Good morning & happy Monday!
“When growth is slower-than-expected stocks go down. When inflation is higher than expected, bonds go down. When inflation is lower-than-expected, bonds go up.”
– Ray Dalio, billionaire investor & hedge fund manager
As promised, this morning I’m going to jump into a discussion about bonds. I know you’ve had a hard time containing your excitement since I mentioned this last week 😉
As we discussed last week, bonds are the debt issued by a company or an entity. If you buy a bond you are lending a company or entity your money in exchange for a promise of repayment with interest.
The terms of bonds are usually set, so for example I may purchase a bond for 5 years for a rate of 5%. Bonds are issued with a face value of $1,000 so if I purchased $100,000 worth of bonds then I would purchase 100 bond units (100 units x $1,000 face value = $100,000 invested).
Ok, so there is the groundwork. Having fun yet?
Bonds are generally considered to be the “safe” part of portfolio construction, but they most certainly have risks. The 4 main risks with bonds are:
- Default risk – whoever you lend your money to goes out of business / files for bankruptcy protection.
- Inflation risk – if the bond you hold does not keep up with inflation you may lose purchasing power.
- Reinvestment risk – uncertainly on what rates will be when the bonds mature.
- Interest rate risk – this is the huge one we are dealing with now – as interest rates increase bond values decrease – this will be the major point of discussion in this memo.
There are strategies for each of these risks. I’ll briefly discuss the first three so as to allow for the primary interest rate risk commentary.
With default risk there is always a risk that whoever you lend your money to is not able to pay it back. Rating agencies exist to help investors understand how solid the company or entity is. It’s kinda like a credit score for an individual … this will help investors determine how risky it is to lend to the company / entity and in turn what kind of rate they can expect. The lower the rating of company / entity the higher the interest rate they will be forced to pay on their bonds issued … just like someone with a low credit score is going to pay a higher interest rate than someone with a high credit score. This risk can be managed with diversification … diversifying one’s portfolio to own bonds of many companies, industries, etc. At Intentional Wealth we utilize mutual funds and ETFs to accomplish this critical diversification.
Inflation risk is what it is. If I purchase a bond paying 5% for 5 years and inflation goes to 8% that means that I am actually losing purchasing power as my bond is not keeping up with inflation. Bonds are really only designed to modestly beat inflation in a normal market, so if inflation rears its ugly head, then a bond investor is not a happy camper.
Reinvestment risk occurs when bonds mature. If I purchase a $100,000 worth of bonds for 5 years paying 5% and I am counting on that income of $5,000/year to pay my bills, then this is a very real risk I face. What if rates are only 3% when the 5 years are over? My income will decrease from $5,000/year to $3,000/year … that can be very problematic for income driven bond investors.
And finally, we come to interest rate risk. Fasten your seatbelt, this is a doozy and exceptionally relevant in today’s market.
As I often do, I’m going to use an example to illustrate this principle.
Let’s say bond investor #1 purchased a 10-year bond 2 years ago with an interest rate of 3.5% for $100,000. That means that every year for the 10-year period of time that investor is going to get $3,500 per year in interest and at the end of the 10-year period he/she will get the original $100,000 principal back. 10-year bond lifetime income = $35,000 ($3,500/year x 10 years).
Bond investor #2 comes on the scene today and has $100,000 to purchase bonds with and sees that the current interest rate for an 8-year bond is 6.5%. That means that every year for the 8-year period of time that investor is going to get $6,500 per year in interest and at the end of the 8-year period he/she will get the original $100,000 principal back. 8-year bond lifetime income = $52,000 ($6,500/year x 8 years).
Which bond investor would you rather be? Of course, you would rather be bond investor #2!
Because bonds are easily traded (bought and sold) then bond investors can purchase bonds or sell their bonds fairly easily. The issue becomes what the value of the bonds are at the time of sale / purchase.
Let’s say bond investor #1 who has 8 years remaining on his/her 3.5% bond goes to bond investor #2 and says, “I see you are looking to purchase a new 8-year bond … how about you buy my 10-year bond that has 8 years remaining?” Do you think bond investor #2 is going to be interested in that offer to buy a bond for 3.5% when he/she can purchase a new one at 6.5%? No way!
So, bond investor #1 if forced to DISCOUNT his/her bond in order to get investor #2 to buy it. The conversation and math would go something like this: “I’ll purchase your bond but because there is a 3% difference between your bond and the bond I was going to purchase I want a 3% per year discount for the remaining 8 years … that equates to a 24% discount, so I will only pay you $76,000 for that $100,000 bond.”
Now, if bond investor #1 needs the money (or determines to get out for any other reason) he/she is going to have to accept less than the initial investment to bail from the bond because of the increased interest rate environment.
When interest rates go up, bond values go down (and vice versa … stay tuned).
What happens is bond investor #1 does not sell because he/she is not willing to accept $76,000 for the initial investment of $100,000. Very simple, he/she continues to get the $3,500 per year in interest as they always have.
Let’s go one step further and I’ll wrap up.
What if in 2 more years interest rates drop? Let’s say 2 years from now a 6-year bond is paying 5%.
Bond investor #2 has 6 years remaining on his/her 8-year bond paying 6.5% and determines he/she wants to sell. What happens then?
Well, since interest rates have decreased then he/she will be able to sell that bond holding at a PREMIUM.
With a 1.5% better rate than the current market is paying (6.5% vs 5%) and 6 years remaining then the premium would be in the neighborhood of 9% (1.5% x 6 years). That means that bond investor #2 could sell his/her bond to another bond investor for roughly $109,000.
That’s a great deal for bond investor #2. He/she made $6,500 per year for 2 years and then made $9,000 when selling … total proceeds of $22,000 or roughly 11% annual return.
- %
= bond values 
. Same vice versa, % = bond values .
What we have seen since January 2022 is a dramatic increase in interest rates, and that has led to a significant decrease in the value of bonds.
Higher interest rates lead to less borrowing, which leads to less spending, which leads to lower economic growth, which eventually leads to lower interest rates … welcome to the business cycle. 😊
Back-to-back weeks of heavy content … I’ll try to make next week a little lighter. 😉
As always, please feel free to reach out if you have any questions or would like to learn more about any of the topics addressed here.
It’s a tremendous honor to partner with you on your financial journey. Make it a great week ahead!