Bonds have not been a thing for a minute now. They have been boring for my entire financial career, offering negligible returns. A quick Google search for “bonds” will bring results for James and Barry, not the $46 trillion fixed-income market.

When bringing up bonds in meetings with clients and prospects the past few months with people under 40, their responses have been, “What are bonds?” “Are they like stocks?” “How do they work?”

What is a bond?

A bond can be considered a loan and belongs to the fixed-income family of investments. A company or government issues a bond, and the issuer typically pays interest over the bond’s life and the principal at maturity.

Whereas a stock or equity investment puts the investor in the owner’s shoes, a bond investor is in the lender’s shoes. Bonds are safer investments because bondholders receive their money before stockholders. However, bondholders have limited upside because they do not receive capital appreciation from stock market gains or profits.

It’s a historically bad year for bonds.

Bonds just had one of their worst years since the mid-90s. Because bonds pay interest, their value is closely tied to the prevailing interest rates. As the Fed has hiked rates at a historic clip this past year, bond values have suffered quite a bit. However, their interest rate has become much more appealing to investors as bond prices fall.

Why do bond prices fall when interest rates rise

Bond values have an inverse relationship with interest rates. When one goes up, the other one falls. It may seem counterintuitive initially, but it is an essential mechanic to bond investing.

A bond can be considered a loan made by an investor to a company. The company pays a fixed interest rate to the bondholder, typically semi-annually. That interest payment remains the same no matter the current level of interest rates.

Bond issuers compete with each other by offering competitive terms and coupon payments (interest payments). New bond issues will reflect the prevailing interest rates at that time. Older bond issues will keep the same rate.

For older bonds to sell in the market, their price must adjust to reflect the current level of interest rates. If current interest rates are higher than the interest payment on the bond, its market value must fall to remain competitive with newer issues.

Bond price change example

Suppose you purchase a bond with a par value of $1,000. It has a 5% coupon or interest payment. The bond matures in 5 years when you get back the initial investment.

As this bond pays 5% interest, you will receive $50 yearly for five years. Bonds pay semi-annually, so you will receive $25 for each payment period.

Let’s say you want to sell your bond one year later, but interest rates have increased to 6%. Your bond will still mature at $1,000, and you will get the remaining eight payments at $25 each.

For your bond to compete on the open market, its market value will fall to $964.90. It will still mature at $1,000 after all the interest payments. That discount from the initial purchase price and the following appreciation makes the bond competitive in the open market.

What happens to bond prices when interest rates rise?

Bonds are boring to a lot of investors. Small changes in interest rates can have a significant impact on bond values. There are a few things that affect a bond’s discount:

  • the current level of interest rates
  • the number of coupon payments left
  • amount of the coupon payments
  • value of the bond at maturity

Taking the example from above, let’s assume that there are ten payments of $25 left and that the bond will mature for $1,000.

Interest Rate5%6%7%8%
Number of Payments10101010
Coupon Payments$25$25$25$25
Future Bond Value$1,000$1,000$1,000$1,000
Market Value$1,000$957.35$916.83$878.34

What happens to bond prices when interest rates fall?

Similarly, bond prices adjust when interest rates fall. Always remember: bond values move in the opposite direction of interest rates.

Interest Rate5%4%3%2%
Number of Payments10101010
Coupon Payments$25$25$25$25
Future Bond Value$1,000$1,000$1,000$1,000
Market Value$1,000$1044.91$1092.22$1142.07

What is a bond fund?

A bond fund is similar to a stock mutual fund. It pools cash from individual investors to buy a bunch of bonds, diversifying a portfolio for a lower cost.

Holding a bond fund is quite different from owning an individual bond. Bond funds:

  • Have a range of maturities, not just one
  • Managers often trade to keep the underlying bond portfolio consistent with the fund objectives
  • Monthly income fluctuates, whereas individual bonds make consistent payments semi-annually
  • Value depends on the units of the mutual fund, not an individual bond
  • Bond funds have a theme, such as long-term corporate or short-term government.

Types of bond funds

US Treasury bond funds, as the name suggests, hold US Treasuries of various maturities, long, intermediate, and short.

  • Considered to be the safest investments from the default
  • The longer-term bonds are more sensitive to interest rate changes
  • Short-term bonds are less than five years; intermediate bonds are between five and ten years; and long bonds are over ten years.

Municipal bond funds invest in “munis,” which come from local governments or other public nonprofits. Munis typically have a lower interest rate but are federally tax-exempt and often state and local exempt for residents.

  • Need to consider the tax-equivalent yield to compare to taxable bonds
  • Offer a lower rate of return than other bonds of equivalent risk
  • Often better to stay local to take advantage of state tax breaks

Corporate bond funds purchase and hold bonds from businesses. There are various lengths and credit qualities available to investors among many subcategories.

  • Lower credit quality usually comes with a higher yield
  • Higher yield than US government securities, but riskier
  • Lots of maturities available

Global bond funds invest in government bonds from all over the world. Unlike the US, these bonds carry credit risk, as many other governments do not have the same financial withstanding as the US government.

  • Typically considered safe
  • Carry other forms of risk
  • Allows investors to diversify beyond the US

What are bond yields?

A bond yield is a return that a bond investor receives on the investment. It is calculated using both the coupon payments and the principal at maturity.

There are a few ways to calculate a yield for a bond. Remember, bond math can get tricky for even finance majors, so I will spare you the formulas. However, you will see yields cited anytime you research bonds or funds.

Yield to maturity

The yield to maturity of a bond is the rate of interest that would make all of its future cash flows, principal, and interest equal to its current price. It is found via a trial and error process, or you can use a spreadsheet like an adult.

Trailing twelve-month yield (TTM)

This measure of a fund’s yield shows the amount of income the fund has paid out over the preceding twelve-month period. It estimates the percentage paid to an investor maintaining an average investment over the year. Actual results will vary, but it’s a good approximation.

30-day SEC yield

The 30-day SEC measure approximates the return the investor would experience if every bond in the portfolio were held until maturity. However, bond fund managers never hold bonds to maturity, so they will never mature. However, this metric is still a useful comparison tool for investors.

It’s challenging to come up with a great and specific measure of yield when investing in bond funds, as bonds are never held to maturity. However, these measures can help investors make comparisons and investment decisions.

Bonds are an essential part of your financial plan

In “normal” times, bonds are a crucial source of diversification. You give up a little bit of return potential and get a lot of risk reduction.

A steady income helps too. A steady cash flow stream can help you purchase other assets as they experience the usual ebb and flow of markets.

Are bonds a good investment?

Bonds have been a poor investment for some time now. They have offered nothing. Compared to stocks, they look even worse.

As interest rates have soared over the past year, bonds look better. After a long time, bonds offer a little return and safety.

The current level of yield also means that investors will need to take on less equity market risk to hit the same level of return. Holding bonds means that investors can have a more return versus risk-efficient portfolio.