Bond Buyer Basics

April 18, 2024

Sooner or later, every serious investor confronts two important questions: 1) what are bonds, and 2) how do they fit in my portfolio? The following discussion should help answer these questions, but I must warn you—bonds are complex.

Personally, I love bonds because they are so quantitative. It was their complexity that drew me to them when I first started my career as a bond trader and then later as a bond portfolio manager. If bond complexity overwhelms you, don’t worry. Just find an advisor who understands them.

A bond is a debt instrument. When someone issues a bond, they effectively borrow money from whoever buys the bond. A bond is a contract stipulating three essential commitments:

  1. When the bond issuer will repay the bond holder (the bond’s “maturity date”);
  2. How much money the bond holder receives at the bond’s maturity (the bond’s “principal”);
  3. The periodic interest payment the bond issuer makes to the bond holder (the bond’s “coupon”).

The secret to valuing a bond is understanding its future cash flows. To value a bond, each contractual cash flow is discounted to its present value using current market interest rates. The value of the bond is the sum of all those discounted cash flows. As market rates go up, the present value of the bond’s future cash flows (and hence, its price) goes down; as interest rates fall, the present value of the bond’s future cash flows (and hence, its price) goes up.

Simple, right? (I warned you.)

Taxes add another layer of complexity. Some bonds have unique tax advantages. For example, income on U.S. Treasury bonds is exempt from state taxes, while income paid on municipal bonds is exempt from federal taxes. If you live in California, interest income from bonds issued by California municipalities is exempt from both state and federal taxes. Corporate bond interest, however, is taxed by everyone.

Not all bonds are equal. Some bond issuers are “investment grade”, meaning they have very good credit. Others have poor credit and are often referred to as “junk” or “below investment grade”. In most cases, the lower the quality, the higher the yield on the bond.

There are several reasons you might want to invest in bonds.

First, bonds represent a senior claim on the assets of the issuing company, so they give you greater security than you can get from owning the company’s stock. If the company were to slip into bankruptcy, bondholders get first call on the company’s assets. Because of their senior claim, bond returns are usually lower than equity returns.

Second, bonds provide more income that stocks.

Third, bond prices are usually less volatile than stocks, so they can help stabilize the value of a portfolio.

If you decide bonds are a good fit for your portfolio, the type of bond you buy will depend on what type of account you have and which bonds produce the best after-tax returns. Under normal circumstances, you would never put a tax-free municipal bond in an IRA. However, if you are working with a taxable portfolio, tax-free municipal bonds might make sense. The only way to know is to compare the municipal bond’s taxable-equivalent yield with the yield on comparable taxable bonds.

You can calculate a municipal bond’s taxable-equivalent yield by dividing its yield-to-maturity by one minus your marginal tax rate. For example, at the time of this writing, AA-rated California municipal bonds with five years to maturity yield around 2.76%. If my combined state and federal marginal tax rate were 43%, the municipal bond’s taxable equivalent yield would be 4.84% (2.76 / .57 = 4.84). A corporate bond of similar quality and maturity yields 4.85%, so the municipal bond is an equivalent value to the corporate bond. Note that if your combined state and federal tax rates were less than 43%, the municipal bond’s taxable equivalent yield would be much lower than the corporate bond yield.

A final word of caution: the bond market can be difficult to navigate. Since bonds are traded over-the-counter, their prices are not transparent so you have to shop carefully. Another challenge is that bond structures can be very complex. If you decide to invest in bonds, it pays to work with an advisor with significant bond experience. For most people, a better approach would be to stick with a well-managed bond mutual fund or exchange-traded fund.

 

Please see important disclosure information here.

Steven C. Merrell  MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have about financial planning and investments. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to smerrell@montereypw.com.