What are Bonds? (Updated 2023)

Recent financial headlines about an inversion in the bond yield curve have sounded recession alarms.

On a global scale, the value of the bond market is more than twice that of the stock market. Movements in the bond market, even more so than the stock market, can give investors a heads up that it’s time to rethink their portfolio allocations.

In early October, data from the US Department of the Treasury indicated that the spread between the yield on two and 10 year Treasury bonds was narrowing, as per Business Insider. Economic researchers say that such an occurrence — a de-inversion between short- and long-term bond rates — is a clear sign that a downturn is on the horizon.

‘The US Treasury yield curve is de-inverting very rapidly,’ DoubleLine Capital CEO Jeff Gundlach, who is known as the ‘bond king,’ said in a post on X (formerly Twitter). ‘Should put everyone on recession warning, not just recession watch. If the unemployment rate ticks up just a couple of tenths it will be recession alert. Buckle up.’

Many leading analysts are predicting that the economy could be headed toward a recession, especially if the US Federal Reserve continues to raise interest rates in an attempt to curb inflation. The federal funds rate currently stands at 5.25 to 5.5 percent.

What is a bond?

Bonds are a type of investment that entitles the holder to guaranteed repayment of principal, in addition to interest payments.

Bonds are essentially units of debt issued by companies or governments to raise funds for business costs or finance projects. Think of a bond as a loan an investor (the lender) makes to an issuer (the borrower).

There are four main types of bonds: agency bonds, municipal bonds, corporate bonds and government bonds.

Agency bonds are issued by private government-sponsored institutions that provide public services such as lending programs. For example, the Federal Home Loan Bank in the US and the Canadian Mortgage and Housing Corporation issue bonds that are guaranteed by their respective federal governments.Municipal bonds, or munis, are issued by state governments or local governments to fund public projects such as the construction of schools, hospitals, parks and roads.Corporate bonds allow businesses to raise capital for the development of new products, acquisitions, ongoing operations, the purchase of equipment and other assets, as well as recruitment budgets. The upside for companies is that the bond market often offers more favorable terms and lower interest rates than traditional bank loans. For investors, these bonds typically offer the highest rates compared to other bond types.

“These four bond types also feature differing tax treatments, which is a key consideration for bond investors,” advises Forbes.

Many, but not all, muni bonds are considered tax-exempt investments. However, corporate bonds are subject to federal and state income taxes, while government and agency bonds are subject to federal tax, but exempt from state and local taxes.

How do bonds work?

Bonds are considered fixed-income investments because they provide bondholders with fixed interest rate payments (coupon payments) at regular intervals between the issue date and the maturity date. The maturity date is the time at which the bond principal must be paid back to the bondholder.

The coupon payment amount is determined by the interest rate, known as the coupon rate. For example, a 4 percent coupon rate on a US$5,000 bond would translate into US$200 in annual payments to the bondholder.

What determines the coupon rate? “The face value, coupon, maturity, the issuer and yield are all factors that play a role in a bond’s price,” according to financial services company Desjardins. “However, the factor that influences a bond more than any other is the level of prevailing interest rates in the economy.”

Some bonds come with the option to convert debt into stock with certain conditions. These are known as convertible bonds.

How to invest in bonds?

If you want to invest in bonds, your broker can help. Large firms such as Charles Schwab, E*TRADE, Fidelity, Interactive Brokers and TD Ameritrade specialize in bond investing and investors can buy new-issue bonds through these platforms.

Another important point for investors to understand is that bonds are tradable assets. Most corporate and government bonds can be traded in secondary markets after issuance. Bondholders can trade their bonds through a broker before the maturity date. Most bond trading occurs over the counter; however, there are many bonds trading on public exchanges.

In the case of US Treasuries, investors have the option of going through their broker or buying bonds directly from the federal government on the online platform TreasuryDirect.

When considering which bonds to purchase, bond investors should practise due diligence by researching the bond’s rating. S&P Global Ratings, Moody’s Investors Service and Fitch Ratings are the go-to independent ratings agencies. Each has its own grading system, but they all classify bond investments by quality grade and risk.

Bond ratings inform bond buyers as to the creditworthiness of the bond issuer and how likely it is that they’ll see a repayment on their loan. The highest bond rating is AAA, while a rating of C or below is a sign the bond issuer might be at risk for defaulting.

Investment-grade bonds are rated as the safest investments. They come with a low default risk, but provide lower yields. Non-investment grade bonds, also known as junk bonds, are considered riskier than investment grade, yet they offer a higher yield.

Mutual funds and exchange-traded funds (ETFs) offer another avenue for investing in bonds. Bond ETFs typically have lower management fees than bond mutual funds. As of October 12, 2023, the three top bond ETFs by assets under management were:

How do bonds compare to stocks?

As an investment vehicle, bonds are considered less risky than stocks. In times of low stock market performance, the less volatile bond market often offers a safe haven for those looking to liquidate their stock holdings.

“Because bonds pay investors interest at regular intervals, they are often referred to as ‘fixed income investments’ and can help offset any losses you may experience when you also put your money in stocks,’ states Elizabeth Gravier of CNBC Select Money in an explanatory article.

The lower risk of bonds compared to stocks also translates into lower returns on investment. However, bonds are not without their risks. Companies can default on their debt, and bond yields can fall alongside falling interest rates.

Another risk to investing in bonds is that you can’t access your money until the maturity date. “So, a 10-year bond has to be left untouched for 10 years,” as per Gravier. “It’s important you know what a bond’s maturity date is before handing over your money.” This means that the bond market is less liquid than the stock market.

Of course, bondholders can sell their bonds on the secondary market prior to the maturity date, but they will most likely not get back their entire initial investment. If interest rates have risen since the bond was issued, the bondholder will need to sell it at a deep discount. On top of that loss, the broker will most likely further decrease the price of the bond in order to turn a profit on its sale. Investors can compare markdowns between brokers prior to listing their bond for sale.

Regardless, this doesn’t mean investors have to choose between stocks and bonds. Both are important to a strong, diversified investment strategy. “Bonds can help hedge the risk of more volatile investments like stocks, and they can provide a steady stream of income during your retirement years while preserving capital,” according to Forbes.

One market environment that’s negative for both stocks and bonds is high inflation, which often leads to higher interest rates.

How does inflation affect bonds?

Bonds are often considered safer investments than stocks; however, certain market conditions can increase the risk of owning bonds. Of all the market forces investors should keep an eye on, inflation has the greatest impact on bonds.

“When inflation rises, returns on bonds become negative, because rising yields, led by higher inflation expectations, will reduce their market price,” explained Nouriel Roubini, chief economist at Atlas Capital Team. “Consider that any 100-basis-point increase in long-term bond yields leads to a 10% fall in the market price — a sharp loss.”

During the stagflationary environment of the 1970s, stocks fell in value and bond yields exploded in the face of overwhelming inflation, “leading to massive market losses” for both these investment vehicles.

Roubini notes that in the last 30 years, with inflation rates in the “low single digits,’ bonds have enjoyed a long bull market run as bond returns rose alongside bond prices. Hence, bonds have only put up negative overall yearly returns a handful of times. Most recently, Roubini points to the fact that in 2021 “higher inflation and inflation expectations” pushed bond yields higher and the overall return on bonds reached negative 5 percent.

It’s no wonder that inflation is infamous for being the “enemy of the bond investor.’ Multinational financial services corporation Fidelity spells it out: “Rising inflation erodes the value of bonds and makes their coupon payments less appealing.” This loss of value is the harshest on longer maturity debts and can be exacerbated if central banks tackle rising inflation with rate hikes.

How do interest rates affect bonds?

Alongside inflation, interest rate changes are another significant market factor affecting bond returns. While both rising inflation and interest rates can result in bonds losing value, the latter can also increase bond yields, leading to falling bond prices.

The Financial Industry Regulatory Authority says there are three main rules for investors to remember when it comes to how interest rates affect bond prices. First, when interest rates rise, bond prices generally fall. Second, when interest rates fall, bond prices generally rise. Lastly, but most importantly, every bond carries interest rate risk.

Unsurprisingly, changes in interest rates will have a direct impact on your bond portfolio. “This is a function of supply and demand,” according to US Bank. “When demand for bonds declines, issuers of new bonds must offer higher yields to attract buyers, reducing the value of lower-yielding bonds already on the market.”

For example, let’s say you purchased a corporate bond with a face value of US$5,000 and a 10 percent coupon payment, and then a year later rising interest rates prompted the company to issue a new bond with 10.5 percent coupon payment. Your bond would have less market value than the new bond. To sell this bond, you’d have to do so at a discount. Conversely, if interest rates fell to 8 percent, you could sell your bond at a premium.

In 2022, the interest rate environment changed significantly. Rising interest rates have had a sizeable impact on bond markets, and bond yields began increasing in August of that year, leading to fixed income market losses.

“Bond yields rose primarily because the Fed pivoted to a much more hawkish position, as investors anticipated aggressive interest rate hikes to rein in inflation,” said Bill Merz, head of capital markets research at US Bank Wealth Management. Bond markets typically move in anticipation of upcoming monetary policy changes by the Fed.

Many market analysts believe movements in bond yields can also reveal a lot about the health of the economy and whether or not a recession is on the horizon.

Can the bond market predict a recession?

“The bond market can help predict the direction of the economy and can be useful in crafting your investment strategy,” Investopedia states. “This metric — while not a guarantee of future economic behavior — has a strong track record.”

Mike Larson, income and dividend analyst at Weiss Ratings, has underscored the inverted bond yield curve as a sign that a recession is brewing. An inverted yield curve occurs when the two year bond yield exceeds the 10 year bond yield, and it has been a harbinger of every recession since the 1970s. Market watchers witnessed this same phenomenon ahead of the 2008 recession, the dotcom bubble burst at the turn of the century and the recession sparked in the early 1990s by the Gulf War and oil price shock.

While this phenomenon was on display in last year’s bond market, sparking recession fears, a different phenomenon, the de-inverted bond yield curve is taking shape in late 2023. As mentioned, this is also a harbinger of a potential economic downturn. Some would argue that its an even more dire warning than its inverted counterpart.

‘This very recent move in Treasurys has been a little bit more dangerous,’ said Priya Misra, fixed income portfolio manager at JPMorgan Asset Management. ‘I think the move in the Treasury market, the disinversion of the curve, I think that actually makes a hard landing much more likely.’

Securities Disclosure: I, Melissa Pistilli, hold no direct investment interest in any company mentioned in this article.

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