Many consider bonds to be the plain vanilla of the investing world, yet they can generate substantial returns. Since bonds are debt securities, their essence is the issuer’s promises to pay interest and to repay principal. A bond’s stated interest rate is called its “coupon rate.” In an earlier era, bonds were issued on fancy paper. Attached to each one were coupons the holder clipped off every six months and took to the bank to collect interest.
Debt securities issued by the U.S. Treasury are called bills, notes and bonds. Bills are short-term; notes are typically issued for two to 10 years and bonds from 10 to 30 years. Treasury bills, most commonly issued for 13 weeks, currently yield about 4.5 percent, which compares favorably to most money market funds and short-term bank CDs.There are only two ways to generate bond returns greater than those obtainable with Treasury bills—take more credit risk or more interest rate risk. Credit risk is the risk that the bond issuer will default on one or more promised interest payments, or worse yet, be unable to repay the principal at maturity. Interest rate risk is a bond’s market value change when prevailing interest rates change.
Treasuries are assumed to have no risk of default. Bonds issued by corporations and municipalities have their credit quality rated by firms that provide opinions on the issuers’ creditworthiness. Standard & Poor’s, the best known rating agency, expresses its opinions in letter grade terms, with AAA being the highest. Bonds rated BBB and above are considered “investment grade,” with a low likelihood of default. Those below investment grade are often called “junk bonds.” They bear increasing expectations of default as the grade descends from BB to D. Generally, the higher the perceived credit risk, the greater the yield.
Duration
Regardless of credit quality, a bond’s market value varies inversely with changes in prevailing interest rates. You can determine how bond market values change from a statistic called “duration,” which you can calculate for any bond with a fixed interest rate and date of maturity. Understanding duration is essential to understanding interest rate risks. A 10-year bond with a face value of $10,000 and a coupon rate of 6 percent is actually a promise to make a total of $16,000 in payments to the holder—20 semiannual payments of $300 each followed by a final payment of $10,000. When first issued, this bond has a duration of 8.2 years. As time passes, its duration declines until it reaches zero at maturity.
The change in a bond’s market value equals its duration multiplied by the change in interest rates. If prevailing interest rates increase 1 percent, the market value of a bond with a duration of 8.2 will decline 8.2 percent. The duration of a newly issued 30-year 6 percent bond is 20.5, so the same 1 percent rise in prevailing interest rates will result in a 20.5 percent drop in its market value.
Duration applies to bond portfolios and individual bonds. You can determine the interest rate risk in a bond-based mutual fund by looking up its duration. The duration of the bond market taken as a whole typically runs around 4.5 or 5. A fund with a duration in this range would be considered an intermediate-term bond fund. A long-term fund might have a duration of 8, 10 or more. A fund with a duration of 10 will have twice the interest rate risk of one with a duration of 5 but will almost certainly not achieve twice the return of the latter.
The role of bonds
Bonds play two main roles in a portfolio of financial assets. One is obvious: they’re useful for generating reliable cash flows. The other is more technical: Price movements in the bond and stock markets are not closely correlated. Sometimes the two markets move in step; other times their price trends diverge. By mixing bonds into a stock portfolio, we can improve the overall return achieved for the amount of risk taken.
Stocks are generally understood to provide higher potential returns than bonds but with significantly greater risk. Suppose, for illustration, that stocks have an expected return of 4 with a risk of 2, and bonds have an expected return of 2 with a risk of 1. The expected return of a 50-50 portfolio of stocks and bonds will be the simple average of the two expected returns, or 3 in our example. However, the expected risk will always be less than the simple average of the two risk factors. How much less will depend on how “imperfectly correlated” the movements in the stock and bond markets are with each other.
You can lessen the risk in a growth-oriented stock portfolio without sacrificing much return by including a measure of bonds. Conversely, including some stocks in an income-oriented bond portfolio can improve returns without significantly increasing risk.
The steadiness of bond returns can be very appealing in turbulent times. At the end of 1999, everyone was excited about stocks, but many who got into the market then still haven’t broken even. Had you invested in a total stock market index fund in January 2000, your annualized returns to the present would have averaged all of 1 percent. If instead you’d invested in a portfolio of intermediate-term bonds, your annualized returns would have been 7 percent. An investment of $100,000 in bonds then would be worth $152,300 today compared to $107,200 for a like investment in stocks. For plain vanilla, those results are pretty tasty.
This column is not intended as investment advice. You should consult your own adviser in determining whether to incorporate any of the opinions expressed here in your investment decisions.
David Raub has 16 years’ experience as a registered investment adviser. He is co-owner of Raub Brock Capital Management in Larkspur. You can reach him at draub@northbaybiz.com.
