Bond Concepts Series

This series discusses the nuances of fixed income investing, including the risks, opportunities, and investment styles. Topics include:

Bonds Are Back: Where to Find Value Ahead of Potential Rate Cuts

In this article, we revisit arguments discussed in "Yield Curve Scenario Analysis: Using Duration and Bond Math to Measure Return Potential" and "Why Accept More Risk for Comparable Yield?" and introduce additional insights for our readers.

Yield to Maturity: The Yield That Matters

In fixed income investing, there are several different ways to measure an individual bond’s ability to produce income. Three of the most often cited measures are a bond’s coupon rate, current yield, and yield to maturity. Each measure has its place, but which matters the most?

Correlation: The Importance of Quality in Fixed Income Allocations

In portfolio construction, understanding how each investment or asset class complements one another can be your most valuable ally. Correlation can be analyzed between asset classes but also between segments of the same asset class. Within fixed income, for instance, credit quality will often dictate the relationship between a bond portfolio and the equity market.

Why Bonds Now?

Traditionally, fixed income has played three important roles in asset allocation: principal preservation, steady income, and risk reduction. However, pandemic-induced monetary and fiscal stimulus decreased the appeal of bonds due to low yields and interest rate risks. Today, these key attributes of bonds have returned, and investors can expect their fixed income allocation to fulfill its traditional role in a portfolio.

Interest Rate Risk: Understanding Duration and Convexity

Most people look at a bond’s maturity to gauge the security’s risk. However, maturity only looks at the time until repayment of principal. To accurately measure a security’s risk, both principal and coupon payments must be considered. The use of two metrics better defines a security’s risk: Duration and Convexity.

Cash and Money Market Funds vs. Bonds: Which is Better?

In an environment where short-term yields are the same or higher than long-term yields, many investors are replacing traditional bond investments with cash. While both financial instruments are perceived to be “safe,” investors should consider two important factors when determining which is best for their portfolio: total return potential and reinvestment risk.

Why Accept More Risk for Comparable Yield?

Many assume that longer-duration strategies will offer greater yield and total return potential than intermediate-term strategies. However, analysis of current valuations and historical performance patterns tells a different story.

Credit Analysis

History has taught us that even highly-rated bonds can quickly experience deteriorating credit quality and wreak havoc on a portfolio. Naturally, credit quality becomes a focus in weakening market conditions, but the importance of credit research in all market conditions must be considered.

Active Management of Bond Risks

Building a bond portfolio is more complex than simply buying bonds and holding them to maturity. Understanding the risks in fixed income can help an investor avoid pitfalls while optimizing opportunities in pursuit of long-term goals. We discuss the most common examples.

Liquidity

Imagine a crowded room with just one exit. If everyone suddenly had to leave, those close to the exit would be fine, but it would be chaotic for others. This is similar to bond liquidity, which is like the available exits. When bonds are highly liquid, investors can smoothly come and go without a hitch. But when liquidity is low, it's like many investors trying to exit through one door. This article delves into bond market liquidity and its effects.

Yield Curve Scenario Analysis: Using Duration and Bond Math to Measure Return Potential

The recent challenges faced by bond investors stem from a prolonged period of low interest rates, followed by a significant shift in Federal Reserve policy. Now, with the 10-year Treasury yield nearing 5% and the Fed suggesting that rates may be reaching their peak for this cycle, investors are curious about future bond market returns. To demonstrate the total return potential in fixed income, we analyze four potential economic scenarios that may play out over the next 12-18 months.

Municipal Bonds

Municipal bonds make up nearly 10% of the investment grade bond market. The $4 trillion in municipal debt is issued by government entities to cover expenses and finance projects that significantly benefit the public. This paper provides an overview of Municipal Bonds, highlighting their tax advantages, illustrating with examples, and exploring their intricacies.

Active Bond Management	An approach to buying and holding bonds which applies any number of disciplines to attempt to produce returns in excess of passive management in which bonds are simply held to maturity.
Asset-Backed Securities (ABS)	Bonds made up of a collection of consumer debts.
Agencies	A bond or other debt security issued by a government agency or government-sponsored agency such as Freddie Mac or Fannie Mae, and are the highest quality debt securities after Treasuries.
Barbell Structure	A bond portfolio comprised of short and longer-term bonds, whose average produce a portfolio with an intermediate maturity, which will react to market conditions in a manner that differs from a portfolio of intermediate bonds.
Bullet Structure	A portfolio of bonds whose individual maturities are similar in term.
Callable Bond	A bond that an issuer can retire prior to its maturity date.
Convertible Bond	A bond which contains an option for exchange for a fixed number of shares of the bond issuer’s common stock.
Convexity	The rate of change in a bond’s duration, a refinement of duration which reflects the change in a bond’s price that is not accounted for or predicted by duration.
Coupon Rate	The annual interest paid on a bond, based on a percentage of its par or face value.
Current Yield	A snapshot measure of yield, measured by coupon divided by current price.
Default	When a bond issuer fails to make required interest or principal repayments.
Duration	A measure of interest rate sensitivity. For example, a portfolio with a duration of three years would be expected to rise 3% if interest rates were to fall 1%. It is measured in years because it can also be used to measure the time it takes to recover one’s original investment taking all cash flows into account.
High-Yield Bonds	Also known as junk bonds, high-yield bonds are bonds issued by companies that are considered to be at a greater risk of failing to make interest and principal payments on schedule.
Mortgage-Backed Securities (MBS)	Bonds made up of a collection of residential or commercial mortgages.
Spread	The yield difference between a Treasury bond and a bond of the same duration that has additional risks, such as a corporate bond.
Total Return	The actual rate of return realized over some evaluation period. Considers all sources of return: coupon interest, interest on coupon interest, and any capital gain/loss.
Tracking Error	The divergence in performance between a portfolio and the index it was intended to replicate.
Volatility	The degree of variation of returns for a given security or market index.
Yield Curve	A graph showing the various yields of similar types of securities that vary in their maturity dates. A flat yield curve is one in which short-term bonds have yields similar to longer bonds.
Yield to Maturity	The rate of return on a bond calculated on the basis of purchase price, redemption price, the total interest payments, and the number of months or years until maturity. The yield to maturity is greater than the current yield when the bond is selling at a discount, and less when the bond is at premium.

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