Bond investments are also known as fixed income. That is, you are buying a fixed amount of income (the interest rate) when you buy a bond. Bonds are issued by governments, agencies, and corporations. The issuing entity agrees to pay interest on the investment for a specified number of years and pay the principal amount upon the maturity date.
Many investors are confused by the inverse relationship between interest rates and bond prices. Very simply when interest rates go up bond prices go down. When interest rates go down bond prices go up.
Why is this happening? The prices of existing bonds are adjusting to the prices of new bonds that may have higher or lower interest rates.
- An existing $1,000 bond has a 5% coupon that produces $50 per year of income
- A new $1,000 bond has a 6% coupon that produces $60 per year of income
- The interest rate went up so the price of the existing bond went down
- The price of the existing had to go down or no one would buy it due to the lower income stream
Several entities sell bonds to finance their activities. The two biggest are the U.S. government and corporations. You also have cities, counties, states and agencies (GNMA).
- U.S. governments are considered to be the safest bonds. This is based on the assumption that the U.S. government cannot go out of business
- Local government is a very different story. Many cities and counties are debt-ridden and struggling to make pension payments
- Investment grade corporate debt is another alternative. AAA corporates are only slightly more risky than the U.S. government bonds
- There are also junk bonds that are issued by low quality companies. There is a substantial risk of default on interest and principal payments.
The primary component of bond performance is interest. Plus, the prices of existing bonds fluctuate when they adjust to the prices of new bonds. These fixed income securities can produce double digit returns during periods of rapidly declining interest rates. HIgh interest rates produce negative total returns due to the inverse relationship between rates and bond prices.
Bonds are not as risky as stocks because a higher percentage of their return is interest versus appreciation. Therefore, one of the primary reasons to buy bonds is reduced risk.
There are three primary types of risk when you buy bonds.
- Borrowers fail to make interest payments or default on principal payments. You or a third party have to foreclose on the loan.
- There is reinvestment rate risk. For example, a 7% matures and you reinvest the principal in a 4% bond.
- The biggest risk is your failure to achieve your financial goals. For example, you rely on bond interest to partially fund your retirement. Persistent low interests force you to invest in higher risk alternatives or reduce your standard of living
Active fixed income management is cheaper than active equity management. That is because bonds are easier to research, there are more buy & hold strategies, and there can be lower turnover rates.
Bonds are not as volatile as stocks, but they still require sophisticated investment strategies to maximize performance, minimum risk, and achieve your financial goals.