Lesson 74
Bonds
English |
Spanish |
Bond Yield Article |
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Video: The Basics Of Bonds 10:43
Video Summary: In this lesson, Mr. Kazanjian discusses the basics of bonds as a fixed income investment compared to stocks, emphasizing that while bonds are loans to companies or governments and provide reliable but lower returns, stocks represent ownership in a business and can yield higher returns with greater volatility. Mr. Kazanjian expresses a personal preference for stocks due to the S&P 500's historical average return of 10% per year, highlighting the impact of interest rates on bond performance, especially in a low-rate environment. Additionally, the speaker outlines scenarios where bonds may be more suitable, such as for older investors seeking stability during market uncertainty. The video also touches on the importance of bond credit ratings, illustrating the risks involved with investing in bonds from countries like Argentina versus the U.S. Overall, the lesson provides insights into the trade-offs between the stability of bonds and the growth potential of stocks.
What Exactly Is A Bond?
A bond is a financial instrument that represents a loan made by an investor to a borrower, typically a corporation, municipality, or government. Essentially, bonds are a way for entities to raise capital to finance projects, operations, or other needs. When you purchase a bond, you are lending money to the issuer in exchange for periodic interest payments, known as coupon payments, and the return of the bond's face value (or principal) at a specified maturity date. Bonds are typically considered fixed-income securities because they provide regular income through interest payments, and they are seen as less risky compared to equities like stocks.
Bonds can vary in terms of duration, risk, and structure. The risk level is often determined by the creditworthiness of the issuer, with government bonds generally being less risky than corporate bonds. Bonds are rated by credit rating agencies to give investors an idea of the issuer's ability to meet its obligations. They also come in various forms, such as fixed-rate bonds, floating-rate bonds, and zero-coupon bonds, each offering different benefits and risks. For investors, bonds are a valuable tool for diversifying portfolios and achieving financial stability, as they often provide a predictable stream of income and can act as a counterbalance to the volatility of the stock market.
Bonds can vary in terms of duration, risk, and structure. The risk level is often determined by the creditworthiness of the issuer, with government bonds generally being less risky than corporate bonds. Bonds are rated by credit rating agencies to give investors an idea of the issuer's ability to meet its obligations. They also come in various forms, such as fixed-rate bonds, floating-rate bonds, and zero-coupon bonds, each offering different benefits and risks. For investors, bonds are a valuable tool for diversifying portfolios and achieving financial stability, as they often provide a predictable stream of income and can act as a counterbalance to the volatility of the stock market.
What Is A Fixed Income Investment?
A fixed income investment is a type of financial asset that provides regular, predictable payments over a specified period, often in the form of interest payments, and typically returns the initial principal amount at maturity. Common examples include bonds (such as government, municipal, or corporate bonds), treasury bills, and certificates of deposit (CDs). Fixed income investments are generally considered lower-risk compared to equities, making them attractive for investors seeking steady income and capital preservation. The fixed payment structure makes them a popular choice for retirees or those with conservative investment goals. However, they may be exposed to risks such as inflation, interest rate changes, and credit defaults.
Are Bonds A Fixed Income Investment?
Yes, bonds are a type of fixed income investment. When you buy a bond, you are essentially lending money to an issuer—such as a government, municipality, or corporation—in exchange for periodic interest payments, known as coupon payments, and the return of your principal amount when the bond matures. The interest payments are typically fixed, which is why bonds fall under the category of fixed income investments.
Bonds are widely used by investors seeking steady and predictable income. However, the value of bonds can fluctuate due to factors like changes in interest rates, creditworthiness of the issuer, and overall market conditions. Despite these risks, bonds are considered more stable compared to equities, making them a cornerstone of many conservative investment portfolios.
Bonds are widely used by investors seeking steady and predictable income. However, the value of bonds can fluctuate due to factors like changes in interest rates, creditworthiness of the issuer, and overall market conditions. Despite these risks, bonds are considered more stable compared to equities, making them a cornerstone of many conservative investment portfolios.
Are Stocks A Fixed Income Investment?
No, stocks are not considered fixed income investments. Stocks represent ownership in a company, and their returns are primarily derived from capital appreciation (an increase in the stock's price) and, in some cases, dividends. Dividends, if paid, are not guaranteed and can vary depending on the company’s performance and decisions by its board of directors.
In contrast, fixed income investments, such as bonds or certificates of deposit (CDs), provide predictable and regular payments (like interest or coupon payments) and often return the initial investment amount at maturity. Stocks, being equity investments, are more volatile and carry higher risk, but they also offer the potential for greater returns compared to fixed income assets.
In contrast, fixed income investments, such as bonds or certificates of deposit (CDs), provide predictable and regular payments (like interest or coupon payments) and often return the initial investment amount at maturity. Stocks, being equity investments, are more volatile and carry higher risk, but they also offer the potential for greater returns compared to fixed income assets.
Hey Wait Mr. K., You Said That Bond Yields Are Affected By Interest Rates. What Are Interest Rates Again?
Interest rates represent the cost of borrowing money or the return on lending money, expressed as a percentage of the principal amount. For borrowers, interest rates determine how much they pay in addition to the loaned amount, while for lenders or savers, they represent the earnings on their money. Interest rates influence various aspects of the economy, including consumer spending, business investment, and overall economic growth.
In the United States, interest rates are primarily set by the Federal Reserve (often called "the Fed"), which is the central bank of the country. The Fed adjusts the federal funds rate, which is the interest rate at which banks lend to each other overnight. This rate serves as a benchmark for other interest rates, including those for mortgages, car loans, credit cards, and savings accounts. The Federal Reserve uses interest rate adjustments as a tool to achieve its dual mandate of promoting maximum employment and maintaining stable prices (inflation control).
In the United States, interest rates are primarily set by the Federal Reserve (often called "the Fed"), which is the central bank of the country. The Fed adjusts the federal funds rate, which is the interest rate at which banks lend to each other overnight. This rate serves as a benchmark for other interest rates, including those for mortgages, car loans, credit cards, and savings accounts. The Federal Reserve uses interest rate adjustments as a tool to achieve its dual mandate of promoting maximum employment and maintaining stable prices (inflation control).
Do Investors Earn More $$$ Investing In Bonds When Interest Rates Are High?
Investors have the potential to earn more from bonds when interest rates are high, but this depends on the context of their investment strategy and market conditions. High interest rates mean that newly issued bonds typically come with higher coupon payments (interest rates), providing greater income for investors compared to bonds issued during lower interest rate environments. For example, if a bond offers a 5% coupon in a high-rate market compared to a 2% coupon in a low-rate market, investors purchasing new bonds during high-rate periods will benefit from the higher returns. This makes high-interest-rate periods attractive for those looking to build a portfolio of income-generating assets.
However, rising interest rates can negatively affect the value of existing bonds in the secondary market. When interest rates increase, the prices of older bonds with lower coupon rates decline because newer bonds offer better returns. This means that investors holding older bonds may experience a decline in the market value of their holdings if they need to sell before maturity. For example, a bond paying a 3% coupon becomes less appealing when new bonds are issued at 5%, so its price drops to make it competitive. Investors holding such bonds to maturity will still receive the original interest payments and principal, but those trading bonds could incur losses in a high-rate environment.
High-interest-rate environments can also provide reinvestment opportunities. As bonds mature or interest payments are received, investors can reinvest these funds at higher prevailing rates, increasing overall income potential. This is particularly beneficial for long-term investors or those using a laddering strategy, where bonds mature at staggered intervals, allowing regular reinvestment at current market rates. Over time, reinvesting at higher rates can compound the benefits of high-interest environments, enhancing returns compared to reinvestments during low-rate periods.
Nevertheless, investors should also consider inflation and risk factors when investing in bonds during high-rate periods. High interest rates can often accompany inflationary pressures, which erode the real value of fixed income payments. Additionally, rising rates can signal economic uncertainty, which may affect corporate bond issuers’ creditworthiness. While high rates can boost nominal returns, the real return—adjusted for inflation—may be less impressive. Therefore, while high interest rates generally offer higher earning potential for bond investors, the overall benefit depends on factors such as the bond type, market timing, and broader economic conditions.
However, rising interest rates can negatively affect the value of existing bonds in the secondary market. When interest rates increase, the prices of older bonds with lower coupon rates decline because newer bonds offer better returns. This means that investors holding older bonds may experience a decline in the market value of their holdings if they need to sell before maturity. For example, a bond paying a 3% coupon becomes less appealing when new bonds are issued at 5%, so its price drops to make it competitive. Investors holding such bonds to maturity will still receive the original interest payments and principal, but those trading bonds could incur losses in a high-rate environment.
High-interest-rate environments can also provide reinvestment opportunities. As bonds mature or interest payments are received, investors can reinvest these funds at higher prevailing rates, increasing overall income potential. This is particularly beneficial for long-term investors or those using a laddering strategy, where bonds mature at staggered intervals, allowing regular reinvestment at current market rates. Over time, reinvesting at higher rates can compound the benefits of high-interest environments, enhancing returns compared to reinvestments during low-rate periods.
Nevertheless, investors should also consider inflation and risk factors when investing in bonds during high-rate periods. High interest rates can often accompany inflationary pressures, which erode the real value of fixed income payments. Additionally, rising rates can signal economic uncertainty, which may affect corporate bond issuers’ creditworthiness. While high rates can boost nominal returns, the real return—adjusted for inflation—may be less impressive. Therefore, while high interest rates generally offer higher earning potential for bond investors, the overall benefit depends on factors such as the bond type, market timing, and broader economic conditions.
So Wait......If Stocks (Generally) Outperform Bonds, Why Would People Choose To Invest In Bonds?
Well, look at the images below. You are ALWAYS moving forwards when you invest in bonds (although some years inflation outpaced 10 year treasury return).
Chart 1- 10 Year US Treasury Bond Yield: Wow! That is remarkable. Notice that the annual return (the red line) is always positive. That means you are always making money. Below lets look at the S&P 500 return by year.
Chart 2- Annual Return Of The S&P 500 Stock Index: There has been more good years than bad years with the S&P 500 but as you can see there are SOME years that the S&P 500 has DROPPED more than 35%. In a year like that, you would LOSE 35 out of every 100 dollars. As you could see by the chart above, you would eventually earn it back, but you can come to the conclusion that reputable bonds always earn you money, while stocks generally make you more money over time but can definitely have bad years where you lose money.
What Group Of People Generally Benefits The Most From Investing In Bonds?
Retirees invest in bonds primarily because they provide a stable and predictable source of income, which is essential during retirement when individuals rely on their investments to cover living expenses. Think about it and imagine yourself as a 65 year old who has worked an entire career to save $1,000,000. A 35% downturn in the S&P 500 would mean that you would be down to $650,000! Yes, history has proven that it will recover, but the downside risk of stocks makes older investors who are retired, consider bonds.
Bonds pay regular interest, known as coupon payments, which retirees can use to supplement other sources of income, such as Social Security or pensions. Unlike stocks, where returns can be uncertain and volatile, bonds offer a consistent stream of cash flow, giving retirees peace of mind and helping them manage their financial needs effectively. In a scenario where the retiree saved $1,000,000 over his/her career, these coupon payments would equate to $40,000 per year if the return is 4%.
Another key reason retirees favor bonds is their relative safety and ability to preserve capital. Retirees typically have a lower tolerance for risk since they have less time to recover from potential losses in the market. Bonds, particularly government bonds or high-quality corporate bonds, are considered less risky than stocks and other high-yield investments. At maturity, bonds return the principal amount invested, which helps retirees protect their nest egg while earning a steady return.
Bonds also play a crucial role in diversifying a retirement portfolio. They tend to be less volatile than stocks and often perform better during economic downturns, helping to offset potential losses in equity investments. Additionally, strategies like bond laddering, where bonds with staggered maturity dates are purchased, allow retirees to create a predictable income stream while managing interest rate risk. These features make bonds a practical and attractive choice for retirees who prioritize income stability, capital preservation, and risk management in their financial planning.
Bonds pay regular interest, known as coupon payments, which retirees can use to supplement other sources of income, such as Social Security or pensions. Unlike stocks, where returns can be uncertain and volatile, bonds offer a consistent stream of cash flow, giving retirees peace of mind and helping them manage their financial needs effectively. In a scenario where the retiree saved $1,000,000 over his/her career, these coupon payments would equate to $40,000 per year if the return is 4%.
Another key reason retirees favor bonds is their relative safety and ability to preserve capital. Retirees typically have a lower tolerance for risk since they have less time to recover from potential losses in the market. Bonds, particularly government bonds or high-quality corporate bonds, are considered less risky than stocks and other high-yield investments. At maturity, bonds return the principal amount invested, which helps retirees protect their nest egg while earning a steady return.
Bonds also play a crucial role in diversifying a retirement portfolio. They tend to be less volatile than stocks and often perform better during economic downturns, helping to offset potential losses in equity investments. Additionally, strategies like bond laddering, where bonds with staggered maturity dates are purchased, allow retirees to create a predictable income stream while managing interest rate risk. These features make bonds a practical and attractive choice for retirees who prioritize income stability, capital preservation, and risk management in their financial planning.
Don't Buy Bonds From Riff Raff!
What Are Bond Ratings? Why Are They Important?
Bond ratings are assessments of the creditworthiness of a bond issuer, provided by credit rating agencies such as Moody’s, Standard & Poor’s (S&P), and Fitch. These ratings indicate the issuer's ability to meet its financial obligations, including timely interest payments and repayment of the bond's principal upon maturity. Ratings are typically expressed as letter grades, ranging from "AAA" or "Aaa" (highest quality and lowest risk) to "D" (default), with variations in between such as "AA," "BBB," or "BB." Bonds rated "BBB" or "Baa" and above are considered investment-grade, while those rated below are referred to as high-yield or "junk" bonds, which carry higher risk but offer higher returns.
Bond ratings are important because they help investors evaluate the risk associated with a particular bond. Higher-rated bonds, like those with "AAA" or "AA" ratings, are less likely to default, making them suitable for conservative investors seeking stability and reliability. Lower-rated bonds, on the other hand, carry greater risk but may offer higher yields to compensate for the increased chance of default. By understanding bond ratings, investors can make informed decisions that align with their risk tolerance and financial goals.
For issuers, bond ratings significantly impact their borrowing costs. A higher rating allows issuers to attract investors more easily and secure financing at lower interest rates, while a lower rating typically results in higher borrowing costs due to the perceived risk. Bond ratings also influence market liquidity, as highly rated bonds are more attractive to a broader range of investors, including institutions with strict investment guidelines. In this way, bond ratings play a critical role in both investment decision-making and the functioning of the broader financial markets.
Bond ratings are important because they help investors evaluate the risk associated with a particular bond. Higher-rated bonds, like those with "AAA" or "AA" ratings, are less likely to default, making them suitable for conservative investors seeking stability and reliability. Lower-rated bonds, on the other hand, carry greater risk but may offer higher yields to compensate for the increased chance of default. By understanding bond ratings, investors can make informed decisions that align with their risk tolerance and financial goals.
For issuers, bond ratings significantly impact their borrowing costs. A higher rating allows issuers to attract investors more easily and secure financing at lower interest rates, while a lower rating typically results in higher borrowing costs due to the perceived risk. Bond ratings also influence market liquidity, as highly rated bonds are more attractive to a broader range of investors, including institutions with strict investment guidelines. In this way, bond ratings play a critical role in both investment decision-making and the functioning of the broader financial markets.