How Bond Returns Work – Part 1
Investing in bonds can be a stable and reliable way to protect your wealth over time while earning enough along the way to offset inflation. However, the intricacies of bond returns, particularly how interest rate changes affect bond prices and the dynamics of bond funds, can be confusing for many investors. This article aims to demystify these concepts, providing a clear understanding of how bond returns work and what to expect when holding individual bonds or investing in bond funds.
What is a Bond?
At their core, bonds are debt securities issued by governments, municipalities, or corporations to raise capital for expanding their businesses or paying employees. When you purchase a bond, you are essentially lending money to the issuer in exchange for periodic interest payments and the return of the bond’s face value, or principal, at maturity.
Unlike the stock market, bond returns are mathematical in nature meaning that you know in advance how much money you will receive along the way and when you will get your money back.
When you buy a bond, you typically receive coupon payments (interest) based on the stated rate of the bond. Then, when the bond matures, you receive the face value of the bond (bonds are issued in $1,000 increments).
Components of a Bond Return
Bond returns are influence by the structure of the bond and the market dynamics.
Return Components Built into the Bond
- Coupon Rate: The fixed annual interest rate paid by the bond issuer to the bondholder, expressed as a percentage of the bond’s face value. New bonds are always set with a coupon rate to give the bond a return competitive with the current market yields.
- Payment Frequency: The regularity with which the coupon payments are made, typically annually, semi-annually, or quarterly.
- Maturity: The specific date in the future when the bond’s principal, or face value, is scheduled to be repaid to the bondholder.
Return Components Governed by the Markets
- Current Yield: The bond’s annual coupon payment divided by its current market price, expressed as a percentage. It reflects the income return on the bond based on its current price.
- Current Price: The market price at which the bond is currently trading, which can fluctuate due to changes in interest rates, credit quality of the issuer, and other market conditions.
Example 1 - Bond Returns without Yield Changes
Assume you purchase a 5-year bond for $1,000 that has an annual coupon of 4% or $40 of interest per year. The bond maturity is in 5 years which is when you will get your $1,000 back.
If you hold that bond for the full 5 years and are able to reinvest the coupon payments that the same 4% rate, your annual return will be 4%.
Let’s assume you then want to sell that bond after 1 year. Yields are still 4% so you can sell the bond for $1,000. The buyer of that bond will then begin collecting the coupon payments and have a return of 4% for the next four years.
Example 2 - Bond Returns With Yield Changes
Current Yields Go Down - Prices Go Up
Now, let’s say you decide you would like to sell the bond after 1 year, but current yields have now decreased from 4% to 3% which means new bonds are being issued for $1,000 with coupon payments of $30 per year. How much can you sell your bond for?
If you sold it for $1,000, the buyer of the bond will actually receive a rate of return higher than the current market rate of 3% which anyone would jump at. Markets are competitive though so the bond you sell will be priced (through bidding) so that the buyer will receive a rate of return equal to the market. Since the coupon, maturity date, and maturity value of the bond are fixed and do not change, the only thing that can change is the price that you sell it for.
So to reduce the return of the bond to 3%, the price of the bond needs to increase. In this case, you could sell your bond for $1,036 rather than $1,000 netting you an additional $36 from price increases. Your total return, $40 of interest plus $36 of price return, actually resulted in a total return of 7.6%!
The buyer will still receive $40 per year in interest, but when the bond matures, they will only receive $1,000 and not the $1,036 they invested. The $36 loss offsets the higher coupon interest they received resulting in a 3% total return.
Current Yields Go Up - Prices Go Down
Assume the same bond except that rates instead move from 4% to 5% which means new bonds being issued at $1,000 have coupon payments of $50 per year. How much can you sell your bond for?
If you sold it for $1,000, the buyer of the bond would have just a 4% return when they could buy a new bond with a 5% return. How do you entice buyers to buy your bond? Lower the price.
For a buyer to obtain a 5% rate of return by buying your bond, you would have to lower the price to $964 resulting in a $36 loss. While the buyer is collecting only $40 of interest per year rather than $50, they will receive $1,000 upon maturity.
Your total return, $40 of interest minus the $36 loss, is only 0.4% rather than 4%.
What if you don't sell?
Bond prices fluctuate based on current market prices. But what if you don’t sell and hold to maturity? Well, you get the original return you purchased the bond at – 4%!
In this case, what you will see on your statements is that the bond price will still drop (if rates increase) or rise (if rates decrease). But, as you approach maturity for the bond, the price of the bond will move towards the maturity value ($1,000)
How Do Returns in Bond Funds Work
Bonds within a bond fund work exactly the same as if you bought them individually. Meaning the above illustrated bond will react the market rates the same way, pay the same coupon, and mature at the same value regardless of if it is owned directly by an individual or if it is owned by a large bond fund.
What is different though is the operation of the bond fund which often is different than individuals owning bonds directly. Bond funds own a large portfolio of different bonds from many different issuers with different maturities and coupons and purchased at different times.
Also, bond funds often focus on certain investing strategies as well such as trying to buy bonds in the same proportions as the total bond market, or owning short term corporate bonds, or owning junk bonds in emerging markets.
It is operation of the bond fund itself that drive the differences in returns when comparing individual bonds versus bond funds.
For example, a bond fund focusing on 5 years bonds can buy 5 year bonds, hold them for a year, and then sell them at market prices. In the bond illustrated above, the return will mimic the results then individual investor had. They then take that money and buy new 5 year bonds now earning a different yield.
This buying and selling to maintain the target bond allocation results in gains and losses that the individual would also realize if they did sell their bonds before maturity.
The important decision with bond funds is ensuring that the bond fund dynamics match the spending need of the individual. If you buy a longer-term bond fund for a near term expense or a shorter bond fund for an expense far off, you may not experience the return your are expecting.
Key Concepts
- A Bonds coupon rate, maturity date, and maturity value do not change.
- Bond prices rise when yield fall. Bond prices fall with yields rise.
- Your total return is impacted by the current market yield when you invest, and the time at which you sell!
Summary
Understanding how bond returns work and how interest rate changes affect bond prices is crucial for making informed investment decisions. While individual bonds provide the certainty of principal repayment if held to maturity, bond funds offer a way to achieve a diversified portfolio with the expectation of returns aligned with the fund’s starting yield, regardless of interest rate movements. By grasping these concepts, you can better navigate the bond market and align your investment strategy with your financial goals.