If an investor is going to invest in bonds, either for income purposes or as a hedge, he really should have a good understanding of them so that these investments can be made properly.
Bonds seem to be such a simple concept, where one loans money to the bond issuer and they agree to make interest payments over time on the loan, and then pay back the principal amount when the bond matures.
Things start to get more complicated due to bonds not being bought and sold at par value but at a price set by the market. The issuing price will be the par value, the amount that it is worth at maturity, but bonds, like stocks, are traded on markets and the trading action will see the price rise or fall according to the supply and demand of the market.
When bonds are in high demand, as they are these days, with demand exceeding supply, people will pay more for them, and this puts their price up. When supply exceeds demand, this will cause the price of bonds to drop accordingly.
There are two ways to make or lose money with bonds, just like there are two ways to profit or lose with stocks, and it’s the same two, income and capital gains. If there are two variables, just focusing on one is going to be a bad idea, although this happens all the time, and investors must be aware of this mistake and avoid it.
Anyone remotely familiar with bonds will recall how much of a big deal people make out of the yields that bonds are paying at any given point in time, and while yields do matter a lot, they matter for different reasons than most people think.
There are people who invest in dividend stocks or dividend funds for instance, and they focus a lot or even exclusively on what the dividend yield will be. They may pay little attention to the other side of stocks, which is the effect of movements in price upon their value. Stocks change in value mostly from price movement, and one can be happy with a stock’s dividend yield but get very disappointed and lose quite a bit of money if the stock goes down in price a fair bit.
An investor can buy a stock and pocket a 3% yield on it over a year, and see it drop in price by 10% to 20%. The net result is that the investor suffers a considerable loss. He bought it based upon the expectations of profit from dividends but he should have also looked to what sort of price expectations it had, because whether the investor cares about these things or not, they will impact him the same way nonetheless.
If we’re not watching this, we’re not managing it either, and this does need to be managed if you’re actually looking to invest wisely. Investing wisely involves managing risk, and it certainly involves looking to manage potential profit and loss, because that’s what investing seeks by definition. We’re supposed to look to make money and not lose it and if we just ignore the manner in which we can lose, this does not make sense.
There are people who will prefer stocks that pay a higher dividend over lower dividend stocks, and actually select them on this basis. We should be taking this dividend into account, but only to the extent that it impacts total potential return, and with stocks, price movement will represent the lion’s share of both the upside and the downside.
Movements in Bond Prices Significantly Influence Their Value
Bonds are similar in many ways to stocks, other than with interest generally having a higher impact and with price movement having a lesser impact than with stocks. This means that bonds are less volatile generally, and make a higher percentage of their total return from interest income than stocks make by way of dividends. Like with stocks though, if there are two things in play here, we need to pay attention to both and not just one.
There are two main reasons why people invest in bonds, which are to earn income and to hedge against stock positions. We’ll start by looking at the mistakes that people make when investing in them for income, and then look at the ones that they often make when using bonds as a hedge.
Yields are such a big focus with bonds that they get just about all of the attention, and you rarely see price charts with bonds, and we are shown yield charts instead. This isn’t a problem in itself, as we can judge price movements from yield charts just by inverting them. As the price goes up, yields go down, and vice versa.
Just because bond prices don’t move as much as stock prices do, this doesn’t mean that they don’t matter. The price you paid is always going to matter, and the price that you sell it at will also matter if you plan on ever selling it or even if you might, rather than just holding it to maturity with no exceptions.
People usually buy their bonds through a bond fund, which rarely holds bonds to maturity and will trade them when it may be wise to. Bonds are traded like stocks and the goal isn’t just to lock in a certain yield, it is also to seek capital gains and avoid capital losses.
If you own bonds and bond yields are going up, you might think that this is a good thing but it’s not. Your yield was set by the price you paid for this income flow, and as yields climb, this means that this income flow is worth less. If you sell it when it is worth less than you paid, you suffer a capital loss, just like when you sell a stock for a share price below what you paid.
A lot of investors seem to pretend that this doesn’t matter, and this is usually because they don’t understand even the basics of bonds, and the time for the required lessons isn’t after you have lost money that you should not have.
Bond prices move in trends, like stocks do. The easiest way to understand how these price changes affect the value of bonds is to look at the price chart of a bond fund. Bonds rallied for almost a full year, until they got to the point where the price went up too much that they became overbought. Once enough traders sell to take their profits, this can cause the trend to reverse and now we’re going in the other direction, with prices dropping and yields climbing.
The more overbought bonds are, the more risk they have, and we could also express this as the lower the yield with bonds, the riskier they are, and the less profit potential they have as well. When we see yields as low as they have been lately, this really allows for this point to be more readily understood.
Bonds usually move in a way that is pretty tame compared to stocks, and even in the most volatile of markets, they tend to lose less. For instance, in the first 6 months of 2009, treasury funds lost about a quarter of their value, but stocks during this time lost quite a bit more from bottom to top during this crisis.
Like with stocks, it took quite a while to recover from this, and in this case, it took treasury funds 3 years to gain this back. Bonds go down in price less but they also go up in price less as well.
When bond yields are low, this means that the downside with them is higher and the upside with them is lower, neither of which are preferable. When the yields are high, we should be in, and when they are low, we should at least look to exit before they reverse too much or we will get stuck with the losses that the rebound brings.
Those who seek income from bonds will instead think that when yields are low, this is not a good time to buy them because their yield will be lower, but that’s only part of the story. Bigger or smaller yields are only significant relative to inflation, and if inflation and yields are both high, you’re not really making any real money with this, just nominal gains.
Inflation is low right now, and so are yields, so they do go together. If you buy bonds right now though, with these lower yields, just getting a return back the same as inflation and breaking even on them isn’t the biggest issue here, it’s the risk of capital losses.
The Low Yields Right Now Bode of Less Upside and More Downside
If bonds are sitting around their all-time high like they have been at lately, and you buy some, you just aren’t buying the income stream, the interest you’ll collect, you’re also speculating on their price, whether you want to or not. If you are, then this aspect does merit your attention.
From a price standpoint, we could say with considerable confidence that the upside of bonds right now is very limited. Bonds don’t accumulate in value the same way that stocks do, as there is much more of an ebb and flow with their prices, and we can see this when we look at charts of yields where they go up and down but in a much more limited way than stocks.
The main reason is that, unlike stocks which can go to the moon if people bid them up that much, bonds are much more limited by fundamentals such as interest rates and inflation. If we look at our current situation, we see a modest slowdown in the economy but a much bigger rise in bond prices. There is a limit as to how far off the road we can go, and when you see 30-year treasury rates lower the Fed’s overnight rate, that’s certainly pushing it and there’s only so low this could go and stay on the side of sensibility.
What created the gap between where treasuries should be based upon economic data and where they went to was the effect of momentum. The natural tendency over these past few months would have been to see prices move in the direction of the fundamentals more, in other words go down, but all the extra momentum that the market created pushed it the other way.
By understanding how markets work, we can actually be pretty confident that this move is now more than likely not going to go much further. Just believing that something is more likely to happen than another is enough reason to act on this knowledge, because we are choosing in both cases, and it’s better to be on the likely side.
Investors that hold bonds benefit when yields drop, but lose when they go back up, so whether or not you hold bonds or are planning on doing so, rising yields will harm you. The yield itself doesn’t affect you, but the risk of capital losses will.
If someone bought treasuries in August when they peaked, it is entirely conceivable that they may never get even on price, if that record stands for a while. Any capital gains would be limited to how much we can break this record, and it’s not that likely that we would break it by very much.
With yields this low, both the probability of a loss versus a gain and the magnitude of this loss are unfavorable. In a roundabout way, the investors that find that low yields produce a distasteful income flow end up getting it right here.
Yields matter a lot more than even the most fervent yield watchers usually think, because yield is indicative of both potential and risk. While there are more sophisticated ways to measure these things, yield in itself provides an elegant view of the desirability of both.
This all needs to be kept in mind as well with folks who use bonds to hedge stock positions. The normal approach is to seek to reduce risk by taking advantage of the lower volatility of bonds. A portion of your portfolio is parked in a bond fund and provides a stationary hedge.
The reason why we hedge stocks is that they experience price swings that we are uncomfortable with and wish to mute this risk. A true hedge would be cash, which in itself isn’t in need of hedging, where bonds to some degree are.
For it to make sense for bonds to use as a hedge instead of cash, this will require a superior overall positive expectation. This will require that we be in bonds when they have a positive expectation and avoid them when they do not.
The lower the yield, the less effective bonds are as a hedge. Reducing risk is only one requirement of a hedge, as it also needs to have a positive expectation to be a better choice than doing nothing,
We must also be aware that there may be times where the risk with bonds rises enough to be comparable to risks with stocks. Our move off the recent highs was an example of this. If bonds significantly limit upside and have similar downsides, they aren’t doing what they are supposed to.
Understanding bonds properly requires that we account for the factors that come into play and affect our bottom line. This means that we take bond prices into account and measure how suitable their positions may be at a given point in time.