Understand How A Bond Works

Over the past three decades, people have moved large shares of their portfolios from bonds to stocks. That is exactly the opposite of the way people thought sixty years ago. Is one way or the other right?

Thinking about investments.

Stocks are a tiny fraction of ownership of a business. Bonds are a loan to a government or a business. The value of ownership positions is more volatile than the value of debt.

Why is that?

There are more variables that affect the value of a business. Competitive pressure, innovation, adaptability, and most important of all, how people estimate the future to be. Both the economic future and the future of the particular business.

Debt, on the other hand, is stable until the government or business cannot make the payments as they come due. In a failed business, bonds are worth more than stocks because debt has a priority over equity in a business. They don’t lose until all of the equity is destroyed.

At one time, there was a distinction in the form of debt. A bond was secured by specific assets, while a debenture was not specifically secured. Today most bonds are not specifically secured, and you won’t hear debenture mentioned very often.

Why own bonds?

Not everyone has the same time until they need to have some of their investments available as cash to spend on living. Like at retirement or for an emergency. Volatility is not their friend, even though it may ultimately provide a greater reward. If you need the money in the short term, the long term is not a valuable factor.

How do you value a bond?

There are several factors that are in common use.

  1. Risk. Bonds are valued based on the security their issuer provides. US Government treasury bills have a very high likelihood of repayment. Those issued by large corporations have a lower probability of repayment, but it’s still very high.
  2. Yield. The interest rate offered matters. Bonds are valued against other securities available. They must provide the likelihood of a competitive future reward.
  3. Time to maturity. The length of time you must wait for the return of your capital matters. Giving up the use of your money for a long time must be rewarded, or no one will do it.
  4. Liquidity. There are ways to buy and sell bonds, just like stocks. People will demand less interest if they can sell the bonds they own easily.

Valuation is just an arithmetic question. Once you see it it becomes less terrifying.

Suppose I want to assess the value of a highly secure, marketable bond. What I must address is yield and time to maturity. To do that you will need to notice one factor. Bonds are composed of many promises. Each of them has a different value once you decide the interest rate you want.

Let’s look at a $10,000, 10-year bond with a coupon rate of 4%.   There are eleven promises. 10 of $400, and one of $10,000. Let’s suppose you want 4% on your investments.

The first $400 interest payment is due one year from now. and so has a present value of 400/1.04 = 384.62, the second has a value of $400/ (1.04×1.04)= 369.82. The third is $400 divided by 1.04 to the third paper and so on out to 10. The 10th interest payment has a present value of $270.27. The principal amount of $10,000 is also ten years away. and it is worth $6,756.76

When you add up the present value of all the promises, you will get the $10,000 you must give up now to get the bond.

What if interest rates change after I buy the bond?

The process is always the same but more opaque if the yield you want is higher than the coupon rate. If you want a higher yield you will get it, but you do it by buying the bond for a discount from its face value. Let’s suppose two years after you buy the bond, you’d decide to sell it in the marketplace. Its security is unchanged, but now people want to earn 5% instead of 4%. That will make the present value of each future payment less. It is worth not $10,000, but $9,353.68. If they decided they wanted 7%, it would be worth $8,208. The annual payments wouldn’t change, but they would get back $10,000 at the end instead of $9,353. That extra $647 makes up the interest shortfall they suffered for eight years.

If interest rates fell to 2%, the value would be $11,465.

You can see the different outcomes with a bond price calculator. 

If rates fall, bond values go up, and if interest rates rise, bond values go down. You cannot use history to tell you about rates of return unless you know how interest rates changed in the period. Bond value changes in the past decade or so have been fairly stable. They look anemic compared to those in the decade after 1979, but only because rates fell so much in the ’80s.

Projecting the future just now is not too difficult. Interest rates have been abnormally low for some time and are likely to rise. That means the future values of your bonds are likely to fall. If you hold them to maturity you might not notice.

 The bit to take away

On average, bonds are less volatile than stocks in the short run., but they are not so intuitive as stocks when ti comes to valuation. You must be able to do some arithmetic with a spreadsheet to understand. You might find an ETF to your favour. Let someone else do the arithmetic.

I build strategic, fact-based estate and income plans. The plans identify alternate ways to achieve spending and estate distribution goals. In the past, I have been a planner with a large insurance, employee benefits, and investment agency, a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business. I have appeared on more than 100 television shows on financial planning. I have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, and Banks – from CIBC to the Business Development Bank.

Be in touch at 705-927-4770 or by email at don.shaughnessy@gmail.com.

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