A Closer Look at Bonds

Yawning Cat
Bonds may seem boring, but you need to know about them!

It was more than a year ago that Wharton business school professor Jeremy Siegel, author of the classic Stocks for the Long Run, co-wrote an op-ed in The Wall Street Journal called “The Great American Bond Bubble.” Siegel and Jeremy Schwartz caused a stir with their claim that the “possibility of substantial capital losses on bonds looms large.” If 10-year interest rates rose from 2.8% to 3.15%, bondholders would lose capital equal to the current yield. That's because as rates rise, the value of existing bonds fall.

In an interview with IndexUniverse.com from last July, Siegel brought up the article, saying, “That happened to be a nice call.” Well, not really. Yes, stocks have outperformed bonds since the article's publication in August 2010, but the average bond fund still made money. As for this year so far, stocks are down and bonds are up.

Yes, with rates so low, there are risks to owning bonds. But I find that there's a good deal of misunderstanding out there. So before you sell all your bonds (if you own any), let's take a look at how the market works and what could happen if rates rise.

Note: And before we even do that, it might be useful to review how bonds work or read about the basics of bonds. For many investors, bonds are a mystery. It doesn't have to be that way!

Price Doesn't Necessarily Matter
First and foremost, remember that a bond is not like a stock. Over the long term, the returns from bonds do not come from rising and falling prices.

For instance, consider a share of Coca-Cola stock, which traded for a split-adjusted $13.56 in January 1991. More than 20 years later, it trades for $67.04. Stock investors expect this type of price growth.

However, let's say you bought a $1,000 20-year Coca-Cola bond in January 1991. How much was it worth when it matured in January 2011? Just $1,000 — the amount of principal that Coke returned to you. From a price perspective, you didn't make any money for two decades. But you did rake in some cash by earning interest and reinvesting that interest; in other words, interest on interest. That's known as compounding, and it's crucial to understanding the long-term returns from bonds.

Cuy -- Guinea pigs being fattened for eating in Ollantaytambo
Compounding returns make your money grow — like a group of guinea pigs!

Compounding Matters
Consider an example based on an illustration from The Bond Book by Annette Thau. Let's say you invest $10,000 in 30-year bonds with a 7% coupon (that's the interest rate on a bond when it is issued). Like most bonds, these pay interest semi-annually, so you receive $350 every six months. You reinvest that money in an investment that also earns 7%.

During the first year, you receive two payments for a total of $700. However, reinvesting those payments gets you an additional $12.25. No big deal, right? Well, look at how interest on interest compounds over time:

Time Number of Payments Coupon Interest (Cumulative) Interest on Interest (Cumulative) Total Interest (Cumulative)
Year 1 2 $700 $12.25 $712.25
Year 5 10 $3,500 $605.99 $4,105.99
Year 10 20 $7,000 $2,897.89 $9,897.89
Year 20 40 $14,000 $15,592.60 $29,592.60
Year 30 60 $21,000 $47,780.91 $68,780.91

As you can see, the interest on interest of $47,780.91 is more than twice the amount of interest you actually received from the bond ($21,000) and almost five times more than your original investment ($10,000). This is all because you used the interest payments from your bonds to buy more bonds, which also paid you interest that allowed you to buy more bonds, and so on.

Now, you may be saying to yourself, “Sounds good, but that $350 I received as the first coupon — or even the $700 in the first year — wouldn't have been enough to buy another bond, since most trade around $1,000. Plus, buying a single bond has relatively high transaction costs.” You're right (goodness, you're smart!). This demonstrates one of the values of bond mutual funds: The interest — even small amounts — is automatically and easily reinvested, commission-free. Furthermore, while most bonds pay interest semi-annually, most bond funds pay interest quarterly or monthly, which allows for faster and more efficient reinvestment.

As the table demonstrates, the dramatic payoff from compounding comes after two or three decades. But you can still see the benefits over shorter time frames. Consider someone who invested $10,000 in the Vanguard Total Bond Market Index Fund on Dec. 31, 1999. According to numbers provided to me by Vanguard, $10,000 would have purchased 1,046 shares of the fund.

Fast-forward to Dec. 31, 2010. Thanks to interest reinvestment, this person now owns 1,704 shares of the fund. The $10,000 investment has grown to $18,061 as of Dec. 31, 2010, mostly because the investor owns 658 more shares. Plus, even though rates have fallen since 1999, the total amount of interest this investor receives is more today than it was back then, because she has 63% more shares making distributions.

Patient Dog
Patience is a virtue — in the long run, bonds pay off

What If Rates Go Up?
So far, we've looked at a scenario in which rates stay the same and a scenario in which they drop. Now, let's look at what might happen if and when rates go up — in fact, let's assume they skyrocket by four percentage points. In a research report [PDF] published in 2010, Vanguard did just that, estimating the future returns on intermediate-term bonds if rates were to increase from 2.9% t o 6.9% — a 140% increase, steeper than any the U.S. has yet seen. Here are their projections:

Today +1 Year +2 Years +3 Years +4 Years +5 Years
Yield (%) 2.9 6.9 6.9 6.9 6.9 6.9
Price change (%) 0 (18.4) 0 0 0 0
Total return (%) 2.9 (13.5) 6.9 6.9 6.9 6.9
Cumulative total return (%) (13.5) (7.5) (1.2) 5.7 13
Annualized total return (%) (13.5) (3.8) (0.4) 1.4 2.5

As you can see, the price of the bonds would drop an estimated 18.4% in the year rates begin to rise, but the decline would be offset by the interest payments, so the total one-year loss would be just 13.5%. Historically, the overall bond market has never suffered such a decline; the actual worst 12-month return for the Barclay's Capital U.S. Aggregate Bond Index was a loss of 9.2% from April 1979 to March 1980.

Importantly, bonds now have a much higher yield, which helps the investment recover. As stated in the Vanguard report, “[T]wo years following the hypothetically worst bond market return ever, the diversified bond investor would be close to breaking even, simply by reinvesting interest distributions.”

Still, the 2.5% annualized return is lower than the 2.9% a year the bonds would have earned had rates not changed. It would be just grand if we could time the bond market, getting out before rates rise and getting back in when rates are about to fall. But that's pretty hard to do. As legendary mutual fund manager Peter Lynch wrote, “Nobody can predict interest rates, the future direction of the economy, or the stock market.”

Also, had the folks at Vanguard extended their analysis beyond five years, the annualized return would have exceeded 2.9% as several years of higher interest payments made up for the initial decline. In other words, higher interest rates eventually lead to higher returns. This is demonstrated in a table based on research from fund company Pimco:

Change in Interest Rates Return After 1 Year Return After 3 Years Return After 5 Years Return After 7 Years Return After 10 Years Return After 30 Years
+2% -1.7% 3.8% 4.8% 5.2% 5.5% 6.2%
+1% 1.6% 4.3% 4.7% 4.8% 5.0% 5.2%
No change 4.3% 4.3% 4.3% 4.3% 4.3% 4.3%
-1% 8.3% 5.2% 4.4% 4.1% 3.9% 3.4%

In this analysis, the starting yield on the bonds was 4.3%, and future returns are estimated based on a few scenarios. The scenario that produces the highest longer-term returns is the one with the highest spike in interest rates. As you know by now, this is partially thanks to the reinvestment of interest. But there's one last point we must understand about how bonds perform after interest rates rise.

Rae talks with Julisa (and her lamb, Laurita)
Bonds can help safeguard your portfolio

Rising Prices, Guaranteed
Let's return to how bonds differ from stocks. When the stock market is down, the right move may be to buy more shares in the hope that the market will eventually recover. But the stock investor doesn't know when the recovery will occur. What will the stock market be worth five years after, say, a 10% drop? Who knows?

However, when an existing bond drops because of a rise in interest rates, the belief that its prices will rise again is more than a hope; it's a certainty, as long as the issuer doesn't default. For example, let's say one of the bonds in your bond fund drops from $1,000 to $900 because of a rise in rates. Unless that bond defaults, it will definitely recoup that loss, gradually growing back to $1,000 as it nears maturity. Meanwhile, you're reinvesting the distributions from your bond fund to buy more of these lower-priced, higher-yielding bonds.

The Bottom Line on Bonds
I don't mean to downplay the risk of bonds right now. There is a real possibility — some say a likelihood — that rates will rise and the values of existing bonds will drop. And I agree with Siegel and Schwartz that, for the long-term investor, high-quality, dividend-paying stocks are a better bet than bonds at current rates.

But my concern is that all this talk of a “bond bubble” is scaring people into thinking that declines of 30% are on the way, causing investors to flee to non-yielding cash or buy stocks when they shouldn't be taking on that much risk.

For money you absolutely need in the next three to five years, stick to short-term bond funds or a ladder of CDs. But for longer-term investments that aim to reduce the risk and volatility of your stock portfolio, a low-cost, high-quality, intermediate-term bond fund is still a good option.

Alpaca at Saqsaywaman in Cuzco, Peru
In general, bonds protection against stormy weather in the stock market
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STRONGside
STRONGside
9 years ago

JD, I sincerely hope that you got to try the Peruvian delicacy Cuy (Qui Qui)!. If not, I would highly recommend trying it on a return visit!

J.D. Roth
J.D. Roth
9 years ago
Reply to  STRONGside

I’ve tried cuy twice, and I like it. (Most of my companions do not.) I’m aiming for a third time before I head home. Yum! (And yes, those guinea pigs in the photo are destined to be turned into dinner. They’re like chickens here.)

STRONGside
STRONGside
9 years ago
Reply to  J.D. Roth

Glad to hear you liked it! I got to sample the Andes variety in the northern Ancash region of Peru when I was there. Maybe it was the altitude, and the other food alternatives, but I thought it was excellent. Along with the conejo, they made for great eating!

Jaime B
Jaime B
9 years ago
Reply to  J.D. Roth

I was just about to ask you if that group of guinea pigs was kind of like picking out your lobster at a seafood place. The thought took me right out of the article in fact. (returning to reading)

SB @ One Cent At A Time
SB @ One Cent At A Time
9 years ago

My 401 (K) has mix of bonds and stocks. Over time bonds are expected to produce the highest interest rate compared to any other means of investing money (CD, Saving, Money market etc).

I took some risk and invested in high yield bonds as well as safe muni bonds. Over all good article .

TM @ My University Money
TM @ My University Money
9 years ago

I’m glad you mentioned the strategy of purchasing strong dividend-paying stocks near the end of the article. There are many stocks out there today that have extensive asset bases, and LONG history of raising dividends. I would argue (and some of the ratings agencies agree with me, although I’m not sure that’s necessarily a mark in my favour) that some of these stocks represent less risk than many government bonds at this point. When your annual dividends are substantially higher than the bond returns, you are throwing in the long-term capital gains growth as a virtual bonus! With the stock… Read more »

honeybee
honeybee
9 years ago

Bonds are so cute!!

Ross Williams
Ross Williams
9 years ago

There are dividend paying stocks that provide income similar to bonds. The impact from reinvestment of the dividends is the same.

Not addressed here is the difference between buying bonds and bond funds. If you hold a bond to maturity, you are guaranteed the return of your principal with interest. That is not true of bond funds.

Pat
Pat
9 years ago
Reply to  Ross Williams

To your second point, even if you hold that lower paying bond to maturity and get back your principal, you are in a way loosing money because you could have been getting a higher rate with a different bond. I think that’s the benefit of the bond fund. Even though it makes the loss more obvious by decreasing the value of your bonds, any reinvestment will be at the new higher yield and over time you should come out the same if not better in a bond fund. I guess if you know you will need the money at the… Read more »

Kathryn C
Kathryn C
9 years ago

Great article. Side note, I’m still skeptical of the “buy your age in bonds” theory given interest rates are at 30 year lows. That worked over the last 30 years but I think it’s outdated (I’d allocate less than my age). I’m curious what you think? Thanks!

Kelley
Kelley
9 years ago
Reply to  Kathryn C

We’re at about 80/20 and we’re in our early thirties. We’re willing to take a little more risk and proved it by not selling off when other people are panicking every time the market drops.

Kathryn C
Kathryn C
9 years ago
Reply to  Kelley

Interesting, so you’re now longer subscribing to the buy your age in bonds theory anymore either. Good to know.

MC
MC
9 years ago
Reply to  Kelley

33 yrs and 100% stocks. The way I see it, (all my shares are in my 401) the 30+yr horizon it just doesn’t make any sense to be conservative at this stage with those investments… I also upped my contributions with each of the last two downturns. If you’re 30… whether the market goes up or down in the near term it’s all still a relative sale from what the cost will be 30 years from now.

Now with my emergency funds/spending cash, that’s where to be conservative.

Lara
Lara
9 years ago

Good article. Great pictures.

SG
SG
9 years ago

You know, the real problem is that government debt levels in the Western world are so high right now and still shooting up sharply with no end in sight (and another recession looming) that the risk is that standard responses to tackling debt (i.e. cut expenditures, increase taxes etc.) won’t work to bring the debt level down. What this means is that there is a substantial risk of either defaulting on debt or of inflating it away by using the printing press. Parts of Europe will probably go for the default option (see Greece and the recent discussions about Italy),… Read more »

babysteps
babysteps
9 years ago

Great article. Would love a follow-up talking a bit more about re-investment risk and inflation expectations. Individual bonds can certainly be as volatile as stocks, but as OP says, great thing about bonds is (ex a default) you have little principal risk – which is not the case with stocks. Also agree with the nod to dividend-paying stocks (seem like a nice way to get your cake-potential principal upside – and eat it too – current income from dividends). This past April I got side-tracked in data land and thinking about what the risks of a bond portfolio over the… Read more »

Mom of five
Mom of five
9 years ago

I found this article very helpful. Thank you.

AndrewL
AndrewL
9 years ago

Let’s say you bought a bond with some interest rate, say 5% from your example. Let’s also say the going nominal interest rate is 1%. You find someone who wants a higher return than 1%, so they lend you money at 2% interest rate and take the bond (at 5%) as collateral. This is win win for you because you have cash and the 3% difference in interest rates. You pay the cash lender back when the bond matures. You take the cash and buy more bonds and in effect you have a kind of bond ladder. This works if… Read more »

erika
erika
9 years ago

LOVE the animal photos and the captions relating them to the content 🙂

Rick Francis
Rick Francis
9 years ago

This is not a bad start, but it is incomplete. It was good to show that the intermediate term bond fund doesn’t get destroyed by an increase in interest rates but a long term bond fund would have done worse- I don’t think readers would appreciate that, and I doubt anyone that isn’t in the bond idustry has a clear idea of HOW much worse. There is a measure for how a bond or bond fund would respond to yield changes called modified duration, from wikipedia: “…modified duration (sometimes abbreviated DM) is a price sensitivity measure, defined as the percentage… Read more »

Chad
Chad
9 years ago

Bonds are something I’m always curious to know more about, but I question anything written by anyone from The Motley Fool and I am surprised to find their writers on GRS. After hearing about them on this blog I thought I would check out their site. I was immediately bombarded with ads for get rich, these stocks can’t fail, 3 secrets you need to know in the stock market, best 3 dividend paying stocks ready to explode etc. etc. etc. More out of curiosity than anything (because every GRS reader knows that cheap index funds are the way to go)… Read more »

reinkefj
reinkefj
9 years ago

Sorry to bring gold and politics into what should be a technical discussion of the impact of a rising interest rates on bond price. At least there you have arithmetic to give right and wrong answers. (Disclaimer: I have an adult “fee for service” who manages my portolio and pays no attention to my ranting and raving.) (1) Gold and bonds. Ron Paul is right that the FED is a cartel that manipulates the economy. And discussion of bonds, must imho, should recognize that the dollar you receive later is NOT the same as the dollar you gave sooner. It’s… Read more »

MelodyO
MelodyO
9 years ago

That poor limbless alpaca. I hope he’s got a good emergency fund. He must, because he still looks pretty happy. :0P

Thanks for the spoonful of sugar to help the bond medicine go down, Robert.

Jeff
Jeff
9 years ago
Reply to  MelodyO

I *love* the apparent smirk on his face. 🙂

Laura
Laura
9 years ago

Cute way to repurpose your animal pictures!

Bill Rice
Bill Rice
9 years ago

Great article!

Bonds are the forgotten slow and steady of any balanced investment portfolio. Although, during the mortgage meltdown they got a pretty nasty wrap when the MBS market got a little greedy.

I’ll have to take this info and peek into my portfolio to see if I can tune anything.

Eileen Goddard
Eileen Goddard
9 years ago

great article and excellent pictures 🙂

Cherleen @ My Personal Finance Journey
Cherleen @ My Personal Finance Journey
9 years ago

Nice post. Just in time that I am trying to learn bonds and its trade as I am considering it for my next set of investment.

Chris
Chris
9 years ago

Robert’s posts always teach me something that I didn’t know. I’ve wondered how bond funds operate in comparison to individual bonds. This was a great explanation and I now feel much more comfortable about my bond funds.

Thanks for including his posts.

JJ
JJ
9 years ago

The thing that scares me most about bond funds is duration. If the average duration is 5 years and rates begin to go up… people will begin selling the bond fund. If enough people begin to sell and there aren’t enough bonds maturing to satisfy redemptions, the fund manager will begin selling bonds on the secondary. With yields rising, the manager will get less and less on the secondary and the nav of the fund will spiral downward. As it plummets, you get more and more redemptions and more and more sales on the secondary way below par. It is… Read more »

Vince Thorne
Vince Thorne
9 years ago

I might go for industrial bonds but national and municipal bonds carry too high a risk for too low a return.

Matt A.
Matt A.
9 years ago

It’s pretty easy to point out that compounding is possible with bonds, too, so long as you ignore inflation. The payouts of stocks are going to rise with inflation as the rising prices get passed along to their customers, but the payouts of fixed-income instruments like bonds won’t.

Harm
Harm
9 years ago

Correct me if I’m wrong, but your $1000 Coca
Cola bond does NOT pay compound interest, unless
it’s a zero-coupon bond…..maybe I’ve missed
something.

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