Investment Fundamentals: Introduction to Bonds

by Mitchell J. Smilowitz, CPA

What Are Bonds?

A bond is a loan made to a corporation or government. The amount of the loan is known as its face value. Bonds pay interest over a fixed period of time. When the bond matures at the end of this fixed term, the borrower repays the principal – the face value of the loan – to the bond holder.

Because most bonds pay investors a fixed rate of interest, known as the coupon rate, they are called fixed-income securities. Bonds are considered less risky than stocks because stocks do not offer any guaranteed rate of return.

The term of a bond, the length of time before it is repaid, is fixed when the bond is issued. Short-term bonds generally mature in 3 years or less; intermediate-term bonds generally mature in 3 to 10 years; any bond that matures in more than 10 years is considered a long-term bond. Generally, the longer the term on the bond, the higher the coupon rate. The higher interest rate offered on longer term bonds compensates investors for the additional risk of lending their principal for many years.

The Risks of Bond Investing

Bond investing carries three types of risk.

  • Interest Rate Risk – If interest rates go up, the bond may be worth less to investors than they paid for it. Imagine you purchase a bond with a face value of $1,000, a coupon rate of 5% and a 5-year maturity. Your annual return on the investment is $50 (5% x $1,000 = $50). If interest rates rise to 7% the next year, someone could buy a new 5-year bond that pays $70 annually (7% x $1,000 = $70). Do you think they would pay you $1,000 for your 5% bond? On the other hand, if interest rates fell to 3%, an investor would be willing to pay more than $1,000 for your 5% bond.
  • Inflation Risk – The coupon rate of most bonds is fixed; the amount you earn on your bond investment remains constant over the term of the bond. Because inflation erodes the value of money, the income from the bond buys less over time.
  • Credit Risk – Not all borrowers are equal. Some borrowers – like the federal government – are more capable of repaying their debt than others. Independent rating agencies, such as Moody’s and Standard & Poor’s, analyze the financial condition of bond issuers to determine their ability to repay principal and interest. They rank credit worthiness from AAA for the best quality bonds to C for bonds with the greatest risk of default. Less qualified borrowers usually offer higher coupon rates to entice investors to purchase their bonds.

Bond Mutual Funds

Bond mutual funds hold many different bonds. Fund managers buy and sell bonds all the time. As a result of this diversified portfolio, bond mutual funds do not have a specific maturity date or a guaranteed rate of interest. Bond funds make it easier for investors because:

  • Fund managers closely analyze each bond before purchasing it.
  • Bond funds allow you to participate in a diverse portfolio of bonds you could not afford on your own.
  • Bond funds hold a diversified portfolio, reducing the impact of a default on any one bond.

Bond funds are categorized by two factors: credit quality and interest rate sensitivity.

  • Credit Quality is determined by the average credit rating of the bonds held by the fund – from AAA to C.
  • Interest rate sensitivity is a measure of the average term of the bonds held by the fund. The longer the term of the bonds, the more sensitive the bonds are to rising and falling interest rates.

Just as there is a Mutual Fund Style Box to categorize stock funds, Morningstar has created a Fixed-Income Style Box. The Fixed-Income Style Box classifies bond funds according to credit quality and interest rate sensitivity. The following chart places the bond funds offered by the JRB into the style box. The box includes a link to the Morningstar fact sheet on each fund.

Fixed-Income Style Box

 Limited Rate SensitivityModerate Rate SensitivityExtensive Rate Sensitivity
High Credit Quality 

Western Asset Core Bond

Vanguard Total Bond Market Index

Goldman Sachs US Mortgages

Vanguard Inflation-Protected Securities

Medium Credit Quality

Metropolitan West Low Duration

  
Low Credit Quality 

Fidelity Strategic Income

 

 

Bonds play an important part in a diversified portfolio. While stocks have historically provided higher returns over the long-term, there are many years when bonds outperform stocks. The balance of stocks and bonds in your portfolio, known as your asset allocation, depends on your risk tolerance and the investment returns you need to achieve. To discuss a diversified investment strategy that meets your needs – and the role of bonds in that strategy – contact the JRB or call 888-JRB-FREE (572-3733).