Bonds are a common type of investment used to diversify a portfolio. Many times they have less volatility than stocks. But many people don’t understand how they work. Today we dig into the basics of bonds to help you understand why this asset class has struggled in 2022.
Watch now – Bond Basics
- 0:00 – Intro
- 0:13 – Disclaimer
- 0:18 – What is a bond?
- 1:52 – What determines a bond’s interest rate?
- 3:07 – Bonds do fluctuate in value on a daily basis
- 4:44 – Understanding why the bond market has struggled in 2022
- 6:03 – Should this be a major concern for investors?
- 7:42 – Looking for opportunities to improve while watching risk
- 9:56 – Advisors can cook – Our best dishes
- 11:16 – Outro
What is a bond?
Basically, a bond is a loan. It has a contractual obligation where the issuer borrows money at a fixed rate of interest--also called the coupon--for a specific length of time (maturity). These notes are issued by the US Government, state and local governments, government agencies like Fannie Mae, and corporations.
As a bondholder, you are the creditor. You will receive interest over the live of the bond, and when it matures, your principal will be returned to you (provided the issuer doesn’t default).
What determines how much interest is paid?
There are two major components that drive interest rates on bonds. Both are driven by risk. The first factor is maturity. A bond that matures 20 or 30 years in the future carries more risk than one that matures in 5 years. Those longer-dated notes will normally pay more interest.
The other factor is the credit quality of the issuer. Bond issuers are rated based on their financial conditions and their ability to pay the interest and principal due to the borrower. Moody’s and Standard and Poor’s are popular rating agencies. It works the same as if you were to borrow money. If you have a high credit score, your interest cost is less than someone with a low credit score.
US Government bonds are considered to be the least risky from a credit quality perspective. As a result, the interest they pay is normally less than the interest found on corporate bonds or municipal bonds.
Bonds do fluctuate in value
The bond market is huge, far bigger than the stock market. Bonds trade daily and their prices fluctuate as a result. But we as investors often don’t see the prices as we do on stocks.
Bonds are traded on a yield basis. A bond’s yield is determined by dividing the interest it pays by the current price. A bond’s yield is also the return you as an investor will receive for owning it.
If you have two similar bonds—same maturity, same credit rating—they will have approximately the same yield. The interest payment may be different for each of them, which will lead to different prices. But in both situations, your return for buying either issue will be roughly the same.
What drives Bond Prices?
Bond prices fluctuate with changing interest rates. If interest rates increase, the price of existing bonds will decrease. If interest rates fall, the price of existing bonds will go up. This year, we have seen interest rates rise, pushing bond prices much lower. So far this year, the aggregate bond index is down more than 10%.
Higher inflation will also push bond prices down. A bond’s future payments are known. And when inflation is rising, it makes the present value of those future payments less. Thus investors will want to pay a lower price to account for their loss of purchasing power. This has also played a role in the poor returns for this asset class.
Is it time to worry?
In our opinion, no. Remember, as long as the bond issuer does not default, investors will receive the principal payment back. Prices have dropped as a result of market forces. But holding bonds until they mature prevents you from losing money.
If you sell your bond positions before they mature, there is always the possibility you will do so at a lower price than your original purchase.
What are we doing now?
We rely on a number of firms to provide insight into the investment markets. Most companies believe the worst times for the bond market are behind us. As a result, we have been looking for opportunities to improve the overall yield while being very mindful of the risks at hand.
Would You Like to Know More?
Fill out the form to connect with one of our financial advisors. They can help you better understand how bonds work and how they still are an important part of your overall asset allocation.
Appearing in this video
Daniel Spurgeon, CFP®
Daniel is a Certified Financial Planner Professional in Parkersburg, West Virginia.
Tyler Safran, CRPC®
Tyler as a financial consultant in Wheeling, West Virginia. i.
Neal Watson, CFP®
Neal is a financial advisor in Marietta, Ohio.