Bonds 101

Brad 2016-11.jpg

by Brad Houle, CFA
Executive Vice President

Bonds are, at their core, less complex and more easily understood than most clients might assume. While “interest rates” and “bond yields” make them sound complicated, bonds can be boiled down quite simply: bonds are loans. They are issued or sold by governments, municipalities or corporations. Bonds are used to fund operations, invest in new business opportunities or to build new infrastructure. The interest is then paid by the issuer to compensate the bondholder for loaning money to the entity selling the bonds.

Interest rates are determined by the market based on the perceived risk of the bond, with the primary risks being default and uncertainty around future inflation. For government debt such as U.S. Treasury bonds, default risk is minimal: the U.S. government has the intent and the ability to meet its obligations. The risk with government bonds is future unexpected inflation. Due to the fixed nature of bond interest payments, the risk is that inflation increases over time and erodes the value of the interest that is received in the future. As a result, the bond market is sensitive to the expectations for future inflation. It can be easy to confuse bond interest rates with the interest rate determined by the Federal Reserve. The Federal Reserve adjusts the Federal Funds Rate which impacts short-term interest rates whereas longer-term interest rates are set by the bond market. Investors in the bond market buy and sell bonds which determines the level of longer-term interest rates.

Currently, bond yields are low across the developed world as seen in the chart below. This is due in part to slow growth and a lack of current and expected inflation. The U.S. 10 Year Treasury is at 2.65 percent and yields more than most countries in the developed world. A common question that we get from clients is why should I own bonds in my portfolio with the low level of interest? In this environment, it is important to think of the bonds as inexpensive insurance. Bond returns are not correlated with stock returns; said differently, when the stock market declines, bond returns often move higher. Having a bond allocation in your account is the most effective way to dampen the volatility in the stock market.

Source: Bloomberg

Source: Bloomberg

Ferguson Wellman’s fixed income strategy is a conservative strategy in a conservative asset class. We view our client's fixed income portfolios as an anchor to windward, what is going to protect against stock market declines. All of our clients have a risk budget: this is the amount of risk that a client can tolerate given individual needs and objectives. This risk budget is more efficiently spent investing in the stock market where the potential for greater returns commensurate with the greater risk.

Week in Review and Our Takeaways:

  • The stock market was relatively unchanged for the week. For 2019, the S&P 500 has returned more than 11 percent and the Russell 2000, which tracks small companies, is up more than 17 percent

  • Fourth quarter 2018 GDP was released following a one-month delay due to the government shutdown. For the full year 2019, U.S. GDP was 2.9 percent with positive contributions from personal expenditures

  • As a bond investor you are simply loaning money to a government, municipality or corporation

  • Fixed income returns are pretty unexciting in this low-interest rate environment. However, owning bonds is the cheapest insurance you can get against stock market volatility