Bond Basics

Saturday, July 27, 2013

By Brian Tall

With interest rates likely to rise from their historically low levels, fixed income investors are going to be assaulted with persistent fearmongering in the years ahead. To help you refrain from acting in response to sensationalized headlines, we thought it would be helpful to arm you with an understanding of how fixed income securities work in addition to providing you with a historical background of fixed income performance.

In order to illustrate how bonds work, we have outlined three scenarios below. In each case, we assume that an investor purchases a bond for $100,000 with an interest rate of 5%. At Time 0, the investor will have a negative cash flow of $100,000, but will take ownership of a bond worth the equivalent amount. In each of the next 6 years, the investor will receive $5,000 in interest payments in addition to receiving the $100,000 par value back in the final year. We further assume the investor takes each $5,000 interest payment and reinvests in new bonds at prevailing interest rates. We calculate the growth of wealth as the cumulative income earned plus the current market value of the bond. The three scenarios illustrate the impact on cash flows, the market value of the bond, and the growth of wealth during periods when interest rates (1) remain constant, (2) when they rise, and (3) when they fall:

Let us review the key takeaways:

  • In all three scenarios, the cumulative income plus market value in year 6 (excluding income on reinvested income) was $130,000 regardless of interest rate movements. This is because fixed income cash flows are contractual, with the timing and amounts specified in advance.
  • Taking into account interest earned on reinvested income, the investor yielded the highest return in the rising interest rate scenario (because the income was reinvested at a higher rate).
  • In the rising interest rate scenario, the bond price initially fell below its $100,000 par value, but subsequently made up losses and redeemed at par in year 6 (despite interest rates continuing to rise at 1% per year).
  • In the falling interest rate scenario, the bond price initially rose above its $100,000 par value, but subsequently gave up its gains and redeemed at par in year 6.
  • In Scenario 3, an investor could not benefit economically by selling the bond at a gain prior to maturity while reinvesting the proceeds in a different bond that still matured in Year 6 (and carried the same credit rating). Here is the math to prove it: If an investor sold the appreciated bond for $111,764 in year 3 and reinvested the proceeds at the prevailing interest rate of 1%, the annual payment would drop from $5,000 to $1,118. Remember, instead of receiving $100,000 back in year 6, the investor would receive $111,764. When adding up the income, the reinvested income, and they repayment of principle, we end up with $131,900 in both cases. However, if we factored in commissions, transactions costs, and taxes, the investor in scenario 3 would be better off than in scenario 4.

scenario 4

The key takeaway is that bonds are not like stocks—bonds are contractual obligations with specified cash flows. In a Brighton Jones portfolio, our cash needs analysis enables us to match the approximate timing and amounts of expected cash needs with the maturities of our fixed income holdings so as to (1) mitigate as much as possible the risk of having to sell a fixed income security when prices move lower, and (2) earn as high of a return as possible while controlling for this risk.

Fearmongering

Most investors have likely come across an article or two making note of the recent “bond market collapse,” while citing that some investors have taken a double-digit haircut on their fixed income holdings. Despite the fact that the average maturity of outstanding US Treasury securities is around 5 years, many in the media opt to report the performance of 20+ year Treasuries because they are substantially more volatile than an index comprised of all Treasury securities (thus allowing for the use of sensational headlines to draw attention). Take the following illustration, for example, which shows periodic peak-to-trough declines of a capitalization-weighted index comprised of all outstanding Treasuries (blue) versus an index comprised of only 20+ year Treasuries (orange) going back to 1980. As you can see, both market segments regularly experience pullbacks comparable to what we just experienced in the second quarter, but the longer-term treasuries fell significantly more than the aggregate treasury index. While nobody likes to see losses, recent performance is hardly unprecedented and it certainly does not resemble a total collapse of the bond complex.

The key takeaway is that the performance of your portfolio of fixed income securities likely does not resemble what is being reported by the media unless you own primarily long-term bonds. Revisiting Scenario 2 from Bond Mechanics, note that interest rates rose from 5% to 11% yet the market value of the bond did not fall by more than ~7% while the cumulative income plus market value did not fall below the initial par value of $100,000. Over the long-term, fixed income returns come from income—and reinvestment of income—not price fluctuations, which ultimately net out at zero.

Returns Follow Yields

In Bond Mechanics, we illustrated that rising yields initially impair bond prices (moderately), but ultimately lead to higher ending wealth. In order to provide a longer-term perspective using real market data, we plot below the 5 year rolling return of 5-year Treasury bonds (blue line) against short-term interest rates (brown area). In doing so, we can see that fixed income returns follow yields. That is, after interest rates rise (1981), returns on fixed income securities follow suit (1986) and vice versa. This chart also shows that 5-year Treasury bonds have never had a negative return when held for a period of 5 years! So long as you match your investment time horizon with the maturity of your bond(s), as diversified fixed income investors, you should not fear price fluctuations or rising interest rates.

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IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Brighton Jones LLC), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained on this blog serves as the receipt of, or as a substitute for, personalized investment advice from Brighton Jones LLC.

To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Brighton Jones LLC is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Brighton Jones LLC’s current written disclosure statement discussing our advisory services and fees is available for review upon request.

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