Given the state of market investing, bonds have become very popular. In fact, if you compare investing in markets to investing in bonds, you will see that a bond investor fared much better.
One basic observation of bonds is over the last three years bonds have provided a premium above the basic interest coupon (As interest rates fall, bond values go up). Bonds also tend to move in the opposite direction of stocks. They are what we call negatively correlated.
Two elements to bond returns
- Interest return. This is quite easy to understand. Bonds provide a fixed amount of interest for a certain period of time (known as the term of the bond). For example, if you have a 10-year bond that pays 5.0%, then the interest return is 5.0%. This interest could be paid monthly, quarterly, semi-annual or once per year.
- Price return. The more complicated part of the return is the fluctuation of the bond price. Bonds can be traded and sold at any time. As a result, the price of the bond can change. The main determinant of the bond price is interest rate movements. For example, if interest rates fall, the bond prices will go up. If interest rates go up, then bond prices will fall. However, if you hold the bond to maturity, price return does not matter as much.
So, if you have an interest return of 5.0%, what could cause you to lose money? If interest rates start to rise, then the price of the bond will start to fall. If the price of the bond falls by more than 5.0%, then you will start to lose money.
Long term bonds have greater price fluctuation
Generally speaking, the longer the term of the bond, the greater the interest rate you will get. However, it is also important to know that the longer the term of the bond, the greater the potential for fluctuation in price return based on interest rate movements.
In today's times, there is some concern that interest rates are more likely to rise than continue to fall. If this is the case, there is a potential that it may not be the best time to invest in bonds. Basically, the interest portion of the bond is low and does not give investors much of a cushion if interest rates start to trend up. In fact, bonds have had negative returns in the first quarter of 2003.
Top bond tips
That being said, markets are not giving us a lot of reasons to invest. So here are some of my tips for bond investors today:
- Look for shorter-term bonds. They will give a lower return but also less likely to lose money due to rising rates.
- Buy Real Return Bonds. These bonds are unique in that they are special bonds issued by the government. They tend to be less interest rate sensitive but the real benefit is they provide an inflation hedge. With Real Return Bonds, you will get your basic interest rate return but the government kicks in an inflation return. For example, if the interest rate on the bond is 4%, and inflation is running at 3%, the bond return is 7%. These bonds are especially attractive in inflationary times.
- High Yield Bonds. High Yield bonds are simply corporate bonds. Corporate bonds typically pay a much higher interest rate than government bonds because they are considered to be lower grade bonds. High Yield bonds are great for a few reasons. First, they are not interest rate sensitive. In fact, they are more influenced by economic activity and corporate performance that interest rates. Second, the yield on these bonds is very attractive. Corporate bonds are paying 8% to 12%. Finally, High Yield bonds have demonstrated very solid risk return characteristics.