio

Including bonds in a stock portfolio has two effects. The first is that bonds tend to reduce the returns during bull markets and secondly, bonds tend to reduce the losses during bear markets. Thus the effect of bonds is to smooth out the long-term returns (this is referred to as lowering the volatility) but it also generally reduces the long-term returns.

Bond Allocation:

  1. Passive Investing: A common asset allocation theory is to include bonds in a stock portfolio based on the investor's age. For example, an investor who is 30 years old would allocate 30% to bonds and an investor who is 60 years old would allocate 60% to bonds. This allocation is generally appropriate for passive investing.
  2. Active Investing: The general advice (such as from Benjamin Graham) tends to be for active investors to include no less than 25% in bonds and no more than 75% in bonds. The maximum 75% in bonds is based on asset diversification. If the portfolio consists mostly of bonds, then there is no asset diversification (the same as holding only stocks).

Some stock investors only include bonds when market conditions are poor, while other investors include bonds as part of an investing strategy. Then there are stock investors who only occasionally include bonds.

What category of bonds to include is really a personal choice? Treasury bonds are extremely popular with stock investors due to their safety, which helps offset the higher risks from stocks. Municipal bonds are popular with both stock investors and non-stock investors due to their tax advantages. Corporate bonds tend be more popular with the more experienced and/or active stock investors as these are more risky than treasury bonds and municipal bonds.

Understanding Bonds - The Bond and Stock Portfolio; picture of a large overhead road sign with large white writing on a green background board with a blue cloudy sky behind it

The next consideration with bonds is what maturities to include in a portfolio. As a general rule the shorter term maturities reflect the current inflation rate and the longer term maturities reflect the future expectations for inflation.

When inflation is low, the shorter term maturities tend to have interest rates which are less than the longer term maturities. The opposite can occur when inflation is high - the short term rates may be higher than the longer term rates.

The longer term maturities are more volatile with regards to bonds value, but tend to produce higher long-term returns. Thus even with bonds, the higher the risk then the higher the long-term return. To diversify a portfolio, the general portfolio theories suggest that a variety of maturities are held to smooth out the long-term returns. For example, a two year bond, a five year bond and a ten year bond.

Inflation is another consideration and becomes significant with the longer term maturities. Inflation adjusted bonds such as Treasury Inflation-Adjusted Securities (TIPS) are a logical choice to combat the effects of inflation. Some portfolio theories suggest that inflation adjusted bonds should make up around 30% of bonds held. It is generally not advisable to hold only TIPS since they do underperform treasury bonds when inflation does not increase.

Including Bond Funds in a Stock Portfolio

Some investors prefer not to buy individual bonds and for some investors it is not even appropriate.

Bond Face Value:

The minimum face value of treasury bonds is $100 and the minimum face value for most other bonds is $1,000.

Portfolio Size:

The portfolio size is a major consideration for investors with limited capital. To build a diversified portfolio containing say 50% bonds with $1,000 in capital would require $500 worth of bonds.

  • Buying treasury bonds of various maturities is simple enough as five bonds can be purchased at $100 each.
  • However, with both municipal bonds and corporate bonds it is generally advisable to diversify with a larger number of issuers due to the higher risks with these bonds. Around 10 bonds would be a preferred minimum, but at $1,000 per bond this comes to $10,000. Thus the investor would realistically require $20,000 in capital for a diversified 50/50 Bond/Stock portfolio.

Another issue is with dollar cost averaging. Unless the regular contributions are significant then the investor cannot realistically make use of the dollar cost averaging approach.

The simplest solution is to buy a bond fund. Minimum purchases vary considerably but can be as low as $100 for mutual funds. An alternative which suits a lot of stock investors are Closed-end funds and Exchange Traded Funds (ETF). The minimums for these are even less than that of mutual funds. The minimum purchase cost is simply the share price as these funds are traded on a stock exchange and shares are bought in exactly the same way as buying stocks. Thus the minimum is simply the stock price for one share.

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