A Note About Bonds

By Macy Jae Moore on July 14, 2022

Written by: Zeke Anders

Bonds, often called fixed income assets, are loans to the government, companies, or consumers. They pay coupons (also called interest) over time, and when they mature they return the original investment or principal. When the interest rate on new bonds increases, the price of outstanding bonds decreases. Investors won’t pay the same amount for a bond with a 3% coupon as for a new bond with a 4% coupon. The price drops until the yield, which is the coupon divided by the current price, matches the yield on new bonds. The magnitude of the change depends on the duration or time to maturity of the bond; more time to maturity means larger price moves. Alternatively, when yields on new bonds are lower than existing bonds, the price of outstanding bonds increases. Either way, if bonds are held to maturity, they return the initial investment, also called face value or par, assuming the underlying borrower does not default (meaning fail to pay off the loan).

Bonds have traditionally been used for diversification from equities. Bond prices and stock prices are usually not correlated, meaning they move independently of each other. This year, however, interest rates have increased dramatically, which has reduced the price of outstanding bonds.

The stock market has dropped in tandem, reducing the benefits of diversification compared to previous periods. Bonds have still dropped less than the major equity indices, but that may be little consolation. The important thing to remember, is that if held to maturity the bonds will pay back the same initial investment. Assuming the borrower (also called the issuer) does not default, the bonds will regain their initial value over time. For bond mutual funds this is a bit more complicated since they don’t necessarily hold bonds to maturity, but over time the bonds they hold may recover some value and they replace outstanding bonds with new bonds with higher yields.

You’ve probably surmised the moral of the story, which is to stay invested. Selling your bond or bond fund because the price has fallen means you will miss out on the recovery. Unless yields fall, the recovery will be gradual as bond prices do not generally snap back. A prudent reason to sell might be to rebalance your portfolio. Stocks have fallen more than bonds, as such your asset allocation plan might require selling bonds to purchase equities. Sticking to the investment plan can be difficult at times, but it helps us make better decisions with our portfolio.

Zeke Anders – Planning Specialist zanders@twickenhamadvisors.com

Disclaimer

Hightower Advisors, LLC is an SEC registered investment adviser. Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.