Are Bonds Really Safer Than Stocks?
It is commonly perceived that bonds are a “safer” asset class than stocks. We come across this perception in conversation with clients, potential clients, and sometimes even with peers in the wealth management industry. How many times have we heard the words “safe” and “bond” in the same sentence? But bonds are not always safe. In this post, we will illustrate risks inherent in bond investing and market dynamics to beware of.
Bonds have four primary attributes to consider:
- Principal/Par Value – This is the amount of money that will be paid out once the bond matures. A newly issued bond usually sells at the par value.
- Coupon – This is the amount of money the bondholder receives as interest payments.
- Price – This is the bond’s current price in the market.
- Yield – Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.
Let’s demonstrate this with an example. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). Pretty simple stuff. But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).i
The prospect or expectation of rising interest rates, which we face during 2017, is one market dynamic that makes bonds a less attractive and even risky investment. Bond prices and interest rates have an inverse relationship – when interest rates rise, bond prices fall. This inverse relationship may seem counterintuitive, but after consideration it makes sense. When interest rates rise and new bonds are issued, the new bonds will have a higher coupon rate than the previously issued bonds – this creates a dynamic where the yield on older bonds is no longer competitive or attractive because it is lower than the yield on new bonds; in order compete with the newly issued bonds, prices fall across older bonds until their yield is on par with the newer bonds. That is a lot of information to digest, so consider the following simple example.
Imagine if we were to buy a bond today with a 10% coupon for $1,000 – this bond would pay $100 and the yield would be 10% ($100/$1,000). And then in a year, interest rates doubled and newly issued bonds had a 20% coupon with the same $1,000 principal. These new bonds would make our old bond less attractive because they pay twice as much! To remain competitive in the market, the price of our older bond would have to drop to $500 for its yield to reach 20% ($100/$500). Ultimately, our recently purchased $1,000 principal bond would be worth $500 – a 50% loss on our investment.
Inflation can both directly and indirectly effect bond prices. During periods of high inflation, the Federal Reserve will often raise interest rates to tighten the money supply and curb inflation. As we now know, interest rates and bond prices have an inverse relationship and a rise in interest rates pushes bond prices down; in this case, inflation is indirectly having a negative effect on bond prices. More directly, inflation reduces the purchasing power of a bond’s coupon payments and its overall yield. For example, consider the performance of a short-term bond that yields 1% over the course of a year with 4% inflation, this bond will yield a 1% nominal return but when you adjust for inflation, the bond will yield a -3% real return.
Finally, it is important to consider default risk and trading liquidity. Although these are typically not large risks in treasury or municipal bond investing, they exist across corporate and high yield bond investing. When a corporate bond is purchased, the purchaser is ultimately reliant on the respective corporation’s ability to pay the interest payments and, eventually, the principal; sometimes, due to unforeseen economic circumstances or poor performance, payback isn’t possible and the loans are defaulted. It is also important to consider trading liquidity, as corporate bonds often trade at low daily volumes. Low trading volumes make it hard to get out of positions, and this dynamic can push prices down.
If you have any questions about this post or bonds in general, please reach out! Thanks for reading and please share this post.