A safer way to build a bond portfolio

April 21, 2023

Q: My supposedly safe bond portfolio was hit really hard last year. Can you please explain why something that was supposed to protect me got hit so hard and what I can do to keep from making that mistake again?

A: 2022 was one of the worst years in history for the U.S. bond market. Fortunately, the bond market is doing much better this year. In fact, with inflation moderating and the economy starting to slow down, some analysts are predicting that the Fed will start cutting rates in the next 12 months. In anticipation, market interest rates have already fallen below their recent peak levels driving the bond market 2.5 percent higher in the first quarter.

You ask why bonds did not provide the safety you expected. The answer requires a brief explanation of what bonds are and how they work. We can then explore how to make sure you do not get blind-sided by them again.

A bond is a contract between the bond issuer and the bond holder. There are many types of bonds, but in its simplest form, the bond issuer (typically a corporation or a government entity) promises to make a series of future payments to the bond holder. These payments include periodic payments over the life of the bond called the bond’s “coupon” and a large lump-sum payment called the bond’s “principal” due at the bond’s maturity.

A bond is priced based on the financial concept of present value. Financial theory tells us that a dollar received in the future is worth less than a dollar received today. You can gain an intuitive grasp of this idea by asking yourself which you would prefer: $100 right now or $100 ten years from now. Most of us would prefer immediate payment.

Financial theory also tells us that we can determine how much that ten-year time difference is worth by calculating how much we would have to invest today at a market rate of interest to have $100 in ten years. This is the point of indifference between the two options and is called the present value of the future payment. The further a payment is in the future or the higher the market rate of interest used to calculate the point of indifference between payment today and payment in the future, the lower its present value.

Now here is the important part: The market value of a bond is equal to the present value of all the future cash flows associated with that bond. If market rates go up, the present value of those future payments goes down. If market rates go down, the present value of those future payments goes up. The relationship is simple and predictable.

If safety in bonds is of paramount importance for you, this information can help you in two ways. First, since bond cash flows are contractually defined in terms of amount and timing, you can design a bond portfolio that will deliver exactly the cash flows you want when you want them. It may cost you something in terms of reduced long-term returns, but you do not have to guess if the cash is going to be there when you need it. This portfolio construction technique is called portfolio immunization. Note that you do not need to immunize your entire portfolio. You can set aside a portion of your portfolio to immunize those future cash flow needs that are essential to your well-being.

Second, if you have an immunized portfolio, you do not need to worry about the value of the bond portfolio moving with changes in interest rates. The portfolio value will change as market rates change, but the cashflows you need will be there when you need them. With an immunized portfolio, the interim changes in market value are unimportant. If this sounds interesting to you, your advisor should be able to help you design an immunized portfolio.

For portfolio immunization to work properly, the bond issuer must meet its financial obligations under the bond agreement. Failure to do so is called a default. You can minimize the risk of default by only using high quality bonds, preferably US Treasury obligations. Your advisor should be able to help you keep the credit risk in your portfolio to a minimum.

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Steven C. Merrell  MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey.   He welcomes questions you may have concerning investments, taxes, retirement, or estate planning.  Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to smerrell@montereypw.com.