Overview

Investing is not always about maximizing returns. Investors with shorter time horizons, or in their retirement typically need to reduce investment volatility in order to optimize the probability of reaching their financial goals. Bonds are the primary asset class to address that niche.

When investing in a bond, investors give a loan to the bond issuer. While the loan matures, they receive interest payments, and at the end of the investment, the bond issuer repays the principal. However, in investing, returns never come for free. Instead, investors are paid to take on risks, and bonds are no exception to this rule.

Similar to investments in stocks, the free market sets the prices, based on expectations of the future. But the various market participants rarely agree on the future outlook. Instead, market sentiment changes, based on economic signals, and the news cycle. Consequently, bond investments are prone to irrational price moves, not unsimilar to the stock market.

Types of Bond Investments

There are various ways to invest in the bond market. Just like investments in the stock market, investors can buy individual bonds directly from the issuer, or they can invest in funds that bundle multiple bonds together. In either case, there is a broad range of bonds to choose from. Bonds vary by bond issuer and quality rating, and, equally importantly, by their time to maturity.

Individual Bonds

There is an important difference between investments in stocks and bonds: While stocks can be held in perpetuity, bonds eventually mature, leading to the bond issuer returning the principal to the investor. It is worth pointing out that investors do not need to hold bonds all the way to maturity. Instead, bonds can be sold at any time on the secondary market.

A bond’s time to maturity is a crucial parameter of any bond investment and is tightly linked to the bond’s risk and return. Consequently, this parameter should be carefully managed, to meet the investor’s objectives. There are many ways to manage the maturity of bond investments. Most often, a bond ladder is used to continuously replace bonds, when their time to maturity declines below a chosen threshold. Furthermore, any interest payments not withdrawn as income should be re-invested as part of the regular bond management.

Of course, investors can manage their bond portfolio themselves. However, in times of low-cost ETFs, this effort provides only little reward. Instead, investors should focus their time and attention on picking the right combination of bond issuers and bond maturity. Therefore, I will ignore investing in individual bonds for the purposes of this book.

Bond Market Funds

Bond Issuers and Credit Rating

As discussed above, buying a bond is synonymous with giving a loan to the bond issuer. Consequently, the issuer’s ability to meet the obligations of regular interest payments and repaying the principal is of primary interest to the investor. We can distinguish the following bond issuers:

Bond Issuer	Representative ETFs
U.S. Treasury	FLGV, GOVI, GOVT, SPTB
U.S. Federal Agencies	AGZ, MBB, VMBS, GNMA, MBS, SPMB
U.S. Municipalities	SCMB, TFI, RVNU, JMUB, IMSI, MBND
U.S. Corporations (investment grade)	LQD, CORP, SPBO
U.S. Corporations (high-yield)	JNK, HYG, HYLB

U.S. Treasury bonds are backed by the full faith and credit of the U.S. government. Therefore, they rank among the safest assets in the world. It is important to note that this safety only refers to the issuer’s ability to make payments. Even though the probability of the U.S. government defaulting on its loans is extremely low, these bonds may still bear significant risk, depending on the bond duration.

U.S. Federal Agency Securities are bonds issued by those U.S. federal agencies that have been authorized by Congress to issue debt securities. While the U.S. Treasury does not directly back these, they are considered moral obligations of the U.S. government. Examples of these agencies are the Federal National Mortgage Association (Fannie Mae), or the Government National Mortgage Association (Ginnie Mae).

U.S. states and local political entities, so-called municipalities, also often issue bonds. In the case of General Obligation Bonds (GOs), they are backed by the issuer’s full faith and credit. Most often, they are secured by a pledge of taxes and are therefore very safe. In contrast, Revenue Bonds are secured by revenue received for the operation of functions, e.g., water, sewer, bridges, or tunnels. One aspect that makes municipal bonds stand out is their tax treatment: For residents of the issuing state, interest income earned from investing in municipal bonds is generally exempt from Federal and state income tax.

Companies in need of additional cash may issue corporate bonds. Secured debt securities are backed by assets of the issuing corporation. In contrast, unsecured debt securities are only backed by the reputation, credit record, and overall financial stability of the issuing corporation.

Typical ETFs invest in unsecured debt, and for such bonds, the interest paid largely depends on the risk of default: the lower the risk, the lower the interest paid. To make it easier to compare risk between issuers, bond issuers often use rating agencies, most importantly Standard and Poor’s or Moody’s. In broad strokes, we distinguish the following:

• Investment Grade
• High-Yield

Companies with a rating of BBB or higher are considered investment grade. Companies rated BB, or lower are known as junk grade. To avoid the negative connotation of this word, we also refer to these bonds as high-yield bonds.

The chart above illustrates how risk and returns relate to each other. U.S. Treasuries have the smoothest equity curve and the lowest downside – but also the lowest total return. On the other hand, high-yield bonds show significant drawdowns, but, at least during periods of economic growth, also offer the highest total returns.

Bond Maturity

Bond maturity, the time remaining until the bond issuer repays the principal, has a tremendous influence on the characteristics of a given bond: the longer the maturity, the higher the returns – and the volatility.

This relationship intuitively makes sense. Because planning becomes increasingly inaccurate as the time horizon increases, the future appears riskier, the further we look ahead. Consequently, investors have to be paid better to reward them for the risk they are taking.

The chart above compares U.S. Treasuries with various maturities. It is important to note that the various bonds are highly correlated. However, while all bonds make similar movements, longer maturities make larger swings, resulting in higher volatility.

Treasury Maturity	Representative ETFs
Money market: up to 1 year	BIL, BILS, OBIL
Short term: 1-3 years	VGSH, SHY, SCHO, SPTS
Intermediate term: 5-10 years	VGIT, IEF, SCHR, SPTI
Long term: 10-20 years	VGLT, TLH, SCHQ, SPTL
Extended term: 20-30 years	EDV, TLT

It is generally a good idea to separate interest-rate risks from issuer risk. Therefore, I am of the opinion that it is best to focus on Treasuries, when thinking about varying the bond maturity. The market of available ETFs echos that notion: while Treasury ETFs are available with a plethora of different maturities, bonds from other issuers offer much less variety. The table above shows some representative Treasury ETFs, sorted by their maturity.

Type	Exposure	Pro	Contra
Treasuries bonds	Debt securities issued by the US Treasury	* Backed by the full faith and credit of the US Treasury * Lowest risk of default	* Lower yields than bonds from riskier issuers
Federal agency securities	Debt securities issued by US federal agencies	* Backed by moral obligation of the US government * Low risk of default * Higher yields than Treasury bonds	* Riskier than US Treasuries * Lower yields than bonds from riskier issuers
Municipal bonds	Debt securities issued by US states and local entities	* Backed by municipalities’ tax power or project revenue * Preferred tax treatment * Better yields than bonds from federal agencies	* Riskier than bonds issued by federal agencies. This is especially true for revenue bonds
Investment-grade corporate bonds	Debt securities issued by corporation	* Backed by credit rating of company * Low risk of default * Higher yields than US Treasuries	* Riskier than bonds issued by US Treasury or federal agencies
High-yield corporate bonds	Debt securities issued by corporation	* Higher yields than investment-grade bonds	* Substantial risk of default
Short-term bonds (all issuers)	Debt securities with maturities of three years or less	* Low interest-rate risk	* Lower long-term yields than bonds with longer maturities
Long-term bonds (all issuers)	Debt securities with maturities of ten years or more	* Higher long-term yields than bonds with shorter maturities	* High interest-rate risk

Compare and Contrast

The table above compares the various ways to invest in the US bond market. Overall, higher returns can be achieved by either accepting lower credit rating or going with longer maturities. However, in both cases, the investment risks will increase.

Factors that Move the Bond Market

Interest Rates & Inflation

Investing in bonds is all about interest rates. And just like with the stock market, the bond issuer and the investor have opposing views on the investment. The bond issuer appreciates the utility the borrowed cash, while the investor prefers the profit made from the interest over time.

But investors neither need to purchase a bond directly from the issuer, nor do they need to hold it until maturity. Instead, bonds, or funds investing in them, are traded on the secondary market. Bond valuation puts a price tag on the bond’s future interest rate payments, and the repayment of principal. In a nutshell, this method sums up the net present value of all future cash flows.

One of the most important factors in bond valuation is the market interest rate. This is not the coupon rate paid by the bond, but the rate available when considering other comparable investments. This rate captures the expectation of future inflation, credit availability, and credit risk in a single number. And whenever this central figure changes, the bond valuation will follow.

Based on this, we can expect that inflation has a strong influence on bond market returns. However, because bonds mainly react to rate changes, we look at accelerating and decelerating inflation, instead of absolute readings. The table above demonstrates how bond investments suffer in inflationary periods and strive in in environments of falling rates.

It is important to note that the forward-looking market rate is not always rational. Instead, it is much influenced by economic sentiment, and the news cycle. And the longer the maturity of a bond, the more it will react to changes in the future outlook. As a result, bond investments are not free of risk. In fact, Treasuries with a maturity of 20+ years are almost as volatile as investments in the stock market.

Stock Market Volatility & Uncertainty

When the stock market turns turbulent, investors oftentimes seek to derisk their holdings. This flight-to-quality instinct leads to an increased demand for bonds, which, thanks to the dynamics of free markets, drives up bond prices. This is good news for investors already holding such bonds. However, investors seeking to rotate into bonds, will see their yields diminished.

The table above shows how the aggregate bond market returns are significantly higher than average in periods of rising stock-market volatility (as measured by the VIX index).

In our chapter regarding stock investments, we found that the equity market sees uncertainty in a negative light. The table above shows that bonds also react to economic uncertainty: in an environment of market uncertainty, bond returns run significant above average.

Economy

By statue, the Federal Reserve Bank has the task to maintain maximum employment and stable prices. The tools available to achieve this goal include open market operations, discount rates, and reserve requirements. In particular, we expect the Fed to lower rates in times of recession to support the economy. With that, we anticipate that the state of the economy has significant impact on the performance of bond investments.

The table above shows how bonds perform significantly above their average in times of recession.

Bonds as a Portfolio Component

Bond market investments offer decent returns, at much lower volatility than equities. However, bonds are certainly not a risk-free investment, and the returns fluctuate, driven by the very same factors that also move the stock market.

Interestingly enough bonds oftentimes react inversely to the stock market, making bonds a natural portfolio diversifier. We’ll talk more about this in the chapter about strategic investing.

The Monte Carlo simulation shows us what we should expect from bond investments. After about two years, we can have 95% confidence to break even. After investing for ten years, the 90% confidence interval spans from 3.0% to 7.3%. And after investing for twenty-five years, we should expect returns between 3.8% and 6.5%. We estimate typical deep drawdowns around 7%, and expect recover from such losses to take four years.

Investors should be pleased with the relatively smooth and predictable investment ride that bonds offer. Especially noteworthy, and significantly different than stocks, bond returns remain positive across all but the most extreme economic conditions. Having said that, and as 2022 proves, even bond investments should be managed to avoid deep drawdowns:

• stay away from high-yield bonds (and, to a lesser degree, investment-grade corporate bonds) in times of recession
• stay away from long-term bonds in times of accelerating inflation
• stick to Treasury Bills in times of high inflation

Also, many investors should probably take on more risk than an investment in the aggregate bond market offers. This is especially true for individuals with a long investment horizon. Consequently, an all-bonds investment will only fit very few investors. Instead, at least a small percentage of the portfolio should be allocated to riskier asset classes. Here, stocks are an obvious pick due to their mostly negative correlation with bonds.