A few important market facts to know about Bonds

Investing in bonds is a completely different game than investing in stock. I am offering a few facts you need to know first, if you don't already. You should also be very aware of important information about buying bonds directly vs. bond funds. Directly held US government bonds can be purchased directly from the US treasury (no commission or fees), and possibly through your own broker. Treasury bonds pay a fixed face value interest, and the sales price varies with the current Fed interest rate (a higher price means a lower effective interest rate than the face rate). If in your own control to be able to hold to maturity, face price and rate applies. But if sold before maturity redemption, there is always price risk (or possible gain too) due to whatever current interest rate then. Be aware you are betting on future interest rate at resale. If current interest is up at resale, price then is down, and vice versa.

Bonds may have paid higher dividends in 1994 (for the 4% Rule study), helping to support market crashes, but interest rate has bottomed out near zero more recently, so IMO, bonds seem an outdated investment idea (however the inflation today is increasing bonds and even money market at 5%). Bonds can protect savings from market volatility, and in a market crash, a 50/50 balanced fund drop half as much as a 100% stock fund, and the bonds still could provide some earnings. But markets always do recover, and bonds don't earn what the 100% stock fund can, and don't earn today what bonds have historically earned.

Most of all, you must realize that bonds are also quite volatile too, maybe safe from the stock market, however bond value is very seriously affected by current interest rate changes, which are increasing this year for new bonds (due to inflation). Increasing interest rate lowers resell value of existing bonds. See Duration next below, which is about this.

However, regardless of current interest rates, bonds do pay full face value when redeemed at maturity. However, holding until maturity may be difficult to achieve unless you directly own the bonds to make it be your choice, independent of bond mutual funds. Bond funds value their bonds daily according to the current interest rate.

Government bonds are different yet, sold at auction to bidders, so the price varies (sold at US Treasury). You can also buy there at the current auction price paid. So directly held US government bonds can be purchased directly from the US treasury (no commission or fees). They are called Bills, Notes, and Bonds. Bills are short term, and pay interest only at maturity. U.S. Treasury bonds of 1 to 10 year maturity are called Notes, and those of 20 or 30 years are called Bonds ("Bonds" here refer to both Notes and Bonds). The Treasury bonds are safely backed by the government (when redeemed), and paying a fixed interest based on face value, and are redeemed at maturity at full face value. However initially, they are bought by bidding at treasury auctions on new treasury notes and bonds, so the actual final yields vary with the selling prices that buyers will bid. A higher interest rate is due to a lower price (lower than the fixed face value). The variable auction prices are why interest rates of new government notes vary every day. The bid price drops if buyers won't pay more, and then the yield effectively goes higher than the face value (the yield to maturity), and of course vice versa too. But until redeemed at maturity (at full face value then, for the expected income), the bond resell value varies every day, due to current interest rates. The bond pays a fixed initial dividend in dollars, but resell value varies, making investment gain percent vary too, if sold early. But again, if redeemed at maturity, it pays full face value. The current SEC Yield reported is the previous 30 day interest result annualized to be the equivalent result 12 month Fixed rate, which is a standard way to compare the current earning rate of varying gains.

The first bond fundamentals which do need to be understood are:

Directly held bond dividends are simple interest, which is not compounded (not reinvested). It's dividend is computed from the face interest rate and face value, which never changes value. The bond is redeemed at full face value. However, current interest rate changes do affect the resell value if sold before redemption.

Bond funds hold many bonds, and the bond dividends go into the fund's value, and the fund issues their own dividend. Bond fund dividends are also withdrawals which also decrease the fund value (like stock and stock fund dividends do), but you can reinvest the fund dividends to maintain the same investment value, and achieve compounding.

Definition of the very important bond "Duration":

Any bond resell value varies with current interest rates. The term Duration computes that for Each 1% change in current interest rates, the resell value of existing bonds is expected to change in the opposite direction by "Duration" percent. If Duration is 5 years, and interest rates increase 1%, the bonds should decrease value by 5% if resold. Interest rates dropped to zero the few prior years, so existing bond resell values increased then, and bond funds showed better results. But vice versa, today existing bonds lose resell value when interest rates increase (and now the one year return is negative). The U.S. Federal Bank has announced plans for more interest rate increases to fight inflation. New bond interest rates is increasing, but old bond rates are negative gain now. A bond fund buys new bonds, but they already own many old bonds. But again, if bonds are directly held (in your own control), they do redeem at maturity at full face value.

Morningstar shows the bond Duration (in balanced funds at Portfolio tab, Bond sub-tab, if any). The meaning of a Duration of say 3 means the expected bond value will decrease 3% with each 1% interest rate increase, and vice versa, existing bond values also increase when interest rates fall. But either way, when and if directly held bonds are redeemed at maturity they do still pay face value. Short term bonds will have lower duration with lower risk from interest rates, but they pay even less. That is speaking of all bonds, including commercial, municipal or treasury (but excepting federal Savings Bonds, which are not sold at auction, and can be cashed in, but cannot be resold to a third party). Bonds have a face value and pay a fixed interest rate, of dollars based on their face value. However, when bought new at treasury action, or any bonds resold later in the market may pay a different price than face value, but directly held bonds still redeem face value at maturity. Bond resell value varies with current interest rates (including bond fund bonds) and with Duration, and then the actual purchase price computes the new effective interest rate (when redeemed at face value). If interest rates increase, existing bonds earning lower effective interest can only sell at a lower price to attract any interest in them (and also vice versa, price goes higher when interest rates decrease). This fact is Extremely Important, especially with interest rates currently increasing from a rock bottom low. The bond value decreases and also inflation exceeds the bond interest.

Bond resale value becomes volatile when interest rates change. I say "resale" because if held until redeemed at maturity, bonds are still redeemed at full face value (if directly purchased and in your own control to hold until then). So short term bonds, and bonds nearing maturity date, will have low durations. Long term bonds will have higher duration (more volatile due to interest rates). Morningstar.com shows the Duration of bond funds (on the Portfolio tab, computed each quarter, I think).

However, as individual bonds approach their maturity date, their duration drops towards zero, because directly held bonds do still repay full face value when redeemed at maturity or recall. And existing bonds do continue to pay their same fixed face value dividends, but their resell value varies with current interest rate (existing bond resell value drops with higher current interest rate). But if you buy bonds directly yourself, and hold until recalled or redeemed at maturity, the full face value return then will be as expected. But if sold early, they will have current market value.

So if in a bond fund, or if planning resell, there's much more to know about the volatility. Resell value of existing bonds varies inversely with current interest rates. And bond funds must buy and sell bonds continually as investors buy and sell shares, and bond values are computed daily, not necessarily held until redeemed, but the fund values its bonds at the resell price. So if you buy or resell in the fund, you get whatever the fund value is paying that day (due to interest rate changes). That could be a plus if interest rates fall, or costly if interest rates rise. Right now, interest rates were at near zero but rate is increasing due to the Fed planning to fight inflation with multiple interest rate increases during 2022. That then means the value of lower interest existing bonds is falling, but newly purchased bonds pay more interest.

When inflation increases interest rates of new bonds, it lowers old bond resell values. That's because no one would pay full price for old 1% bonds if they can buy new 2% bonds at same face value price. So then buying two existing 1% bonds at half price is required to match earnings of one new 2% bond. So existing old bond resale value can drop to half each time interest rate doubles (because then it takes two old bonds to pay what one new bond pays). And also vice versa, lower interest rates will increase the value of existing bonds that still pay more. (But see Duration too).

Some bonds are "callable" (most municipal bonds and some corporate bonds), with a callable date when the issuer can redeem the bond early (at full face value but which terminates dividend income). If current rates have increased, the bonds are worth more than face value, and you might consider selling them yourself before the recall date at face value. Or if current interest is lower, the fund issuing new bonds paying lower interest rate would be their plus.

Note that Junk bonds exist too (politely called high-yield bonds), from companies with lower credit rating, paying more dividend to attract buyers, but with higher risk of default failure (meaning 100% loss of your investment). For bond funds, Morningstar.com Portfolio tab shows bond ratings too. AAA is the most secure rating, including government bonds. Bonds rated down to A are considered investment grade. Generally bonds rated B or less are considered speculative and non-investment grade (speculative meaning offering greater dividends if paid, but with greater risk they could fail and default and stop, and not redeem at all). See bond credit rating.

The significant fact to know is that Interest rates dropped in 2019 and 2020 (to near zero), significantly increasing existing bond resell values, so bond funds showed good results then. The results may look real good, but it is important to realize why you see that value increase in the history, because the interest rate situation has changed. Since then, existing bonds lose resell value when interest rates on new bonds increase, and then bond return may go negative. When interest rates are near zero, there is only one direction they can move, up, which lowers bond resale value. The U.S. Fed has done several interest rate increases in 2022 due to inflation, and more are expected.

Bond price changes when reselling are taxed as Capital Gains if held one year or more. However bond dividends are taxed like interest, at regular income tax rates (except municipal bond dividends are tax free of federal tax, and sometimes free of state tax in same state, at least in some states).

Repeating the important stuff: Bonds do still pay full face value when redeemed at maturity (or when recalled earlier). And until then, they continue paying face value interest rate. So if you buy bonds directly yourself, Not in a fund, but in your name as owner, and hold them until redeemed at maturity, the return will be as expected. That's the good news.

However bond funds currently own existing bonds, which will have dropping value as the U.S. Federal Bank interest rate increases (which the Fed is currently doing in a big way, due to record high inflation). The bond funds must buy and sell bonds continually, as investors buy and sell shares. Bond funds value their bonds at the current sale price. And bond resell value varies daily with current interest rates. Bond funds recompute bond values with every days interest rate change. However, bond value does not vary much when close to maturity, so a complication is that bond value sensitivity to interest rates depends on how close it is to maturity, in the special calculation called Duration.

Again, a big point is to not be confused by market return statistics showing bond and balanced funds had good performance history in recent past years. They in fact did, but that is history, when interest rates fell more than 2% over 2019 and 2020, causing the existing bonds to increase in resell value, but which cannot continue today. So it's very wise to also check their current "1 Year Return" results too. The current SEC 30 day yield is shown annualized to represent one total year, which is the accurate current annualized rate value today, but it of course changes all during the rest of the year. The Federal Reserve Bank interest rate was near zero at the start of 2022, so the only way it could go is up. And the high inflation continues to increase it now, and increased interest rates means resell values of existing bonds are going down. However, bonds held until redemption at maturity do retain full face value then, except bond funds might not be able to hold them to maturity when their shareholders are ordering withdrawals because the value is going down. Since interest rates are near zero now, the danger for existing bonds is that rising rates (and lower values) are the only change possible now. We are expecting inflation to cause increasing interest rates. Directly held bond dividend income is taxed with regular income tax rates, but the fund price changes are mostly Capital Gains or losses if held a year or more.

Copyright © 2021-2024 by Wayne Fulton - All rights are reserved.

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