The InvestMentor

November 1, 1999

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This week, I want to talk about bonds...umm...hmmm...zzzz...zzzz.

OH! I’m sorry, I nodded off there.

All right, well maybe bonds aren’t that dull, but they certainly lack the sex appeal of stocks. (Apologies to my colleagues in the fixed-income world.) However, bonds are wrongly overlooked as an investment and when they are used, they are often utilized poorly. I shall use the rest of this piece to tantalize you with an instructive lesson on how bonds work, and how and when to use them.

The world’s fastest primer on bonds goes something like this: Bond prices move the opposite direction of interest rates. That’s because bonds are issued with a fixed rate of interest or "coupon." As the general level of interest rates change, new bonds carry a higher or lower interest rate in line with rates generally. Previously issued bonds, and their fixed rates, will be more or less attractive depending on rates in the broader market.

For example, let’s say Bond A is issued with a 6% coupon at an initial price, or "par," of $1,000. Thus, Bond A pays $60 in interest each year (6% of $1,000). A year later, interest rates in the market have risen by, say, 1% as a result of various factors not the least of which might be a Federal Reserve rate hike. Bond A’s 6% coupon is now less attractive considering that bonds of a similar type are being issued with 7% coupons. So what happens? The price of Bond A falls -- to about $857. That’s because while all owners of Bond A will still get $60/year, new buyers want to match the yield they could get on a new bond. By paying less for the bond, they get a higher yield: $60/$857 is about 7%.

Voila: When rates go up, bond prices go down. Even though existing bonds will continue to pay their fixed coupon rates, their "return" – which includes income yield and price change – will drop. Going back to Bond A, if you bought it at par, and received your $60 during the year, you had an income yield of 6%. However, if the bond price dropped from $1,000 to $857, that equates to a negative 14.3% price change. Netted against the original 6% income yield, the bond’s "performance" for the period would be about -8.3%.

But here’s the punch line: The price change doesn’t need to matter.

Why? Let’s say Bond A is a two-year bond. If you hold it to maturity, the issuer will redeem it at par ( in this case, $1,000) after two years. Even if rates went up another 1% or more during the second year of Bond A’s life, you’d still get $1,000.

Think of it another way. If you buy a car today at $20,000 and you have a contract to sell that car in five years for $20,000, would it matter to you that that "blue book," or market value, dipped as low as $15,000 at some point during your five years? No. All you care is that the car performs well while you have it and that whoever contracted to pay you $20,000 in five years will be able to do it. Same way for bonds. The only thing that matters with bonds is that they pay interest and redeem at maturity as promised. The best way to ensure that is to stick with high-quality bonds -- single A rated or better.

Bonds should be used for either of two purposes – to provide income or to preserve capital. Note that I’ve said nothing about diversification. Bonds water down a stock portfolio and have no business being there. When you are at a stage in your life when you need your investments to provide income, bonds are your best choice. Similarly, if you can’t afford the fluctuation associated with stocks, bonds lock in your yield through maturity.

When creating a bond portfolio, the most important thing to consider after quality and rating is allocating maturities over time. That means spread your money across several bonds, each with a different maturity. For example, you might buy one bond with a one-year maturity, another with a three-year, and others with five-, seven-, and nine-year maturities. This way, a bond is maturing every couple of years and you can reinvest at the then-prevailing rates.

I typically roll the proceeds back into bonds at the end of the maturity spectrum since, after year one, the original nine-year-to-maturity bond now has only eight years left. This approach locks in your yield and allows you to periodically reinvest as bonds mature, ensuring protection from raising rates. Even better, it’s easy to do. Set it up and you can go to sleep (oh, sorry bond guys and gals).