Most individual investors know some basics about bonds. They know the diversifying role fixed income plays in a portfolio. They know bonds are generally less risky than stocks, and they know the cardinal rule of investing in credit: When yields go up, prices go down.
But ask them to go much further, and many balk. Why, specifically, are yields and prices inversely related? What does it matter if yields on 10-year Treasuries climbed more than 100 basis points in three months? And if the bond indexes are tanking, should you sell?
To answer these questions, at a time when bonds are getting more attention than they have in years, Bloomberg News called financial advisers to ask what they wish they could tell their clients.
About those plunging prices
Bond-market dynamics are harder for many to intuit than those of the stock market. That often leaves people talking past each other. Jennifer Lammer of advisory Diamond NestEgg in New York recently cringed when she heard an interview in which one person said “bonds are up” as if it were a good thing and another called it bad. Only later did they realize one person was talking about prices and another yields. But if you can clarify which element you’re discussing, and understand why bond yields and prices move in opposite directions, you can make sense of the market.
Essentially, it boils down to competition with a time-horizon twist. A bond’s yield is the amount of money a new investor can expect to earn each year until the bond matures as a percentage of his or her initial investment. While the actual coupon payout an investor receives doesn't fluctuate, the yield will vary in order to reflect the bond's value as interest rates rise or fall.
Investors planning to hold bonds until their maturity can pretty much stop there. You loan money to an issuer — usually a government or a company — you get annual interest for it in the form of a coupon payment, and then you get back the amount you loaned at the end. (As long as the issuer does not go bust.)
But things change if you want to sell that bond on the secondary market before it matures. Maybe you need cash for a life event such as a home purchase or retirement. What makes this part more complicated is that the value can change when you sell it, depending on interest rate expectations.
This is where competition comes in. If new issues of bonds — or even simple bank accounts — are offering higher yields than an older bond because of a higher interest rate environment, that bond will now be worth less on the secondary market. Higher yields are great for buyers of new bonds. But it’s bad news for people who want to sell bonds previously issued with lower coupon payments, as is the case now.
Bond funds
Another reason people can get tripped up when discussing fixed income is the fact that most Americans don’t own individual bonds or Treasuries, explains Ira Jersey, US rates strategist at Bloomberg Intelligence. Instead, they most often own fixed-income securities through 401(k) accounts that are indirectly backed by bonds or tracking the price of them.