Understanding Bonds and Interest Rates

Bonds are fundamental to a balanced portfolio, providing income and stability. Understanding how bonds work and their relationship to interest rates is crucial for any investor. [DEFINITION] Bond: A debt security where you lend money to an issuer (government or corporation) in exchange for periodic interest payments and return of principal at maturity. ### How Bonds Work When you buy a bond: 1. You lend money to the issuer (the bond's face value, usually $1,000) 2. The issuer pays you interest (coupon) periodically, usually semi-annually 3. At maturity, you receive your principal back [EXAMPLE] You buy a 10-year Treasury bond with a $1,000 face value and 3% coupon. Each year, you receive $30 in interest ($15 every six months). In 10 years, you get your $1,000 back. Total return: $300 interest + $1,000 principal = $1,300. ### Types of Bonds **By Issuer:** - **Treasury bonds:** US government (safest) - **Municipal bonds:** State/local governments (often tax-exempt) - **Corporate bonds:** Companies (higher yield, higher risk) - **Agency bonds:** Government-sponsored entities (Fannie Mae, Freddie Mac) **By Maturity:** - **Short-term:** Under 3 years - **Intermediate:** 3-10 years - **Long-term:** Over 10 years [KEY] The inverse relationship: When interest rates rise, bond prices fall. When rates fall, bond prices rise. This is the most important concept in bond investing. ### Why Prices and Rates Move Inversely [SCENARIO] You own a bond paying 3%. New bonds are issued at 4%. Who would pay full price for your 3% bond when they can get 4%? Your bond's price must drop to make its yield competitive. [FORMULA] Approximate Price Change = -Duration × Interest Rate Change A bond with 5-year duration falls about 5% if rates rise 1%. ### Bond Ratings Credit rating agencies assess default risk: - **AAA/AA/A:** Investment grade (low risk) - **BBB:** Investment grade (moderate risk) - **BB and below:** High-yield/"junk" (higher risk, higher yield) [TIP] In retirement accounts, bond funds are convenient. In taxable accounts, consider municipal bonds—their tax-exempt income can provide higher after-tax returns than corporate bonds. ### Building a Bond Allocation Considerations: - **Age:** Traditional rule: bond allocation = your age (if 40, 40% bonds) - **Risk tolerance:** Higher bond allocation = less volatility - **Income needs:** Bonds provide predictable income - **Interest rate environment:** Consider duration in rising rate environments [EXERCISE] Interest rates rise from 3% to 4%. You hold a bond fund with an average duration of 6 years. Approximately how much does your bond fund decline in value? |ANSWER| Approximately -6% (Duration × Rate Change = 6 × 1% = 6%). This is why longer-duration bonds are riskier when rates are rising. [WARNING] "High-yield" or "junk" bonds offer attractive yields but come with significant default risk. In recessions, high-yield bonds can lose value like stocks. Don't mistake high yield for safety.