In this article, we’ll explore whether or not bonds are a good investment in the current economic climate.
It’s clear to see that the coronavirus has been affecting the economy in the past month. Put simply, the global stock markets are experiencing a drastic change that hasn’t been prevalent since the 2008 recession. In fact, according to experts, what we are going through now will be worse than that recession.
“With each passing day, the 2008 global financial crisis increasingly looks like a mere dry run…”
As such, anything pertaining to our finances is becoming increasingly difficult to handle. Investments are now a risky thing to engage in and our previous investments prior to the outbreak are not looking too healthy.
The Dow Jones Industrial Average would come close to dropping 30% from their recent highs. Those who possess stock-heavy portfolios are especially anxious about what is transpiring. They are wary about looking at their brokerage statements because of the losses they are no doubt enduring.
As hard as it may be to believe, not everything is doom and gloom in the world of finance. In fact, even as stock markets are falling considerably, there is another asset class that is staying afloat. There are a lot of bond investments that are garnering a significant amount of value so far this year. This is providing great assistance for those who have balanced portfolios with both stocks and bonds. They are holding up surprisingly well; better than they would have otherwise.
Moreover, the preservation of bonds is so successful that investors are in a predicament. They are wondering whether or not they should add more bonds to their investments.
With that in mind, looking at the big picture, are bonds really a good investment nowadays?
What is it?
A ‘bond’ is an instrument of the fixed income variety. It is representative of a loan from an investor to a borrower, typically being corporate or governmental. One could interpret a bond as being an I.O.U. between the lender and the borrower. Specifically, one that includes the details of the loan, as well as its payments.
The typical users of bonds are companies, municipalities, states, and sovereign governments to finance projects and operations alike. Those who are the owners of bonds are the debtholders, or the creditors, of the issuer. Details of a bond include the end date when the principal of the loan is due for payment to the bond owner. Most of the time, it includes the terms for variable or fixed interest payments as established by the borrower.
Governments – at all levels – and corporations frequently use bonds as a way for them to borrow money. Governments need money in order to fund roads, schools, and various types of infrastructures. The sudden expense of an impending war may also result in high demand for raising funds.
In a similar fashion, corporations will regularly borrow for the purpose of expanding their business. They also need to buy property and equipment and to undertake profitable projects. Not to mention they need to conduct research, work on development, and hire employees. The common problem that large organizations run into is that they need a lot of money. More than the average bank can provide, even. Bonds provide an effective solution by way of allowing individual investors to take on the role of the lender.
How they work
More often than not, bonds are referred to as fixed-income securities. They are one of three asset classes that individual investors are typically familiar with. The other two asset classes are stocks (equities) and cash equivalents.
A majority of corporate and government bonds are subject to public trading. Others, meanwhile, trade only in an over-the-counter (OTC) manner. Alternatively, the trade is private and occurring between the borrower and lender.
There will come a time when a company or other entity will need to raise money to finance new projects. Moreover, they will need to maintain ongoing operations and/or refinance existing debts. To do this, they may go on to issue bonds directly to investors. The borrower (issuer) issues a bond that includes a few key factors:
- The terms of the loan.
- Interest payments that will eventually be made.
- The maturity date. This is the time at which there is a reimbursement of the loaned funds (bond principal).
The interest payment (i.e. the coupon) is part of the return that bondholders earn. They acquire it in exchange for loaning their funds to the issuer. The interest rate that is responsible for determining the payment is the ‘coupon rate’.
The initial bondholder can sell most bonds to other investors following their issuance. In other words, there is no need for a bond investor to hold a bond throughout the duration of its maturity date. Furthermore, it is also not unorthodox for the borrower to repurchase bonds. Especially not if interest rates are on a decline or if the borrower’s credit is improving. It can even reissue new bonds at a comparatively lower cost.
If you buy bonds, learn these basic characteristics
A majority of bonds share some common characteristics, some of which include:
- Face value: This is the money amount that the bond will be worth upon reaching its maturity. Additionally, it is the reference amount that the bond issuer uses when they are calculating interest payments. Let’s say, for example, an investor purchases a bond at a premium $1,090. Moreover, another investor buys that same bond at a later time when it’s trading at a discount price for $980. By the time the bond matures, both investors will receive the $1,000 face value of the bond.
- The coupon rate: This is the rate of interest that the bond issuer pays on the face value of the bond. It is typically expressed as a percentage. For instance, a 5% coupon rate means that bondholders will receive a 5% x $1000 face value. This equals out to $50 on an annual basis.
- Coupon dates: These are the dates on which the bond issuer will conduct the interest payments. Executing these payments can be during any interval, though the standard is semiannual payments.
- The maturity date: As you may recall, this is the date on which the bond matures. The bond issuer pays the bondholder the face value of the bond at this point.
- The issue price: This is the price at which the bond issuer originally sells the bonds.
A bond has two features that are the principal determinants of a bond’s overall coupon rate. Those are the credit quality and time to maturity. Say that the issuer happens to have a poor credit rating. In this case, the risk of default is much greater and these bonds pay considerably more interest. Moreover, bonds that have a very long maturity date, more often than not, pay a higher interest rate. This higher compensation stems from the bondholder’s heavy exposure to interest rate and inflation risks for an extensive period.
Both bonds and bond portfolios will inevitably rise or fall in value with every change in the interest rates. The general sensitivity to any changes in the interest rate environment is known as ‘duration.’ The use of this term in this context is admittedly rather confusing to new bond investors. This is mostly because it is not indicative of the length of time the bond has prior to maturity. Instead, duration describes how much a bond’s price will increase or decrease with a change regarding interest rates.
So, why are bond prices soaring?
For many investors, bonds are a confusing thing to grasp. Among the several major sources of confusion is how the prices of bonds move. Bond yields typically experience a sharp decline thanks to the Fed cutting interest rates. Because of this, it is normal to assume that falling yields make bonds less desirable. Be that as it may, when bond yields experience a fall, prices on existing bonds rise. This is courtesy of those existing bonds paying higher interest that look more appealing when new bonds’ prevailing rates drop.
Historically speaking, bonds are usually a good alternative to stocks in times of crisis. For example, Treasury bonds receive a great deal of backing from the U.S. government. Therefore, the potential for default is practically nonexistent, making Treasury bonds a safe location to put your money into.
Lately, the returns on bonds are coming almost entirely from the falling yields that are making their prices skyrocket. This has not always been the case, though. The interest that the bonds themselves pay are usually a much more crucial component of bonds’ overall returns. However, even long-term 30-year Treasury bonds are only paying roughly a little more than 1%. On top of that, most shorter-term bonds are paying considerably less. Really, the only chance for there to be a solid return is to see rates still lower.
Can they keep rising?
Investment experts are making calls for a top in the bond market. They did this years ago and they are still doing it now. So far, though, they are coming up short, being completely wrong. Bond prices are continuing to move higher, whereas yields are continuing to hit record lows. In some parts of the world, bond yields are even starting to turn negative. This basically means that bondholders are having to pay issuers interest for the opportunity to invest in their bonds.
With that said, there is something you need to keep in mind and understand. Bond ETFs can just as easily lose money whenever bond yields go up. As a matter of fact, in late 2016, when Treasury yields were rising by a single percentage point, the PIMCO ETF would go on to lose value. To be specific, it lost more than 20% of its value.
Suppose that the rise in bond yields comes because the stock market experiences a recovery. In this case, the boost in the stock portion of your portfolio will counteract the losses on the bond side. That is the flip side of what those with diverse portfolios are enjoying as of late. Moreover, many investors with a modest tolerance for risk will prosper. Even when they give up some of the upsides from a potential revival in their stocks. That is, so long as it means receiving some protection should proceed to follow.
Impact and high-yield bonds during the pandemic
With the pandemic continuing its spread, investors desperately seeking safety are looking to buy bonds. However, interest rates are declining, so traditional bonds will provide them with very low financial returns. Some are starting to look into impact investments as a way to diversify their portfolios.
An ‘impact bond’ is a loan to an organization, typically one that is non-profit. It offers investors a financial return on top of making a direct social or environmental impact for the better. Each bond possesses a different minimum investment, interest rate, and maturity date. A variety of impact bonds will usually generate different types of impact.
It is important that investors need to evaluate the risk before they buy. What’s more, they should allocate only a small portion of their portfolio to impact bonds. There are three main risks pertaining to impact bonds:
- Liquidity risk: The investment is locked-in and is typically for 3 to 10 years
- Duration risk: The interest rate is fixed, so investors will fail to benefit if interest rates increase.
- Default risk: If the organization experiences bankruptcy, then investors could lose some or all of their money
According to Fitch Ratings, in light of the COVID-19 outbreak, almost one-quarter of high-yield corporate bond issues in North America will suffer. Approximately 36% of high-yield corporations “have low rating headroom.” This means that they will probably face substantial rating downgrades. Such issues consist of 50% of those from airlines, 47% from oil and gas, and 44% from restaurants.
Are bonds a good investment? Be practical
Are you someone who wants some balance in your portfolio? If so, then adding a bit of bond exposure along with an asset allocation strategy is not a bad idea. However, there are some who show an interest in selling their stocks to replace them entirely with bonds. If you are one of these people, then you are out of luck. It’s likely that you may wind up switching away from stocks at the worst possible time.
All in all, investing in bonds at this point in time is not a terrible idea. However, try to restrain yourself from going overboard with your endeavors.