Bonds have become unloved. In an investing world where the mentality is dictated by “What have you done for me lately?”, bonds do not have a strong argument. In Canada, bonds had a negative overall return in 2021 and underperformed equities by about 27.5%. The underperformance has continued thus far in 2022. Investors seem to have conveniently forgotten that bonds actually performed better than equities the previous calendar year. More importantly, none of that should matter anyways because it should be about “What are you going to do for me going forward!”.
Bonds, like stocks, are tradable securities, and all investments can be priced as the present value of future returns. In the case of most bonds, this is a very straightforward mathematical exercise with known values. Pricing stocks is far less certain as future returns are very subjective and based on many different individual opinions which can vary widely. Time horizon is another important aspect as the lifetime for a bond investment is clearly defined by its stated maturity, but a common stock security has no such clarity.
To illustrate a typical bond, consider a $1,000 bond issued on December 31, 2021 with a 5% coupon payable semi-annually and a maturity of 10 years. Every six months, you will receive an interest payment of $25 and at the end of 10 years, you are also given back your $1,000. So how is it possible for bonds to deliver a negative return?
The explanation is found in the discounting of future bond payments, which is how bond prices are calculated. Although investors are always paid at the 5% coupon rate specified by the bond, the discounting rate used to value the bond will change over time as interest rates change. The discounting rate is commonly referred to as the yield to maturity (YTM). At issuance, the coupon rate is assumed to be equal to the YTM, but over time those rates will diverge. A very well-known rule in investing is that when interest rates go up, bond prices go down (and vice versa). As an extreme example, if the YTM on a bond was to go from 5% to 6% after it was issued, that would result in a price decrease from $1,000 to $925.61…that is a negative return of almost 7.5%!
But here is the silver lining that many investors tend to overlook: the future payments from the bond have not changed. You are still going to receive $25 every six months and $1,000 upon maturity. That means that your bond price will have to increase back to $1,000 by the time that it matures, or in other words, you will get a full refund on that 7.5% loss! The negative return is merely a temporary mathematical fact that will eventually become redundant over time, and regardless of what happens with future interest rates because the bond will mature at an exact price of $1,000. Furthermore, if you invested in the bond for future income needs, your bond income is 100% unaffected by a change in price of the bond – you will still receive the exact income that you expected when you purchased the bond.
When you own a bond “fund”, rather than an individual bond, it gets a bit more complicated, but the principles remain the same – they just now apply to potentially hundreds of bonds with varying maturities and YTMs, not just one.
The investment industry tends to characterize risk as the volatility of returns (not running out of money!) which is fine for some analytical applications, but it can distort perspective for those who are more concerned about their personal wealth needs, and not industry statistics. If you are in the former category and can embrace the concept that neither the income stream nor returns change over the full maturity cycle of a bond, the appeal of bonds becomes more obvious: they represent very little risk and interest rate changes mean very little. So be careful of what you read or hear, because articles or reports are not written to be specific to your personal needs, they are more likely self-serving “opinion pieces” with questionable merit.
We will follow up this article with Part 2 of why bonds are not so bad next month.
Written by James Gauthier, Chief Investment Officer at Justwealth.