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The Bare Bones of Bond Investing: Things to Know, Pitfalls to Avoid

The size of the US bond market is huge, sitting at around $40 trillion as of this writing in early 2021. Five years ago, it was about twice the size of the stock market. But with stocks booming and interest rates at all-time lows, the size of the stock market now comes to about $30 trillion (this is the total market capitalization, which is to say taking every share, multiplying it by its current price, and then adding it all together).

As an investor or someone thinking of becoming an investor, you’ll therefore be likely to have a portfolio with both stocks and bonds. We’ve addressed stocks elsewhere at Expensivity and are planning an in-depth article on bonds in the next few months. The reason for this article is to get the most important things you need to know about bonds in a convenient and quickly understandable form. The ins and outs of bonds form a labyrinth. Even cataloguing the different types of bonds is a vast undertaking. Besides the usual government and corporate bonds, there are lottery bonds, climate bonds, and celebrity bonds, to name just a few.

So the focus of this article is on bond basics, and in particular the things you absolutely must know to go into bond investing with your eyes wide open, understanding the advantages and benefits, but also the risks and pitfalls of putting money into bonds. Bonds are often characterized as loans that bear interest. And that’s true, but it’s not the whole truth. We’ve all taken out loans, such as car loans and home mortgages. But bonds add some complications that are absent from ordinary loans and that you’ll need to be aware of.

With a standard loan, such as a home mortgage, you owe a fixed amount at a fixed or variable interest rate. As long as you are paying off the interest on the existing principal, and paying down the principal, and do so all in the time allotted for the loan (usually 30 years), you are good. If you don’t or can’t make the necessary payments, then you are in default and the bank can claim your home.

When you invest in bonds, the tables are reversed. Now you are in the position of lender and the issuer of the bond becomes the borrower. But things are not quite as straightforward with bonds as they are with loans. There are a lot more moving pieces, and it is important to keep track of at least some of them.

Actually, there is one type of bond that does function very much like a standard loan, and that’s US treasuries (known as T-bills, T-notes, and T-bonds depending on the length of time to maturity, T-bills maturing in weeks, T-notes in less than ten years, and T-bonds going as long as thirty years). If you buy these bonds and hold them to maturity, you get back what you paid for them plus the interest. Moreover, the US government guarantees the interest payments through to the maturity date.

What makes things more complicated with the bond market as a whole is that bond values change as interest rates change. To put this in stark terms, suppose you bought a $10,000 bond from some source with a coupon payment of $500 (so 5% annual interest). Let’s say that the bond matures (comes due) in 15 years, but that right after you purchase it, the coupon/interest rate offered by that same source on its bonds goes up to $1,000 (so 10%).

In that case, obviously, you would have been better off waiting to invest in the bond offering the $1,000 coupon rather than the one you did invest in. Over the life of both bonds, you’ll see a total of $15,000 in coupon payments on the $1,000-coupon bond versus $7,500 on the $500-coupon bond. That’s a $7,500 difference over the life of the bonds.

It follows that if you try to sell your bond with the $500 coupon payment, this bond’s value has now gone down. For the same $10,000 investment, because you’re going to see a lot more return with the $1,000 coupon payment compared to the $500 coupon payment ($7,500 over the life of the bonds), you’ll see a dramatic decrease in the price of the $500-coupon bond if you try selling it now that you, and others, could be getting a $1,000 coupon payment.

The underlying math here is not difficult, but you don’t need to know the math to understand the principles at play. In any case, it’s easy to see what happens to the value of the bond by using a bond calculator, such as you can find here or here. Given the numbers above, the bond price has now gone down to just over $6,000. The reverse can also happen. So, if the value of the coupon payment goes down to $200, your $500 coupon payment starts to look really good, and the value of your bond now rises to almost $14,000.

It’s easy to think that when you invest in bonds, it’s like buying a US treasury, where you put down a given amount of money and then get that money back at a clear and specified interest rate. But most bonds get bought through funds where you get in on the action in the middle of things. You don’t buy the bond from the start and you don’t hold till maturity. Rather, you get the bond for a price that depends on how the bond’s coupon rate matches up with currently available coupon/interest rates. Moreover, your fund will buy and sell the bonds at going rates. As it is, $700 billion in bonds get traded daily, so there’s constant wheeling and dealing in these bond funds, and the value of your stake in them can therefore fluctuate.

Here, then, is what you absolutely positively need to know if you want to invest in bonds. Specifically, what follows are seven questions you need to be asking when you are thinking about investing in a particular bond or set of bonds:

  1. DEFAULT: How likely is it that the issuer of the bond is going to default? If you are investing in a fund with various distinct bonds, what percentage of bonds in the fund are likely to default? For treasuries and other government bonds, the probability of default is extremely low, and that’s generally true also for state and municipal bonds. But in the absence of reliable probability calculations for assessing risk (and usually such calculations are hard to come by), it’s good to ask about the issuer’s track record for making good on promised payments as well as the issuer’s balance sheet of assets and liabilities (does the balance sheet suggest imminent bankruptcy, especially if the issuer is a corporation?). Bonds are in effect promises (“my word is my bond”), and the problem with promises is that they can be broken. One indicator that you may be dealing with a bond in risk of default is the interest rate. If the interest rate is too good to be true, then you are probably looking at a junk bond with a significant probability of default.
  2. TAXES: What taxes are you going to pay on any income from the bond? For many bonds, any income (i.e., coupon payments) from them is taxable. So let’s say that you are in a tax bracket where you are paying around 30 percent of your income in taxes. Consider a tax-free bond that pays 2 percent interest or a taxable bond that pays 3 percent interest. At the end of the day, either bond will put about the same amount of money in your pocket. Precisely because interest rates are so low at the time of this writing (early 2021), taxes can significantly eat into your income from bonds. You always want to be asking what’s actually going to end up in your pocket, not just the raw coupon/interest rate numbers.
  3. INTERMEDIATION: Are you having a financial firm invest in bonds for you? If so, what is their cut? “Intermediation” is a fancy term for the cut that people investing for you get. The legendary investor John Bogle started Vanguard precisely because he saw financial firms paying themselves an overly generous percentage of the capital that investors had placed with them. Vanguard reduced its intermediation fees to the bare minimum, which is one reason Vanguard manages over $6 trillion in assets (that’s big!). In any case, you need to determine how much any financial firm that is investing on your behalf is taking from your capital in order to manage it. With bond rates at historic lows, those intermediation fees may in fact end up putting you in the red.
  4. CALLABILITY: Are the bonds in which you are investing callable? A callable bond is one that the issuer can buy back for the bond’s face value (i.e., what the issuer got for the bond at issuance) plus all interest to date. Think of a callable bond like a mortgage that you can pay off and then refinance at better terms. Just as you would want to refinance a mortgage with a 5 percent interest rate if mortgage rates have fallen to 2 percent, so companies or other issuers that issued a bond paying a 5 percent coupon rate would benefit by simply buying the bond back (plus the interest) and then issuing new bonds at 2 percent. For callable bonds, the issuer has that option. For non-callable bonds, on the other hand, the issuer is on the hook until the bond matures. The point to realize here is that you might want to invest in bonds for a guaranteed fixed income over a fixed number of years (perhaps your retirement years). In fact, for some financial firms the “bond desk” is also called the “fixed income desk.” But if a bond is callable, you can’t count on that fixed income. If it gets called, you’ll have to look for a new investment.
  5. FIXED v VARIABLE INTEREST: Are the coupon payments (interest rate) on the bond fixed or variable? How much variation is possible? If variation occurs, on what will it depend and how will be gauged? Obviously, for peace of mind, you’re going to prefer a bond that pays at a fixed rate. An exception would be a “lottery bond,” in which lucky winners of the lottery will see their coupon payments go up beyond the original coupon rate but never below. If a variable bond has a floor below which it can’t go, and that floor seems reasonable to you, then such a variable payout could seem reasonable to you as well. But depending on how much the coupon payments can vary and how low they can go, you may be wiser to go with a bond that pays a fixed coupon rate.
  6. CHANGING BOND PRICES: What is likely to happen to the prices of the bonds in which I am investing? If they go down, how much am I likely to lose? As noted above, if you buy a US treasury and hold it to maturity, you will get back the original price of the bond plus all the coupon payments that accrue to the time of maturity. But not all bond investments are like that. You may be purchasing a bond that has already been issued or investing in a fund of bonds. So even if the coupon rate is fixed and getting paid as promised, you may find that at the end of the day you’re still losing money because interest rates have gone up and the value of your bond has therefore gone down. And so, when you need to cash in your bond, you find that it’s still down below what you paid for it. You’ll always want to be aware of how the prices of the bonds in which you are investing can change and what such changes can do to your bottom line.
  7. INFLATION: What is inflation likely to be in coming months and years, and is your bond investment, especially when you factor in taxes and intermediation, likely to keep up with inflation? Factoring inflation into your bond investment strategy is an important reality check. Suppose, for instance, you’re trying to save for your children’s college education. Let’s say you are investing in a college savings fund consisting of bonds that are staying slightly ahead of inflation as gauged by the CPI (Consumer Price Index). If so, you may still be in trouble. The HEPI (Higher Education Price Index) shows an annual inflation significantly larger than that of the CPI. So if your bond investments are just staying ahead of CPI inflation, which characterizes the rise in prices of daily goods and services, you may at the end of the day still be in for a surprise at what college costs. That’s because of the way inflation hits different parts of the economy differently, with higher education getting hit harder by inflation than daily goods and services.

So much of the success in life depends on asking the right questions. That’s especially true of successful bond investing. The previous seven questions are the right questions you need to be asking as you begin to invest in bonds.