Roger Kahle

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Bond Market

Clearing Up Fixed Income Misconceptions

  • 10.07.19
  • Markets & Investing
  • Commentary

Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.

Situation

Explanation

A 10-year bond currently yields 3%

What it does NOT mean: If you purchase this bond today, in 10 years, when the bond matures, you will have made a 3% return on your investment.

What it means: If you invest in this bond today, you are going to earn 3% annually for the life of the bond, for a holding period return (total return) of over 30%.

A bond’s modified duration of 5

What it does NOT mean: This bond matures in 5 years.

What it means: Modified duration tells you a bond’s sensitivity to interest rate changes, specifically, the effect that a 1% change in interest rates will have on your bond’s price. So for a bond with a modified duration of 5, it means that if interest rates rise 1%, the market value of this bond will fall approximately 5%. Conversely, if rates fall 1%, the market value of this bond will rise approximately 5%.

Buying a bond at a premium (price over par)

What it does NOT mean: That you lose money at maturity because you paid more than the maturity value of the bond.

What it means: It simply means that you paid a price over par; most likely because interest rates were lower at the time of purchase than they were when the bond was issued. Regardless of a bond being priced at a premium, par, or a discount, if they have the same yield and same maturity, assuming interest rates stay the same and cash flow is reinvested, all three will earn the same amount of money throughout the life of the bond. The only difference is in the timing of the cash flows (the premium bond is going to return money sooner, in the form of bigger coupon payments).

The market value of my bond falls below what I paid for it

What it does NOT mean: That you lost money on this bond.

What it means: Simply that the market value has fallen; the only way that this will translate into a loss, is if you choose to sell the bond. No matter what happens to the market price of the bond, if you hold it until maturity, you will still earn the yield at which you purchased the bond and receive par back at maturity. The interim prices only matter if you choose to sell prior to maturity.

I buy a bond today and rates begin to rise next year

What it does NOT mean: That you should have waited until the next year to invest

What it means: Market timing is difficult. No one knows what interest rates are going to do tomorrow, next month, or next year. But two things are certain: 1) if you choose to sit on the sidelines until rates move to where you want them to be, you are going to miss out on any income that you could have received between now and this mythical future date; 2) if you do not invest today, rates HAVE to rise tomorrow (or next month, or next year) in order to “catch up” on the income missed while waiting. In addition, the amount that rates need to increase in order for you to break-even (had you invested today) is probably more than you would think.

Interest rates are near all-time lows

What it does NOT mean: Bonds are doomed to lose money and are currently a riskier investment than equities.

What it means: First, there is no guarantee that interest rates will rise in the foreseeable future. Second, regardless of the future direction of interest rates, if you buy and hold individual bonds to maturity, your yield is locked in from the date of purchase, meaning changes in interest rates will not lead to a realized loss unless you choose to sell prior to maturity. And finally, during down years for equities over the past 30 years, the average return has been -17%. Down years for bonds have averaged -3%*. Historically, a bad year in equities has been much more painful than a bad year in bonds. You can decide for yourself which asset class appears riskier and where you would want to invest your money for safety of principal. Also keep in mind that equities require timing the market correctly to earn a positive return, whereas individual bonds do not. Maintaining appropriate asset allocation is important in any market.

The dividend on a stock is higher than the interest rate on a bond

What it does NOT mean: It is a no brainer that you should buy the stock, because it is currently yielding more than a bond you are comparing it to.

What it means: You need to decide what the purpose of this investment is. If your goal is for principal growth, income, and to have this possibility for growth, but you are willing to take the risk of incurring a significant loss to your principal as well as the risk that the dividend rate could get reduced, then buying the stock might be the right decision. If your goal is principal preservation along with a predictable and known income stream, then buying the bond is likely the logical choice.

Cash Flow & Income

What it does NOT mean: Cash flow = income

What it means: Cash flow represents the coupon payments that you receive (usually semi-annually) when you own a bond. It may include income and return of premium dollars paid. The income that you make from owning a bond is the same thing as the yield at which you purchase the bond, this is the money you are actually earning.

*Sources: Bloomberg LP, Raymond James. Equities: S&P 500 Total Return Index; Corporate Bonds: Bloomberg Barclays US Corporate Total Return Index; Municipal Bonds: Bloomberg Barclays Municipal Bond Total Return Index. Investors may not make direct investments into any index. Past performance may not be indicative of future results.


To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.

The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.

Stocks are appropriate for investors who have a more aggressive investment objective, since they fluctuate in value and involve risks including the possible loss of capital. Dividends will fluctuate and are not guaranteed. Prior to making an investment decision, please consult with your financial advisor about your individual situation.