Bonds 101

When it comes to bonds, you have likely heard of them. They are a common fixed-income instrument and investment product, but what makes up this financial security? In this episode we look answer foundational questions for bonds and their space in the market.

Summary – Cents of Security Podcasts Ep. 60

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement:

Welcome back to the Cents of Security podcast. I’m Cassidy Clement, Senior Manager of SEO and Content at Interactive Brokers. Our guest is Steven Levine, Senior Market Analyst here at Interactive Brokers. Today we’re going to be talking about bonds, and you’ve likely heard of this fixed income instrument and the investment product, but what actually makes up this financial security?

In this episode, we’re looking to answer foundational questions for bonds and their space in the market. So welcome to the program, Steve.

Steven Levine:

Thank you so much, Cassidy. Thanks for having me.

Cassidy Clement:

Yeah. So you’ve been on the program a handful of times, whether it’s as a guest or running some of our other podcast episodes as a host, but when it comes to bonds, as our guest of honor here what is your background in the industry?

Steven Levine:

Before working here at Interactive Brokers, where I did a lot of focus on creating some bond courses for our Traders Academy platform and writing about bonds in our Traders Insight articles. Before I was here, I was a fixed income reporter at a company called Market News International, or MNI. At the time it was owned by the German Stock Exchange, and there I covered mostly corporate bonds, issuance and trading performance, but I also wrote about other fixed income products like municipal bonds and agencies or agency bonds and non U. S. sovereign bonds and things like that. Before that, I held roles mainly in credit risk, J. P. Morgan, Citigroup, and then at DTCC, which is the Depository Trust and Clearing Corporation, had a regulatory risk role there. So I’ve been in the financial services industry for about 25 years. Feels like 100, but really it’s 25 years or a quarter of a century.

Cassidy Clement:

That’s exactly why I asked that question, because I like everybody who’s our guest here to kind of show the reason why they were selected as the guest, because we’re not just reading off of PowerPoints here folks, we are actually having conversations with dedicated guests here.

So let’s jump right into it. What exactly are bonds and then how can investors gain income from these? How exactly do they work?

Steven Levine:

Okay, a bond is essentially a contract. That’s made between an issuer or what they might call an obligor and an investor who’s a creditor of the company. It’s not like a stock where say the buyer becomes an equity owner of a company, you know, the investor is actually a creditor. And as a creditor, the bond holder is likely going to be most concerned about the issuing company’s ability to honor its debt obligations. In other words, is it going to live up to the terms of the contract so that this issuer or obligor pays all the specified interest payments that’s due to the investor over the lifetime of the bond, as well as the bond’s par value, or face value, or principle when the bond matures.

We’ll get into all of that a little bit later, but all of these payments are collectively known as the annual rate of return on a bond, or its yield to maturity. This is commonly seen as a YTM. So the terms of the sale will be spelled out usually in, say, a prospectus or an offering memorandum but if the issuer, again, fails in any way to satisfy the debt service payments, whether that coupon payment or the principal when the bond matures, then the issuer is said to be in default. So I suppose the first question an investor who’s interested in buying a bond might ask is, will I get paid as expected, over the life of the bond?

Another way to look at this is, say, through the lens of an investment objective. With a stock, for example, an investor is likely looking for growth, right? Is that stock value going to just climb in an upward, endless trajectory? With a bond, or a fixed income security, the objective is more of a conservative approach. Falls more along the lines of generating steady income or preserving capital. There are ways to make capital gains on bonds. You can talk about that too, but it’s typically that coupon payment, that rate of return the investor’s counting on receiving. This is where the term fixed income stems from. Those fixed payments, both on coupon dates and the principal at expiry.

Someone once said to me, hey, I invested in bonds and I didn’t see them grow very much. Well, they were treating it as if it were a stock or some other growth oriented asset, and the objective here is very different. Also, unlike a stock, the bond typically has some built in time clock, meaning there’s a specific date at which this bond matures.

It’s called the maturity date, and this is when the bond’s life is said to expire and this is when the par value or face value of the bond is due to be paid to the investor. They could be anywhere from less than a year to 30 years or more. A stock is likely going to stay a stock as long as it’s held as a stock. It doesn’t have a maturity date, doesn’t have an expiration date attached to it, but you’re going to hold the bond to a specific period in time. Now, the point of a bond from a bond issuer, if I’m selling debt, to the creditor. I’m going to be doing this for any number of reasons. Let’s say it’s a corporate bond.

If it’s a corporate bond and I’m a corporate bond issuer, I’m a company that’s selling debt, I might be doing this to raise capital for something. Buy new equipment or buy back existing bonds. I might be doing it to help finance a merger. I might be doing it because rates have moved and I want to refinance this debt at a more favorable rate to me as an issuer. It could be any combination of these things. And when we talk about bonds, there is that general idea of the bond, but these bonds come in many different types because there are many different types of issuers that issue bonds.

There’s the federal government that issues treasuries, and these are considered to be the most liquid, risk free investment that you can make. There are local or state governments that issue municipal bonds, can be like revenue bonds or obligation bonds that could be used to finance a road or a bridge.

There’s green bonds and sustainability linked bonds. These are bonds that are used to help pay for ESG related projects. They’ve been around for a little while, but they are fairly new. And there’s all sorts of others. Inflation linked bonds. You have bonds issued by foreign entities.

They might be issued in currencies other than the U. S. dollar and there are also century bonds. Those mature after a hundred years. And those have been issued by companies like Coca Cola, for example, or institutions like UPenn or MIT, the government of Mexico, you lock in a rate for a hundred years. And so your life as an investor is likely set to expire before the bond does. And so you’ll probably want to have some kind of succession plan if. If you see these, but they’re not very common. So there are several different types of bonds being issued by different types of obligors or issuers for different purposes.

And they’re usually consumed by insurance companies and pension funds. As some conservative approach to a fixed rate of return in their portfolios. And so that’s the whole gamut of bonds. We have a lot of information about these in our courses, and I’m sure we’ll provide links to them.

Cassidy Clement:

You talking about the various types of bonds and the multitude of time horizons and the way that they all come down to, okay, how’s this interest payment going to be panned out? What’s this bond for? Who’s this bond for? These are the questions that I think a lot of people have when they actually dig into bonds, because as you know, most people know you hear when people talk as a joke, like about fake finance, they’re like stocks and bonds, buy low, sell high, stocks and bonds, but a lot of people don’t actually know the structure of bonds.

So that kind of goes into my next question, which if anybody here is doing a license test coming up, or they’re studying Economics majors, Business 101, if you’re an FBLA in high school in America, this is the question that you always get on your midterm or your final, which is bonds when it comes to price and interest rate relationship. What exactly is the relationship of a bond price to the interest rate? How would you explain that to people getting started in the space?

Steven Levine:

Yeah it’s a little tricky, but it’s very simple. So, in general, bond prices and interest rates move in proportional, opposite directions. Okay? So, that’s when interest rates rise, bond prices tend to fall. And when interest rates fall, bond prices tend to rise. And that’s the basic relationship. There’s a lot more to it than this, but that’s the glue that holds that whole relationship together. For example, a bondholder might face interest rate risk when rates rise. This is because prices of existing issuance falls. So prices of existing issuance goes down when rates go up. But bond buyers, on the other hand, they’re going to reap the benefits of a higher rate of return on new issuance because we’re in a higher interest rate scenario.

These bonds will have higher coupon rates than those existing bonds in the market. But when interest rates fall, bondholders tend to see the value of their bonds rise, and bond buyers will ultimately get a lower rate of interest with the new issuance. And that’s how that works. So, as interest rate movements directly affect the value of a bond, it’s incumbent upon both investors and issuers, I think to form some kind of opinion about where the direction of rates are going before they even make a purchase or sale.

We have an Introduction to Corporate Bonds course on Traders Academy, and you’ll see an example there of a Verizon bond and how its price changes with both up and down movements and interest rates. Also in these courses, we get into some detail about the role of the Federal Reserve and how they set interest rate policy and their influence on say, the Corporate Bond Market, also very detailed on Traders Academy. In fact, there’s a lot of great courses on Traders Academy. We have an intro to Municipal Bonds there as well, and a section in our ESG Investing course, also on fixed income securities that are related to ESG.

It’s great. Oh, wanted to get into this a bit more too, capital gains. You know, I mentioned capital gains earlier as a way to generate income apart from receiving those coupon payments. You can earn a capital gain for example, when interest rates fall. When interest rates fall, we talked about how the prices of existing bonds, how they tend to rise. If I’m in a higher interest rate environment and I buy a bond and rates fall, the price of my bond is going to go up. And then I can sell that bond for a higher price than I paid for it and that’s considered a capital gain.

Another way is if you buy a discount bond, that some price below the face value, like let’s say par or the face value of a bond is at a hundred and I buy it at like 98 or 97, I do stand to receive as an investor. The full face value at maturity. So when I get that at maturity and I paid less for that face value than I’m receiving, that’s also considered a capital gain. So it’s another way you can earn income on bonds.

Cassidy Clement:

Well, that leads me perfectly into our following question then, because When you’re thinking about bonds, as you said, that price to interest rate scenario, that’s when a lot of people start to really comment on the market a lot. There starts to be a lot more chatter around that type of security.

And you know, you mentioned about how there’s potential for you to sell the item, but there’s been a lot of change in interest rates. And that has put a lot of light on the bond security market because a lot of people are looking to that not only as what was once just a good way to diversify your portfolio, but now, as you mentioned, you know, a good place to kind of look if you have a certain, well known time horizon for your investment. We touched on this in a previous podcast with Jose Torres about low risk investments for shorter time periods and looking into interest rates. But since you write on the topic and you research on the topic with the interest rates at the high level they’re at bonds have really held the limelight for the past couple of years, really ebbing and flowing with different Fed meetings. Can you describe to the audience why that is and why the market chatter really ramps up around those Fed meetings around bonds?

Steven Levine:

Yeah. No, it’s a great question. I would say even before looking at the current environment, before even looking at what that chatter is today in the market, it might be worthwhile to look at rates in terms of inflation.

Rates can go up for any number of different reasons, can be triggered by any number of different catalysts, but its relationship with, say, Inflation, it can play a really important role when deciding to enter the bond market. Might be very attractive to receive the higher rate of interest on a fixed periodic basis for bond buyers who are looking to generate that steady income, especially if the markets or the economy or we’re undergoing uncertainty or bouts of instability or volatility. It’s attractive to have that steady stream of income versus, say, a stock that might see its share value plunge. So you’re looking at locking in, at this point, a fairly high rate of return on a bond in an environment where we’re still facing a great deal of question marks as to where things are headed.

As a side note, there’s a place that listeners can consult. They can look to, say, the Bank of America Merrill Lynch Move Index. This represents volatility of U. S. Treasury futures. You know, it’s similar to the CBOE’s Volatility Index, or VIX, for the S&P 500 and they look at this and they can compare the two. They can get a picture of how these two asset classes, are moving during volatile times. But against all of this, I just want to bring us back also to that inverse relationship between interest rates and prices. If there’s some indication rates could go lower, that tends to increase the value of the bond an investor holds. So, of course, those investors who purchased the bond at the lower rate, are in the higher rate environment today facing realized or unrealized losses on that bond. But it’s important, I think, to form some kind of opinion again about the direction of rates. And this brings me to and to answer your question at this point.

Yes, there’s been a lot of talk in the markets recently. There’s been a lot of conjecture. That the Federal Reserve’s Open Market Committee, that’s the FOMC. And you might hear the FOMC mentioned a lot that is the Fed’s policymaking arm. It could cut rates in the near term. You know, in fact, I’ve seen some reports very recently that there’s several fund managers out there that say, well, the Fed could lower rates at least four times in the next 12 months. Bond investors might be looking at today’s higher rates, to lock those in before rates go lower. They might think, well, rates might not go any higher. This might be as good as it gets. And so let’s do that now before the Fed cuts, or if they cut. I think, a lot of the popularity for bonds these days is driven because of this picture that rates could go lower.

It’s really a question going forward of where inflation is going, where global growth might be going, how the economy’s doing, you know, are we headed for a recession and against that, what the FOMC decides to do at its policy meetings, where the direction of rates might be headed. So overall, a lot of dynamics at play when we’re talking about rates and prices. There’s the technical aspect of that proportional inverse relationship. And then there are the fundamentals, the supply and demand part of it that get influenced for better or worse by the direction rates are moving. And this will likely have an impact, yes, on the bonds value. And it’s going to also impact the supply in the market because borrowing costs for the issuers are also going to rise and fall. So you have to look at both sides of those dynamics when we’re looking at the value of the bond.

Cassidy Clement:

As a holder of a bond, when would you exactly not be seeing your investment doing what it’s supposed to do in terms of growth? I know you mentioned a little bit about a discount. A 100 bond is now worth 98 and you’re able to buy it at a discount, but the maturity was still at a hundred. Is that correct?

Steven Levine:

Yeah that’s right.

Cassidy Clement:

Just out of curiosity, to most people hearing about bonds, it’s like, okay, well, if the price goes up, the interest rate goes down, but maybe I could sell the bond.

 Is there a way they, I think you mentioned default as one of the words, like how exactly do they do kind of the, not the equivalent of a stock plunge, but that they aren’t in the right space for the investment?

Steven Levine:

As long as the issuer does not default. As long as that’s the case, or as long as the contract remains in force, the investor stands to receive the terms of that contract for the life of the bond. If it’s a corporate bond, and let’s say the company is sliding towards default, or undergoing a massive amount of change, even if it’s share value plummets by say 60%. There could be massive changes at the issuer level, but they have an obligation to honor their debt service. So the bondholder will continue to receive those coupon payments or those interest payments over the life of that bond, as well as the principal, as long as they hold the bond. Now, If the company or corporation goes bankrupt or if there are other issuers that decide, well, we just don’t want to pay it or we’re not willing to pay it. We have other priorities at this point. So these are basically called credit events and there is protection against these kinds of things. I will just say that if I’m holding a bond and the terms of that bond are enforced by the issuer, they have the obligation to honor the debt service on that bond, and that is what makes them a little bit safer as a conservative approach. And that’s why you don’t see massive spikes one way or the other, typically with bonds. They are fairly conservative fixed income instruments that don’t typically undergo the kinds of volatility that a stock will or other instrument.

Cassidy Clement:

So the reason I ask that is because we’re talking a little bit about the volatility of it.

What I’m going to ask about is questions investors should ask themselves when planning a bond investment strategy or things to keep in mind with their own personal goals and also the realities that make up the underlying security.

So, as people may be entering the space as a new investor, or as I mentioned at the beginning, maybe you’re looking into studying finance or business. You may initially look at this and say, as you mentioned, this is a very conservative investment. What is the pro and con here to this? So, when it comes to these questions for planning an investment strategy around bonds, what would you say to our listeners to think about?

Steven Levine:

I would one, go back to what someone had recently said to me about the bonds that they were holding and that they were not seeing much growth in those bonds and they were treating them as if they were a stock or some growth oriented product, and you should just basically realize that your objective is to generate income or preserve your capital with these bonds.

Yes, those objectives might change over time, and then you might want to consider growth opportunities outside of bonds, for example. In general, there is just a massive amount of questions that an investor can ask when purchasing bonds. I mean, especially when considering which type of bond investor is interested in purchasing. Generally, investors might want to keep in mind their investment objective, but are they also looking maybe to take on a riskier prospect of some kind? There are bonds out there that are called high yield or junk bonds. And that’s something where a ratings agency like Moody’s or S&P, they conduct an analysis of, say, different companies or different bonds in general, and they assign a rating to them.

Below a rating of triple B minus is an indication that this is a less than investment grade quality credit. For corporate bonds, for example, investors might want to know are market conditions suitable? For me to actually go into this, because it might not be great for that company. It might default in those conditions. Do I want that bond? Are there higher likelihoods then of defaults in say, certain business sectors or among certain individual companies? We addressed inflationary environments. So, let’s say the Fed decides to raise rates, say to, you know, combat inflation again, say something like this happens. Higher interest rates are going to make borrowing costs for issuers more expensive. So, for companies already carrying a lot of debt burden, you know, if it’s struggling, say, with its free cash flow, if it’s having difficulties operating, an investor might want to know whether that debt service that they’re going to receive from that contract. Can it pay that over, say, three years, five years? Is it going to be in business that long, or is it going to default? I want to know this as an investor. Think of it like a loan. If somebody was borrowing because they don’t have a lot of cash on them, right?

And they want to borrow from somebody else. Well, if I’m lending that money, am I going to get my money back from that person? Especially if it’s a high rate of interest that’s being charged over so many years. So that’s going to be questions to ask. Now to address the length of time, there’s a fairly common strategy that’s out there. It’s called bond laddering. You invest in bonds across the maturity spectrum, or as we say the yield curve, you invest in all sorts of different maturities, and then you spread that interest rate risk out. You can reinvest proceeds from say maturing bonds into ones that might pay a higher rate of interest when rates rise.

So when rates rise, you got more attractive bonds out there at higher rates of interest and I can reinvest into those and receive a higher rate or you can protect your portfolio from lower rates receiving just a low rate of interest. You can have higher rates of interest bonds to offset that in your portfolio. So you have higher rates of interest and lower rates of interest across the maturity spectrum. That’s called bond laddering, and that’s something that investors seem to typically do. And then there’s tax purposes. So municipal bonds offer tax exempt securities and so for tax purposes, they’re another type of security that investors can go into.

We talked about rates and prices and inflation. So given that there are uncertainties there, there are inflation protection securities that are offered by the treasury. They’re called TIPS, treasury Inflation Protection Securities and they’re designed for investors to preserve their purchasing powers. The value of the dollar falls when inflation rises, so TIPS are designed to adjust with inflation. On this note, there’s also corporate inflation linked securities, and they’re very similar. They also adjust with inflation. But as investors diversify or they balance their portfolios with bonds, this seems to be the trend these days. They also might want to consider some risks seeing as they’ve recently been caught up in this inflationary or higher rate environment. So depending on what kind of bond they’re holding an investor might ask how have certain companies or business sectors been doing or faring in the inflationary environment? Especially those that say rely on consumer spending. So, you know, what if you got a company whose prices necessarily rose because of inflation? Well, were consumers prepared to pay those higher prices? So now is that company facing, say, revenue shortfalls or is the perception of their credit worthiness?

Is that dented? Are ratings agencies coming in and saying, Hey, we should cut your credit rating lower because it’s not as quality as it once was if you didn’t have inflation or if consumers maintained demand for your products. So again, lessons in the Introductory to Corporate Bonds course. There are lots of questions they can ask. You want to look at all of these things. Really, it’s because of that default risk.

You really want to make sure that you’re going to receive your interest payments and your principal at maturity according to the terms of the deal over the course of the life of the bond. You really want that, so in order to do that, you’ve got to make all these kinds of assessments about the issuer. Their creditworthiness, their operational strength, their financial health, what kind of risks do they face from inside and externally?

There’s a great illustration about a Marriott bond and we have this spelled out in that Introduction to Corporate Bonds course on Traders Academy. I mean, it’s really kind of a fascinating look because Marriott issued a five year bond right at the heart of the COVID crisis. It was during a time when you had government mandated travel bans, you had this massive drop in tourism, and I mean, I think we can all pretty much guess where Marriott gets its revenue from, right? So Marriott ended up suffering huge revenue declines, significant negative cash flow. Ratings agencies were cutting its rating, it was warning of further cuts, its equity plunged.

The Fed stepped in and tried to support the corporate bond market in some ways, but it wasn’t supposed to last like five years for the length of this bond. So what do you do? As an investor, do you invest in this bond? Do you have faith that the company is not going to crash? That this COVID crisis isn’t going to persist for some length of time? What if it did and it forced the company into bankruptcy? We don’t know. But it’s a great way of looking at a corporate bond and how all of these different factors factor into the analysis that an investor takes upon themselves to assess.

So again, depending on the type of bond, investors should be aware of all the factors that can influence its price, like the direction of interest rates, As we talked about, as well as for the potential for default, like we talked about and so on. So investors can look at other types of potential fixed income investments to diversify their portfolios, as you had suggested, non U. S. sovereign bonds issued by governments outside of the U. S., foreign company bonds. So, you know, you’re not just looking at the default risk and fundamental analysis there, you’re also looking at say currency risk. If it’s denominated in something that’s, say, in euros, and you want to look at foreign currency risk, bonds for ESG efforts, like green bonds and social bonds, all of these have their own unique characteristics.

They have their own idiosyncratic risks tied to them, but a lot of opportunities for investors in the fixed income markets. I wouldn’t say it’s a plain, boring, vanilla asset. There’s so much to consider when you look at a bond. And again, I recommend checking out all the great courses on Traders Academy. You’ll be very well informed.

Cassidy Clement:

So everything that you had mentioned kind of boiled down to my bullet points on this, you know, just to hit the high points. You’re looking to get into this area, you know, you want to look at the company background for the internal look, you want to look at inflation and other external factors, what is your risk tolerance and the risk of the investment itself, what type of rating does that bond have, and then also, you know, you kind of alluded to a little bit what are the tax implications? And that can kind of impact people in different ways, depending on what your tax situation is, including the currency factor, which you’ve mentioned there at the end of your answer. But other than the Traders Academy courses that you mentioned, are there any other Traders Academy or Traders Insight items that you want to shout out while I have you on?

Steven Levine:

I would certainly take a look at the videos for the interviews that I had with Ed Grayback from Tempest Advisors. We have those, I believe, in our archive on Traders Insight. It was a three part video interview. I thought that was rather Informative, we also have courses on Coursera, which I think are very well detailed and come complete with exercises and things of that nature to help with the learning progression, an introduction to bond basics, and we also have an entire ESG course and one that’s focused on ESG related assets or fixed income assets like those green bonds and social bonds and sustainability linked bonds.

And it goes into a lot more detail there, especially when you start breaking them out into things like climate. Bonds, et cetera. And I think that there can be a lot of interest in those in today’s environment, complete with examples and quizzes, and we can provide all of these links and it’s a great learning environment.

Cassidy Clement:

Great points. Thanks so much for joining us, Steve.

Steven Levine:

Thank you. Thank you for having me. I appreciate it. Thank you.

Cassidy Clement:

Of course. So as always, listeners can learn more about an array of financial topics for free at interactivebrokers. com and IBKRCampus. com. Follow us on your favorite podcast network and feel free to leave us rating or review. Thanks for listening, everyone.

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