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Interest rates are reaching levels that we have not seen in decades and bonds are finally adding true value to portfolios. This regime change has prompted us to discuss the nature of these positions for investors who might not have any experience with bonds in their lifetime.
The Nature of the Bond Market – Why Do Bonds Exist?
You can think of a bond as a debt obligation. A mortgage is a debt obligation people take on to purchase a home. A bond issuance is a debt obligation a business, government, or municipality takes to fund continuing operations or start new projects. Like mortgage rates, bond rates depend on both the interest rate environment and a person/company’s credit history. Sometimes issuing bonds is necessary if a company or entity does not have enough capital for all anticipated expenditures. However, there can be incentives for these entities to incur debt instead of simply paying for these projects with the cash on their balance sheets, especially if the interest rate is low. A company that takes on debt can amplify its returns –but debt is a double-edged sword– it amplifies both the positive and negative earnings performance.
What’s Meant by Leverage? “Other People’s Money.”
The terms debt, leverage, bonds, and fixed income all essentially refer to the same thing – borrowing money. Using “other people’s money” is riskier than using your own. Why? Because you will eventually have to pay them back with interest. If a business or an individual misses a payment, it is considered a “default.” An entire industry has been built around analyzing the likelihood that a particular person, company or government will default – this is called credit analysis. Analysts’ bond ratings are supposed to help investors determine the level of risk and the potential for default in any given bond issuance. Although analysts can labor over probability distributions and credit history, the possibility of a black swan event happening, leading to a default, will always exist. Bonds are securities that carry risk, and investors are usually compensated for this risk. The risk that the US government defaults on their debt is extremely low – the US is the highest credit quality borrower in the world and can change policies (such as raising taxes) to ensure payments are made. This low risk usually leads to comparatively low levels of returns on government debt. For example, corporations don’t have the luxuries and policy changing abilities that the government does; hence corporate debt is considered riskier – also leading to higher reward in the form of increased yield to investors.
While bonds do carry some risk, this risk pales in comparison to stocks. In the extreme event of bankruptcy, bond holders will be the first to be paid back with any funds raised from bankruptcy proceedings. Only after all bond holders have been fully paid back are stockholders entitled to any piece of the pie. When credit analysts give a company’s bond a rating of BBB or higher, the bond issuance is considered “investment grade.” In any given year, only around 1% of all investment grade bonds enter default. Our fixed-income traders spend countless hours analyzing credit quality with our research partners and always stay within the investment grade category, as our bond allocations are meant to provide stability and income for our clients. Our team’s selectivity in individual bond purchases has proven invaluable over time.
Liquid Fixed-Income versus Personal Debt
This should seem pretty straightforward so far – bonds represent corporate or government debt, and individuals who purchase these bonds are effectively lending these entities money. The interest rate a bond investor receives reflects the current interest rate environment and attempts to compensate the investor for the risk that they don’t get paid back.
But unlike a mortgage that fully pays off the borrowed funds after 30 years, different government and corporate debt issues can have unique terms. Maybe American Airlines expects to need financing for five years, but United thinks they’ll need ten. And unlike a mortgage, with corporate debt, the company usually only pays the interest portion of the loan for those five, ten, or thirty years. Only at the end of the term is the “principal” value of the loan repaid – this is called “maturity.” Exhibit 1 below, courtesy of the CFA Institute, illustrates the timing of cash flows on a typically structured bond. You can see that the investor purchases the bond at par, ¥10k – the down arrow represents the investment or cash outflow. In contrast, all the up arrows represent the interest and principal repayments to the investors or cash inflows. This plain vanilla bond is yielding .4% as the investor receives ¥20 every six months, or ¥40 per year (¥40/¥10,000 = .4%). Not only will the investor receive these interest payments over the life of the bond, but they will also receive a repayment of the principal investment upon maturity (principal of ¥10,000 + interest of ¥20 is the final cash inflow).
Trading Fixed-Income Securities
Here’s where it gets interesting. Imagine your bank could sell your mortgage, so instead of making payments to, for example, Wells Fargo going forward, you are now making payments to Rocket Mortgage. This sale happens “behind the scenes” - lots of mortgages end up with Frannie Mae or Freddie Mac - which also occurs frequently with corporate debt. For example, say you purchase the ten-year United bond but decide that after five years of receiving interest payments, you now would like to use the money to buy a new car. No problem – your bond is a liquid security and can be sold to someone else on the open market, similar to selling a stock. Clients often see their bond maturing in 2028 and think their money is tied up until then, but this is not the case! 2028 simply represents the scheduled maturity date, but the bonds can be sold at any time. Liquidity is important to our team because life often “happens” before we realize it. Ultimately, the portfolio is structured to keep up with our lives.
Bonds Experience Price Volatility, Too
The liquid nature of our bond holdings causes their values to fluctuate until they mature - bonds are actively traded, like stock, and their value will depend on the balance of supply and demand. Supply and demand, in turn, are influenced by interest rates, credit quality, and other macroeconomic characteristics. If you were to sell the United bond that you purchased five years ago today, you would likely receive a market price lower than what you bought the bond for and incur a slight loss by exiting before the 10-year maturity date. Why did the price of the bond decline after five years? Remember, both a mortgage and all other forms of debt are extremely sensitive to the level of interest rates, and we are currently in the most aggressive interest rate hiking cycle of the past few decades. We like to think of the inverse relationship between bond prices and interest rates as a teeter-totter – if one goes up, the other goes down. Nobody would want to buy a 1% bond when the current market rate for new issues is 4-5%, but investors might be willing to purchase the 1% bond if they can buy it for a significant discount. Hence, anyone wanting to sell their 1% bond in this type of environment will need to accommodate potential buyers with a lower price. The inverse, teeter-totter style relationship between bond prices and interest rates holds because the market’s supply and demand reprice outstanding bonds to reflect the new interest rate reality.
The value of a bond will fall in response to interest rate hikes. However, nothing may have fundamentally changed regarding the security or the underlying business, and you are still scheduled to receive repayment of the full principal upon maturity. We feel that selling a bond like this would currently be a mistake; we have been able to lock in favorable rates with this year’s bond purchases! If you need cash from the portfolio, accessing funds from your money market allocation will be the first place our portfolio management team pulls from for you. Selling the bonds will not be the first place to look in the event of a cash need, particularly because of where we are in the current interest rate cycle. In the event of a cash need, particularly because of where we are in the current interest rate cycle.
Hold On – Interest Rate Cycle?
Yes, interest rates experience "business cycles" like the stock market. Gyrations coincide with economic expansions and contractions as the Federal Reserve attempts to control inflation. You can see the fluctuations in rates over the past 30 years in the image below. Investors that purchase longer-term bonds near the top of any interest rate cycle (where the red dots are) can reap the benefits of earning that higher yield for years to come. Our team feels we're getting closer to this point, hence the red dot over 2022, and have been purchasing longer-term bonds to implement this view. Locking in a small allocation of these attractive yields for 10-15 years is attractive from a diversification and investment perspective and helps keep our client portfolios on track with their long-term financial plans. If interest rates do end up climbing higher, we will be excited to take advantage of that opportunity as well, but we would rather be "safe than sorry" and lock in some attractive long-term yields while they are available.
Beware of Bond Funds
Many fixed-income investors (bond fund investors) do not have the luxury of waiting for their bonds to mature and will never receive repayment of principal. This dynamic is typical of both bond ETFs and bond mutual funds. Any time a bond within the fund matures, it’s rolled over into a new bond regardless of pricing. Bond funds still move inversely with interest rates, and with rates rising dramatically this year, bond fund holders have suffered losses without the promise of principal repayment at maturity. Bond funds will likely not recover their lost value until the interest rate cycle rolls over. This leaves bond fund holders with an unfortunate level of uncertainty, particularly because this part of the portfolio is intended to be safety oriented. The Federal Reserve has made it clear that they intend to hold interest rates at an elevated level for as long as it takes to get inflation back to normal. Currently above 8%, we have a long way to go to get back to the 2% inflation target, and bond fund holders may have a long time to wait.