Bonds 101What Are Bonds?

7/19/2022 - By Mark Hemby, CFA

In the past six months, there have been many discussions about the bond market. The classic portfolio is made up of 60% equities and 40% fixed income and cash, and for the first time in decades, stocks and bonds are both down at the same time. Why is that?

First, let’s get into what bonds are, how they work and why they are an important part of an investment portfolio. Bonds are debt obligations of governments or companies. So, why wouldn’t a government or corporation just go to a bank and ask for a loan? Banks have a limit to how much they can loan to any individual borrower. The bond market fills this gap. It is made up of investors globally and is able to fund the demand for large borrowers like corporations and governments.

How Are Bonds Structured?

When an entity borrows money in the bond market, they sell discrete pieces of the total amount borrowed. For instance, if a large U.S. company borrows $100 million in the bond market, this bond issue is made up of 100,000 individual bonds, each with a face value of $1,000. If an investor purchases one bond with a face value of $1,000, they are effectively lending that entity $1,000. Because bond issues are divisible this way, they are able to access a larger pool of capital and potential lenders (investors).

Most bonds are structured with periodic interest payments called coupons. Generally, these coupons are fixed and pay at set intervals, for instance, quarterly, semi-annually, etc. Additionally, unlike stocks, bonds have a stated maturity date, similar to a loan. For this reason, bonds are also referred to as “fixed income” investments. The fixed nature of the coupon, the regularity of the payment and the stated maturity date are characteristics of bonds that attract certain types of investors.

The Yield of a Bond

The concept of yield can be confusing to investors. The coupon and the yield are both expressed as a percentage. The yield of a bond is determined by the price an investor pays for it. The higher the price an investor pays for a bond, the lower the yield and vice versa. For example, let’s say you purchase a bond at its face value, or par price, of $1000, with a coupon of 5%. In this case, both the yield and the coupon are 5%. By contrast, if you purchase the bond at a price lower than $1000, say $995, the yield will be greater than the coupon of 5%, say 5.25%. The opposite is the case if the price of the bond is greater than par. For instance, if the price of the bond is$1,005, the yield is less than the coupon at 4.75%. (Note: this example is for illustration purposes only. Actual changes in price and yield vary greatly for specific bond issues.)

Why is the value of bonds down recently?

The short answer is inflation. If an investor owns a bond that yields 5% and inflation is 9%, the nominal, or stated return, is 5%, but the real return is negative 4%. The real return is the most important factor for investors. If an investor believes that inflation will average less than 5% over the life of the bond, a bond could still have a positive real return. Recently, inflation has increased to over 9%. This dramatic increase has created volatility in the bond market, especially to the downside. The bond market is grappling with the future of inflation. Will the Federal Reserve be able to tamp it down? Will inflationary pressures get worse? As these questions get answered, we could experience continued volatility.

Diversified bond mutual funds, like the ones we use at Saltmarsh Financial Advisors, hold hundreds or thousands of individual bonds. They are managed to take advantage of the changing dynamics in the bond market. While the market had a rough start to 2022, bonds act as a stabilizing ballast in a well-diversified portfolio. This stability happens over time. Any given quarter or year can be difficult for any investment class. Taking a longer view of your investments is the most prudent approach in the current volatile environment.

Questions?

If you have more specific questions about bond investments, please reach out to your Saltmarsh Financial Advisors and Investment Management team.

About the Author | Mark Hemby, CFA®

Mark is a financial advisor for Saltmarsh Financial Advisors, LLC, an affiliate of Saltmarsh, Cleaveland & Gund. He holds a Chartered Financial Analyst (CFA®) designation and as part of our investment advisory group, he works with clients to develop and implement investment strategies to achieve financial freedom while also ensuring their goals and objectives are aligned. Mark has over 15 years of experience in investment banking working with individuals and organizations to manage their portfolios and coordinate investment activities. In addition to his experience with fixed income trading and sales, Mark owned and operated his own business in Alabama.