A Little Bit About Bonds (Article)

A Little Bit About Bonds

Since interest rates will eventually go up, should I allocate more to bonds? The answer is no. The relationship is inverse between interest rate changes and the price of bonds. Let me explain why.

First let me explain how a typical corporate bond works. They are issued individually for a $1000 “par value”. This is the face value of the bond. It is the price you would purchase it for and at the end of its duration it is the amount you would receive from the issuer. The bond also has a “coupon rate” or an annual interest rate. This rate is based upon the creditworthiness of the issuer and prevailing interest rate environment. Most bonds pay interest semi-annually so a 5% coupon bond would pay $25 twice a year.

Imagine you buy a new issue corporate bond today for $1000 with an interest rate of 3%. You hold that bond for a year and in that time interest rates go up to 4%. New bonds issued at the same credit rating will still sell for their $1000 par value but pay a higher coupon.  If you wanted to sell your bond on the market your 3% coupon rate would be unattractive compared to new issue 4% coupon bonds. In order to sell it you would need to sell it for less than face value to make up for the reduced cash flow. Interest rates go up, value of bond goes down unless held to maturity. On the other hand if interest rates fall to 2% your 3% bond is much more attractive. For example the chart below illustrates some time frames with drastic interest rate changes and the average returns for bonds over the same time period.

So what does this mean right now? Should you ditch all your bonds? No. Bonds provide an important hedge to equity markets and the closer to retirement you get the more important this stability becomes. They tend to perform well when equity markets are volatile because lowering interest rates is one way that the government tries to help the economy pull out of a recession. Having an asset class that out performs during a poor market allows you to rebalance some of those bond gains into beat up equity markets. If the past is any indication, long term investors that use bonds in their portfolio are generally rewarded for their patience.

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