Bonds and bond mutual funds have a place in many investors’ portfolios. They are useful for providing income and can help reduce total portfolio volatility (risk) over time. Their market value depends on the general level of interest rates. And while the relationship between bond valuation and interest rates is straightforward, it can seem confusing at first. This article is intended to provide a basic understanding of bonds and interest rates, and their interrelationship.
What is a Bond?
A bond is a certificate evidencing a loan obligation. Bonds are sold by companies and governments (issuers) borrowing money. You’re loaning money when you buy a bond directly from an issuer. It will have a stated face (or par) value. The issuer will repay you at some future (maturity) date. And in the meantime, you’ll earn interest on the loan.
What Determines a Bond’s Stated Interest Rate?
A bond’s stated interest (or coupon) rate is what it pays to an owner over time. The factors that determine the coupon rate include the creditworthiness of the issuer, the length of time until maturity, and the general level of interest rates when the bond is issued, among others.
Once a bond has been issued (trades in the secondary market), its value can fluctuate. The market sets the price. But how do market participants determine value?
The Impact Interest Rates Have on Bond Prices
Bond prices are sensitive to changes in interest rates. And they move inversely to changes in rates. When rates rise, bond prices typically fall. When rates fall, bond prices typically rise. The magnitude of these price changes depends on a bond’s maturity.
The longer the time frame until maturity, the greater a bond’s price will move when interest rates change. So, the value of bonds with long maturities will move more than bonds with shorter maturities, given the same change in interest rates.
What is Yield to Maturity?
Yield to maturity is the straightforward result of a rather complicated calculation. It is the internal rate of return of a bond held until maturity and is based on the bond’s coupon, the price paid, and the remaining time until maturity.
Why Yield to Maturity is Important
When a bond is issued at par, its coupon rate is its yield to maturity. Because interest rates (and bond prices) can change over time, an original owner of a bond may sell it for more or less than par. This is because the bond’s yield to maturity determines its price.
A yield to maturity higher than a coupon rate will price a bond below par (at a discount). A yield to maturity lower than a coupon prices a bond higher than par (at a premium).
If interest rates have risen since a bond was issued, it will be priced to a new higher yield to maturity, making it worth less. If interest rates fall, yields to maturity will also fall. This would increase a bond’s value.
What is a Bond Rating?
The creditworthiness of an issuer also has an effect on a bond’s value. Typically, investors demand greater compensation for taking on more risk. So, the bonds of a low-quality issuer will typically pay more than bonds with the same maturity of a higher quality issuer. This is why credit ratings are important.
There are three major bond rating agencies. They are Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings. These companies assign scores based on an issuing entity's ability to meet its obligations. Each uses a slightly different scale and rating classification.
Examples of the different ratings are:
The ratings are important for a couple of reasons. They provide investors information about the potential riskiness of a given bond and they can impact coupon and yield to maturity.
More highly rated bonds tend to have lower coupons (i.e., pay lower rates) when all other things are equal. Banks and other financial institutions generally only buy investment grade bonds, those rated Baa or higher by Moody's or BBB or higher by S&P and Fitch.
Bonds within this range have a fairly low risk of default. Bonds outside of this range are considered below investment grade and are perceived as riskier. These bonds will tend to have a higher coupon rate to reward investors for accepting the higher risk.
After a bond is issued, and trades in the secondary market, its rating remains important. Ratings upgrades or downgrades can affect a bond’s appeal and marketability.
Upgraded bonds will typically be priced to offer lower yields to maturity. As such, their value will improve. Bonds subject to a ratings downgrade will typically experience the opposite.
Cash Yield vs. Yield to Maturity
There is an important distinction between a bond’s yield to maturity and its cash yield.
Cash yield is a bond’s annual cash flow divided by the amount an investor pays for it (at par or otherwise). This simple calculation tells you what your return is on the cash you invested in a given bond. But it doesn’t provide any information about whether you got a good deal on the investment. It tells you nothing about the bond’s value.
Unlike yield to maturity, cash yield doesn’t consider the time value of money. Cash yield is expressed as a simple interest rate at a specific point in time. Yield to maturity is your internal rate of return that considers each cash flow over time as well as what you paid for the bond and what you’ll receive when it matures.
Are Bonds an Appropriate Investment for You?
Many investors gain exposure to corporate or municipal bonds using mutual funds, which are appropriate for many investors. For investors whose portfolios warrant large exposures, a Separately Managed Account may offer greater control.
However you gain exposure to bonds, the guiding principal leading you there should be your asset allocation strategy. It’s important to understand the risks and rewards associated with an investment, and how it fits into your overall diversification strategy, before considering it.
Bonds are not without risk. But they may help you diversify your portfolio and, in the long run, potentially lower its overall risk. Contact us if you have questions about how bonds might help you achieve your investment objectives.