Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

The death of bond investing has been greatly exaggerated

Noting that 2022 was a bad year for bonds is a little like saying George Santos told a couple of fibs. The Bloomberg Aggregate Bond index, a broad measure of bonds that might be held in a typical American portfolio, lost over 13 percent in 2022. The epic decline in traditionally conservative assets had no historical precedent, and many investors chose to bail on bonds.

The environment in 2023 is radically different and opportunity beckons as interest rates stabilize and a possible recession looms. Investors should consider including fixed income in a balanced portfolio, but the bond market remains something of a mystery to many people. Here’s an explainer.

A bond is a loan structured under defined terms that grants each investor (or bondholder) certain rights and guarantees in exchange for the use of their capital for a specified period. Unlike stock which can only be issued by corporations, bonds can be sold by numerous entities including corporations, governments, agencies, municipalities and even mortgage originators. In fact, bond issuance is so prevalent that the total value in the US exceeds $53 trillion in over 1 million individual issues outstanding, compared with around 15,000 traded US stocks valued at $52 trillion.

While many investors express some confusion about bonds, they really are fairly simple and behave according to a mathematical relationship among a few key elements, unlike stocks which can vary sometimes inexplicably.

Maturity. Bonds are typically issued with a fixed maturity date upon which the agreement terminates, ranging from less than 1 year to 30 years or more. The bond pays a final payment on the maturity date and then ceases to exists.

Par or face value. Bonds are issued in specific denominations, most often $1,000 for corporates and municipals but larger denominations for US Treasury bonds. The par value is the amount the bondholder is promised to receive at maturity and is used to determine interest payments.

Coupon rate. This is the annual interest rate paid to the bondholder through the date of maturity. Annual interest due is the product of the par value times the coupon rate and is usually paid out twice per year. For the vast majority of bonds, the coupon rate is fixed at issuance and does not change, although there are some bonds that carry variable interest rates.

The term “coupon” is a throwback to the days when bond certificates came with detachable coupons that were presented or redeemed at the bank every 6 months.

See, easy. The standard bond is just a simple interest loan contract with a balloon payment of principal on the last day. Issuers set the coupon rate at original issue in what is called the primary market based upon the prevailing rate of interest for bonds of similar maturity and credit risk. Where it gets tricky is when existing bonds change hands.

Bondholders may choose not to keep their bonds until they mature but may wish to sell them in the secondary market. But by then, a couple of things have likely changed. One is that the maturity is shorter as time has passed. The other and far more important factor is the movement of interest rates since the original issue. Never has there been a better illustration than in 2022, as the Federal Reserve’s benchmark interest rate rose from 0.25% to 4.75%, an unprecedented 1,700 percent increase.

Suppose you had purchased a brand-new Johnson & Johnson bond at issue in 2020 with a $1,000 par value, a 30-year maturity, and a coupon rate of 2.25%. Had interest rates remained constant, you should be able to unload the bond at par value since buyers would be indifferent to a “new” or “used” bond that paid the same 2.25% and would receive $22.50 per $1,000 bond each year either way as well as the same $1,000 face at maturity.

But of course, rates did not remain constant but spiked dramatically, so your pathetic 2.25% bond doesn’t look too appealing in a world where a comparable new issue by J&J pays 4.5%. In order to unload the 2020 bond you would have to take a haircut sufficient to make the buyer’s return equal to what they could get by just buying the new issue. In our example, the J&J bond is currently trading at $675, a 33% discount from the $1,000 par value. You could of course avoid a loss by holding to maturity and collecting your full par value. See you in 2050.

That explains why so many investors experinced painful paper losses on their statements even though they did not sell any bonds. Stock and bond values are adjusted in real time for market value fluctuations.

Last year was the mother of all outliers in the bond market. Now that the Fed tightening cycle is nearing its end, bonds are looking more compelling. Any further rate increases during 2023 will be small in reference to the current level, and interest income is now much more attractive. In addition, assuming more economic weakening, fixed income should once again provide the haven from stock volatility that was so conspicuously absent last year for reasons that are now clear. And once interest rates begin to decline on the backside of the economic cycle, bonds may provide capital gains as well as attractive income.

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