From conversations I’ve had, most investors have a firm grasp of why stocks move up and down (because of market trends, economy, or supply and demand), but I don’t know if the same can be said for the bond market. Stocks are fairly simple: You buy a share of said company and make money if the company does well and when they pay dividends. Bond performance can be a bit more tricky.
In this week’s article, I hope to simplify the bond market to help readers understand exactly what they are investing in.
I Owe You
Bonds are simply “I owe you’s” that entities pay back to investors. Similar to CDs that you would get at a bank. Like a personal credit rating, any institution that borrows money is rated by a rating agency; these ratings range from AAA, the highest rating, to CCC, the lowest rating. Anything below BBB is considered below investment grade. Just like your personal credit rating, if you are lending money to an institution with a lower credit rating, you will be compensated by a higher coupon or interest payment. Pretty simple so far. Generally speaking, the higher the credit quality, the safer the bond, and the lower the interest payment to investors.
Timing and Scenarios
The next nuance is bond maturity or duration. Bond maturity and duration are not the same thing, but they are similar. So, for this example, I will just be talking about bond maturity.
Generally, the longer the maturity, the higher the bond's interest rate. This makes sense when considering things in mortgage terms: a 15-year mortgage has a lower interest payment than a 30-year mortgage. The thought behind this is that if I lend money to said company (i.e., Apple) for a year, and the bond matures, I get my principal back. This is a pretty safe bet, as opposed to lending them my money for 30 years. I would still receive annual interest payments and get my principal bank in 30 years, but the thought is that I would want to get paid extra for the risk that I took if Apple goes bankrupt and I never get my principal back. This is a much more likely scenario over a 30-year period than a 1-year period.
So, the longer maturity of a bond the riskier the bonds, and the more sensitive to interest rate moves it is. If your 30-year bond is paying 3% and new bonds are paying 5%, you need to sell it. Let's say you bought it for a face value of $1,000. You will have to discount your bond steeply to account for the lack of interest payments over the next 30 years vs the newer 5% bond. Nobody would want to pay you the total $1,000 when they could go get another bond that pays 5%. This was the phenomenon in 2022 when interest rates moved significantly higher in a short period of time; the market had to rerate existing bonds to account for the lack of interest.
Economic Conditions Influences
Credit quality also performs differently in distressed markets. When economic conditions deteriorate, high-quality government bonds generally perform well. This makes sense because investors rotate out of stocks, which are economically sensitive, and into government bonds, which the US government backs. The opposite of “junk” or lower-than-investment grade quality bonds is true. This also makes sense because overleveraged companies with poor credit are typically the first to default as economic conditions deteriorate when volatility spikes and the stock market drops, like in 2008 and 2020 during COVID-19, junk bonds don’t protect investors much as their price action usually acts more like stocks.
The high yield index spread measures the difference in interest between investment and junk bonds, and as the chart below shows, it widens during crises.
That said, make sure you understand what type of bonds you invest in, whether in a 401k or any other investment account(s). Be sure that the fund or individual bond achieves the proper diversification or income goal that you hope it will. As always, contact your financial advisor if you have questions about bonds or need help with 401k investments. The team of financial advisors at Whitaker-Myers Wealth Managers is ready to help answer questions and create a financial plan to help you achieve your financial goals.
The Bond Market Simplified
October 7, 2024
Jake Buckwalter
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