Bonds and Interest Rate Risk
5 minute reading time
Disclaimer: This post is not investment advice.
When looking around at investing, I often see people suggest that a person’s portfolio should have some percentage in equity (stocks) and some percentage in bonds. In this post, lets specifically look at the bond piece.
What is a bond? When an organization issues debt, investors purchase these bonds to provide the organization the principal of the bond. The principal of the bond is equivalent to the purchase price minus any possible fees the broker might impose.1 The reason investors purchase these bonds is because the organization promises to pay a fixed amount of extra funds on top on a periodic basis. It’s often said that bonds are a great way of producing fixed income.
Let’s get into specifics with an example. Say that Organization A issues a $1000 bond at a 10% coupon rate with a maturity date of 5 years from now. Typical coupon dates are set semi-annually so for this example the purchaser of the bond would receive $50 twice a year. At the end of the five years, the purchaser would receive the $1000 principal back.
The main risk when it comes to bonds is the possibility that the organization might go bankrupt. This is called default risk. If this happens, it does not necessarily mean that the purchaser lose the entire principal of the bond. During the bankruptcy process, the organization’s assets are sold to clear out their balance sheet. An estimate of the percent of the principal one might receive back is called the recovery rate.
One can measure default risk by looking at the credit rating of the organization that they’re considering buying a bond from. Typically bonds with higher yields will have lower credit ratings with the lowest being called junk bonds. It’s up to the individual investor what their risk versus reward preferences lie.
Now when someone says they’ve allocated 30% of their portfolio to bonds, they’re not suggesting that they individually pick out however many bonds to reach that amount. Instead it’s more likely that they’re investing in a bond fund. These are generally mutual funds, and they work by pooling together money from multiple investors to buy large amounts of bonds in a variety of different sectors or credit ratings.
There are several benefits to this approach:
- Lower barrier of entry: Some bond funds allow the individual investor to put in as little as $1, whereas if the investor wanted to purchase a bond it’d often be above $1000.
- Diversification Included: Companies within the same sector are often correlated with one another. That means that if Microsoft is having a bad year, it is likely that Apple and Google are experiencing the same. This means that you’ll often want to make sure you’re not buying bonds only within one sector of the economy. Bond funds often keep track of these for you and spreads your risk across multiple sectors.
- Greater liquidity: Bond funds often allow the investor to buy and sell positions within the fund whenever they’d like. If the investor owned individual bonds, it might take some time before another investor is willing to buy it off of you. They often say that municipal bonds are not that liquid.
Is the risk profile the same for bond funds as it is for individual bonds? Generally yes, however, there’s one risk that I didn’t mention in the last section that has a greater affect in bond funds: Interest or Duration risk.
Let’s continue with our example. Say that the federal reserve increases interest rates and new debt being issued by the organization comes with a 20% coupon rate. Now let’s say the prior purchaser wants to sell their 10% coupon rate bond. They might find that they have to sell at a loss.
“How come?” you might ask, don’t bonds provide a fixed income? That’s only true if the bond is held to maturity. If the purchaser wants to sell the bond before then, then the purchaser is subject to market conditions. To make the example easier let’s say that any coupon payments were made yet.
Prior 10% bond coupon payments: ($1000 * .10) / 2 * 10 = $500 income by time of maturity
Current 20% bond coupon payments: ($1000 * .20) / 2 * 10 = $1000 income by the time of maturity
Why would another investor want to purchase the 10% bond at $1000 if they’ll receive $500 less income by the time the bond matures? The seller would instead have to make up for the difference and sell the bond for $500.
This is the price of liquidity. Bond funds have to be liquid so they often do not hold their bonds to maturity and are subject to market conditions. In the year of the time of writing, 2023, the federal reserve has been consistently raising interest rates. This means that interest rate risk is high during this time period.
One strategy that some funds do, is to only hold short term debt. This makes it easier to either hold to maturity or have the bond mature before interest rates change. As stated in the beginning of the post, this is not investment advice, and I also don’t manage money for a living. This post summarizes the different risks I recently learned about bonds. Feel free to email me corrections or concepts to add.
There could also be some fluctuations in the price based on the credit rating of the organization. ↩︎