ALL ABOUT BONDS: IS A CRISIS LOOMING?
By: J Scott
We’re all taught early in our investing career that a healthy mix of stocks and bonds is a great way to diversify and reduce risk.
The thought being that during bull markets, stocks will perform well, even if bonds lose a little bit of value. And, during economic downturns, stocks are likely to lose value while bonds should produce consistent returns to offset some of the stop losses.
And that's normally the case. But, in the current economic climate, we're likely to see a situation that's relatively rare: a time when both stocks and bonds under-perform.
I think most of us probably understand why stocks don't perform well during a recession. Businesses are struggling, and when businesses struggle, share price drops. But while we all understand how stocks tend to work, the forces that move bonds up and down are not as obvious.
So let's talk about that...
What Are Bonds?
Bonds are simply a form of debt created to raise money. As an example, let's say Walmart needs to raise a million dollars to help fund its operations. It could borrow the money from the bank, or it could borrow money directly from investors (which might be even cheaper). To borrow money directly from investors, Walmart would create $1M worth of bonds.
In this case, let’s pretend that Walmart creates $1M worth of bonds, and promises to pay out a return of 4% per year to investors who buy those bonds. Walmart sells these bonds, and investors who buy these bonds receive their 4% interest for some period of time, before receiving their principal back. For this example, let’s assume Walmart wants to borrow the money for 10 years before paying it back.
We can now say that Walmart has created a million dollars worth of “4% coupon bonds with a maturity of 10 years.”
How does Walmart determine that 4% is the right amount to pay? That return is simply driven by supply and demand. As rates of returns on investments go up and down, the returns on other similar types of Investments increase and decrease, businesses will price their bonds accordingly. Walmart will price their bonds relative to how the market is pricing other similar investments (like bonds from other similar companies).
And it's not just businesses who use bonds to raise money. Local governments, states and even the federal government raise money using bonds. Treasury bonds are simply bonds created by the US government – a way for the federal government to create money. When you buy treasury bond, you are simply helping the federal government raise the money that they use to operate the country.
What Drives Bond Prices?
While bonds are created to raise money, during the lifetime of the bond it can be bought or sold like any other asset. And just like any other asset, the price of the bond may increase or decrease depending on the market, and depending on supply and demand.
For example, if I were to buy $1,000 worth of Walmart bonds, I can expect to receive $40 per year in interest (remember, it was a 4% coupon) for 10 years (remember, it was a 10 year maturity), before receiving my $1,000 back.
But let's say that after 5 years, I decide that I need some cash and I want to sell my $1,000 worth of Walmart bonds.
Five years in, I can still expect to receive another $200 more over the remaining five years in interest, plus my original $1,000 back. A total of $1,200 more if I hold the bond for another five years. If the value of those bonds has gone up since I bought them, I might be able to sell those bonds for more than $1,200. But if the value of those bonds has gone down, I might have to sell for less than $1,200 and take a loss.
But, what determines whether the value of those bonds have gone up or down?
For the most part, it's interest rates. When interest rates go up, bond values go down. And when interest rates go down, bond values go up.
Why is that?
Why Do Interest Rates Impact the Value of Bonds?
To understand why interest rates affect the value of bonds, let's continue the example from above.
Let's say that at the time I purchased those 4% coupon Walmart bonds, 10-year treasury bonds (bonds created by the federal government that pay out for 10 years), had a 1% coupon (would pay 1% per year in interest). Given that government bonds are probably the safest investment of the planet, that 1% interest per year is pretty much risk free. In fact, whatever coupon amount a 10-year treasury bond is returning is typically referred to as the "risk free rate of return."
Buying company bonds obviously has some risk. If the company does poorly and can't pay its investors, those bonds can drop in value or even be worth nothing at some point. When Walmart issued their bonds, the market decided that a 4% return was appropriate for that particular company at that particular time.
In other words, the market determined that Walmart needed to pay 3% over the risk-free rate of return in order to attract investors.
Now, let's say interest rates go up. And let's say that 10-year treasury bonds are now paying 2% returns instead of 1%. As an investor, my risk-free rate of return is now 2%. I can get a 2% return on my money with essentially zero risk.
And let's say I now want to sell those 4% coupon Walmart bonds, as I have someplace better to put the money. Now that the risk-free rate of return is 2%, Walmart is likely creating new bonds that pay closer to 5%, as the company hasn't changed and investors are probably still willing to buy Walmart bonds at 3% over the risk-free rate of return.
Why would somebody want to buy my 4% coupon bonds and they can go out to the market and buy essentially the same bonds now returning 5%? The only way they would do that is if I offered to sell my bonds at a discount.
Because interest rates went up, the value of my bonds went down. Conversely, had interest rates dropped, that 4% return would probably be looking really attractive to investors compared to a lower than 1% risk-free rate of return, and the value of my bonds would have gone up.
Long story short, interest rates and bond values have an inverse relationship. When one goes up the other drops.
What's Going on Today?
So now getting back to our question of stocks and bonds being a good diversification and why that might not be true today...
Typically, during a recession, when stocks are performing poorly, the Federal Reserve is lowering interest rates. Those lower interest rates help boost bond values and so during recessions, bonds typically do well.
But things are a little bit different in our current economic climate. Stocks are under-performing, but interest rates are going up. Because inflation is so high, the Federal Reserve isn't yet thinking about lowering interest rates to fight the recession, but instead talking about continued rate heights over the next year to bring down that inflation.
So while stocks are doing poorly due to the recession, continued interest rate hikes are causing bonds to do poorly as well.
Over the next 12 months, there's a reasonable chance that both stocks and bonds get hit hard, which will be especially bad for those who are retired or nearing retirement and are using stocks and bonds as their main form of diversification in order to preserve wealth.