Confessions of a Math Nerd: Why Bonds are So Fascinating
May 29, 2018
By Michael List
I decided to specialize in the investment profession because I am what some would call a ‘math nerd’. The investment world is full of numbers and formulas, financial statements, ratios, equations, prices and yields. And, the bond market, in particular, has its own special world of bond math. The first thing I noticed when I started working is bonds are priced in fractions (99-29/32) rather than decimals (99.9063). The real world is a big difference from textbooks in school.
What is a Bond?
A bond is a form of investment that is essentially a loan to a corporation or government, who will pay back the funds in a set amount of time, at a variable or fixed income rate. Bonds are used by companies and governments to raise money; meanwhile investors like them because they are a relatively low-risk investment option.
Bond Prices and Interest Rates
Next — and probably the most significant concept for new bond investors — is understanding the inverse relationship between bond prices and interest rates. Simply, when interest rates decline, the value of an existing bond goes up, and when rates rise, existing bond prices go down. This is usually illustrated by a teeter-totter with prices and rates on opposite sides. As rates go up, prices go down and vice-versa.
Now if you're a bond investor, once you grasp this concept your first impression may be, "Rising rates are bad, right?" Well, not exactly. The chart below (from PIMCO) shows what would happen to the bond market if interest rates rise by 1%. As expected, as rates rise, falling prices lead to a loss of 1.8% during the next year. But, over the next 3 and 5 years, the higher interest rates cause new bonds to pay more income, which helps offset the negative impact of the initial price decline.
Another interesting thing about bonds? How well they work with stocks in a blended portfolio. The next chart, from Fidelity, shows that the stock market has declined in 24 of the last 90 years. Not surprisingly, the bond market produced better returns than stocks in every one of those down years. Even better, over 80% of the time when stocks declined, bonds produced a positive return.
So what does this mean for portfolios? Interest rates have risen in 2018 with the 10-Year U.S. Treasury rate now around 3.0%, so bond prices declined since the start of the year. Going forward bond portfolios will produce more income for investors. We do not expect rates to continue to rise at the same pace we have seen the last five months (the current Treasury rate of 3.0% is not far below the median rate of 3.9% since 1871 according to data from Robert Shiller). In addition, bonds remain a good complement to stocks and provide further diversification.
If you would like to have a “dry” conversation about the bond math discussed in this article — or something more interesting, such as how today’s higher income will affect your financial goals — meet with an advisor today.