Because of the importance of bonds in portfolio diversification, a strong understanding of the fundamentals of bond investing is key. Having a solid grasp on the different types of bonds available, calculating bond returns and the differences between bonds and stocks is central to becoming a smart investor.
Bonds allow investors to lend money to corporations and governments (the issuer of the bond). Issuers sell bonds for a wide variety of reasons, including to finance an acquisition, pay for ongoing capital expenditures or to refinance existing debt.
A bond is a fixed-income security that pays the bond investor (known as the bondholder) fixed income and principal payments on a predetermined schedule. When an issuer sells a bond, they receive the face value or par value of the bond upfront. During the lifetime of the bond, the bond investor receives periodic interest (or coupon) payments, most often on a semi-annual basis. On the maturity date, the issuer repays the bondholder the par value.
For example, suppose ABC Corp issues a 10-year bond with a par value of $1000 and a 5% coupon paid semi-annually. Each year, the bondholder will receive two interest payments of $25 ($1000 * 0.05/2), for a total of $500 over the lifetime of the bond. At the end of ten years, the bondholder is repaid $1000.
Once issued, many bonds are traded on major exchanges, similar to stocks. In the secondary market, the market price of a bond fluctuates according to supply and demand. The price is influenced by a number of factors, including the coupon of the bond relative to prevailing interest rates, the credit quality of the issuer (i.e., the likelihood that the issuer will default on their debt), and the time remaining until the maturity of the bond.
Calculating the rate of return on a bond is not straightforward. There are several possible metrics, the simplest of which is the current yield. Current yield is equal to the annual coupon payment of the bond divided by the bond’s market price.
If the bond is trading at par, then the current yield is equal to the coupon. However, if the market price of the bond is above or below the face value, the two metrics diverge. For example, suppose ABC Corp’s 10-year bond is trading at $900. The coupon is still 5%, but the current yield of the bond is equal to ~5.56% ($50/$900). Conversely, if the bond is trading above par, the current yield will be less than the coupon.
While the current yield is convenient and easy to calculate, it is a blunt instrument. It doesn’t take into account the number of interest payments remaining on a bond, for example, or the bond’s face value, which will be repaid at maturity.
A better metric for capturing a bond’s rate of return is the yield to maturity (YTM). The yield to maturity is the discount rate that sets the future cash flows of the bond (interest and repayment of principal) equal to the current market price. Mathematically and conceptually, the yield to maturity of a bond is very similar to the IRR of an investment. The advantage of YTM is that it allows investors to compare two bonds with different maturities and coupons. A higher YTM corresponds with a better return on investment.
Treasuries are bonds issued by the US Treasury Department on behalf of the federal government. These bonds are considered to be “risk-free” investments because they’re backed by the full faith and credit of the government of the United States. The Treasury Department issues a wide range of bonds, including Treasury Bills (or T-Bills), which mature in a year or less; Treasury Notes, which mature in 10 years or less; Treasury Bonds, which have maturities of 20 or 30 years; and Treasury Inflation-Protected Securities (or TIPS), which are structured to protect investors against inflation.
Municipal bonds (or munis) are bonds issued by states, counties, cities, and other municipal entities such as airports and school districts. Interest income from muni bonds is typically exempt from federal taxes and can be exempt from state and/or local taxes as well.
Corporate bonds are bonds issued by a company. Corporate bonds can be secured, meaning they are backed by specific collateral or revenue streams, or unsecured, meaning they are backed by the company’s overall assets and cash flows.
Broadly speaking, the bonds above are divided into two major categories: investment grade and high-yield (or junk). Investment grade bonds have a low likelihood of default, meaning the issuer is very likely to make interest and principal payments when due. On the other hand, high-yield bonds are riskier. High-yield bonds typically have a higher coupon to compensate investors for the additional risk they take on.
To understand the benefits and drawbacks of bonds as an asset class, it’s helpful to compare owning a bond to owning a stock. When you buy a stock, you own a share of a company’s equity. Shareholders benefit from equity upside in the form of price appreciation of the underlying stock and dividend payments. However, if the company does poorly, dividend payments may be cut and the share price may decline.
On the other hand, bondholders own company debt rather than equity. Interest and principal payments on bonds are fixed, meaning that bondholders don’t benefit from company outperformance or suffer if profits are less than expected. When the bond matures, bondholders are returned the par value of the bond. Bondholders also have priority over shareholders in a worst case, bankruptcy scenario.
Many investors like the stable passive income that bonds provide. In recent years, bonds have also been negatively correlated with stocks, making bonds one asset class that can be used to hedge against declines in the stock market.
Although bonds can offer investors a stable source of passive income, they have disadvantages as well. Yields are currently at all-time lows, meaning returns on low-risk bonds barely keep up with inflation. While high yield bonds offer slightly better returns, they are also much riskier. Fitch, a credit rating agency, forecast earlier this year that as many as 5.5% of high yield issuers would default on their debt (and more in certain sectors).
In contrast, some alternative investments offer many of the benefits of bonds without the drawbacks. Farmland is a low-volatility asset class that offers passive income in the form of periodic cash distributions. Farmland is also uncorrelated with the stock market, making it an effective hedge against market volatility. Unlike bonds, however, farmland offers high real returns. Between 1998 and 2018, total returns on farmland averaged ~10% per annum, including income and price appreciation.