Why Government Bonds Could See You Through The Good Times And The Bad

16 mins

Why Government Bonds Could See You Through The Good Times And The Bad

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Why buy bonds?

If you’ve ever freaked out at the size of your student loan or bank overdraft, take comfort in the fact that the United States government owes $24 trillion – more than the entire US economy generates in a year. That US sovereign debt is owed to investors in the country’s government bonds some big ones, sure, but some simply normal, financially savvy Finimizers just like you.

As you may have figured out from reading Finimize news stories, bonds are essentially loans. Governments take them out in order to raise money for infrastructure spending, wars, or simply to pay back the interest on their existing loans. When an investor buys a bond, they’re lending its “issuer” money. In return, they get paid interest for a certain period of time. Plus, when the bond “matures”, they get their initial investment back too.

(Corporations, of course, issue bonds too – although most of them don’t use the proceeds to fund wars. We cover these – the bonds, not the wars – in a separate Corporate Bonds Pack, so be sure to check that out if you’re interested in learning more.)

Let’s say the US government issues a bond with a face value (or par value) of $100, a 1% coupon, and a 30-year maturity. In plain English, buying that bond will cost you $100, and you’ll be paid 1% of that amount each year (i.e. $1) for 30 years. 30 years from now, the bond will mature and the US will repay your $100 – leaving you with $130 in total. That’s a low return, but a reliable one – it’s extremely unlikely that the US government will “default” on its debt and fail to cough up, so you’re almost guaranteed to get your $100 back plus interest. Insulating you from losses in this way is one big reason investors like government bonds.

But it’s not the only reason – and nor do you have to be content with small potatoes. In the above example, you’ll make just $30 if you hold on to the bond for 30 years. But you could sell it on to someone else before then: government bonds trade in a lively secondary market, changing hands just like stocks. That means their prices fluctuate – so you might be able to sell your $100 bond for $110. Or you might find a bond with a $100 par value trading for $90 – and if you keep it until maturity, you’ll still be paid $100. That’s not to mention the $1 interest payments, which will now offer a higher yield (the ratio of coupon payments to a bond’s trading price) since 1/90 is a bigger return on investment than 1/100). Those price changes can open the door to a tidy profit: in fact, since the 1980s, some bonds’ prices have more than doubled.

That’s why many investors think government bonds form a key part of any portfolio: they offer returns, stability, and diversification away from stocks. In this Pack, we’ll give you a primer on the market – explaining how to evaluate government bonds, examining different investing strategies, and exploring the practicalities of getting involved. First off, however: what affects bonds’ prices?

The takeaway: Government bonds can offer security, diversification, and consistent returns – which is why they’re often seen as crucial to forming a balanced investment portfolio.

What makes prices move?

Government bonds get issued all the time. The US Treasury Department, for example, auctions off new bonds every few days, with maturity dates ranging from four weeks all the way up to 30 years.

The yield of a new bond is determined when it’s first auctioned, with investors submitting bids based on the prevailing central bank target interest rate at the time. In general, the longer the maturity, the higher the yield investors demand: we have no idea what the world will look like 30 years from now, so a bet on the US government’s long-term stability typically carries more risk than a bet on it still being around one year from now. As ever, investors need to be compensated for that increased risk with an increased return. At the time of writing, a one-year Treasury bill offers a yield of 1.595%, while a 30-year bond yields 2.375% (the US uses different terms – bill, note, bond – to denote different debt maturities).

Once the bonds are in investors’ hands they start trading on the secondary market, where their prices move based on macroeconomic factors. The primary driver, again, is the **interest rate *set by a central bank, which in turn affects the rate of interest available throughout an economy. If rates fall lower than a bond’s yield, that bond (depending on its maturity) may be a good investment: why put money in a bank account if the government will pay you more? Investors will likely buy those bonds, driving their price up and their yield – the coupon payment as a percentage of that price, remember – down. Similarly, if the government wants to issue new bonds after rates have gone down, it’ll want to take advantage of the new environment – so they’ll be issued at lower yields than the last batch. Of course, rising* interest rates tend to have the opposite effect. As a basic cheat sheet:

Falling interest rates = higher bond prices = lower bond yields

Rising interest rates = lower bond prices = higher bond yields

As discussed in our Pack on News and Markets, in reality prices tend to move before things actually happen – so bond prices often indicate what investors think is going to happen next to interest rates. That also explains why falling rates don’t always lead to lower yields. Investors might worry that lower interest rates will overstimulate the economy and spark excess inflation, which erodes the value of money (more on how that works in our Pack on Interest Rates). Inflation is toxic for bonds, as it makes their coupon payments and maturity repayment worth less over time. So when rates are lowered, longer-term bonds might see their prices fall as investors demand a higher yield to compensate them for the anticipated extra inflation. If inflation does eventually overshoot, however, the central bank will usually raise interest rates again to rein it in – meaning that long-term bond yields should end up reflecting long-term interest rates.

Because of the threat that inflation poses to bonds, some have protection built in: their coupon payments change according to inflation. These bonds, called Treasury Inflation Protected Securities or TIPS in the US, actually become more popular when inflation is high, driving their prices up.

The other big mover of bond prices is risk. Because the UK and US have never full-on defaulted on their debt, their bonds are considered an extremely safe investment. So when uncertainty is high – if, for instance, investors expect an imminent recession to cause the stock market to plunge – people retreat to that safety. Bond prices go up, and their yields go down (which, if a recession does hit, makes sense: the central bank will likely cut interest rates).

Investors are also sensitive to the individual riskiness of any given bond. If a country stops looking safe and a default becomes more likely, investors will demand a better return to compensate them for the added risk. So when a credit rating agency downgrades a country’s rating, its bonds’ prices will fall until their yield looks suitably juicy.

Greek government bond yields had to grow very juicy indeed to tempt investors in 2011…
Greek government bond yields had to grow very juicy indeed to tempt investors in 2011…

Bond supply is another factor that affects prices. If governments embark on big spending projects and issue lots of bonds to fund them, prices might be driven down. And if a central bank, trying to stimulate the economy, starts a quantitative easing program of buying up bonds, that’ll restrict supply and boost prices – part of the reason why bond prices have been on a tear since the last financial crisis.

All these factors influence a bond’s price between its issuance and its maturity date. But as that maturity nears, the bond’s price will gradually return to its par value: a week before maturity and with no coupon payments left, a $100 bond is only worth $100. Unlike stocks, which can gain in price and stay that way, bond price movements are transient – you can only benefit from them by selling before maturity.

Over time, you’ll spot recurrent patterns. Bonds are a “counter-cyclical” investment: they’re most popular in times of economic slowdown, as discussed – less popular during booms, when stocks offer better potential returns – and then back in vogue as the bustman comeths. And there are also longer-term trends. Bond yields seem to be stuck permanently lower than they were 40 years ago; a return to the 15% yields of the ‘80s seems unlikely.

But low yields don’t mean bonds aren’t worth investing in. Next, we’ll look at how you can analyze a given government bond to see if it’s right for you.

The takeaway: Higher interest rates, inflation, and increased risk drive bond prices down – which means bond yields rise. But price changes for any given bond are transient: at maturity, it’ll simply be worth its par value.

Analyzing bonds

There are a few numbers to look at when evaluating a bond. The first is its yield to maturity, or YTM. That gives you the annual yield on the bond, relative to its trading price, if you held it all the way to maturity – imagining that all its interest payments were reinvested (as investors often do) back into the bond at the same yield. YTM is often thought to be more useful than looking at just coupon value or yield, since it takes into account any gains (or losses) you might make from buying a bond below (or above) par value. But because it assumes reinvestment, it doesn’t give you a full picture of what the bond might be worth: if yields continuously fall while you own the bond, they won’t compound as effectively and your return might be lower than YTM suggests.

The other big number to assess is duration – which measures a bond’s price’s sensitivity to interest rate changes. Duration is a “weighted average” of the time you need to wait for both the payment of coupons and the return of your original investment, and is therefore linked to – but distinct from – maturity.

The longer a bond’s duration, the more coupons remain to be paid. The higher that figure – and therefore the more exposed the bond is to interest rate changes over time – the more its price will fall as rates rise (or rise as interest rates fall). Generally speaking, for every 1% change in interest rates, a bond's price shifts around 1% in the opposite direction per year of duration.

You should also look at the credit rating of the government issuing the bond. That’s less of a risk with big economies like the US, UK, or Germany, but if you’re investing in more exotic locales you need to be aware of the likelihood of getting your money back. That’s particularly true of emerging markets – which, as we’ll see in the next session, is one popular area for investment in government bonds. Argentina, for example, has defaulted eight times in the past 200 years. The ratings are put together by agencies, all of whom use different scales – you can find them here.

When you’re looking to invest in a bond fund, rather than individual bonds – more on that later, too – you’ll see the credit rating presented as an average of everything in the fund’s portfolio. That means it’s liable to change over time as the fund’s holdings change, and depending on how it’s calculated it may not give you a full idea of the fund’s profile.

Now you know what to look for when analyzing a bond, it’s time to figure out how to actually build a bond portfolio.

The takeaway: Yield to maturity, duration, and credit rating are three key things to consider when evaluating a bond.

Investment strategies

Just like with stocks, there are several major strategies for bond investing. Laddered portfolios distribute money equally across bonds with different maturity dates: you might have 20% in bonds that mature in one year, 20% in two-year bonds, 20% in three-year bonds, and so on. As the shorter-duration bonds mature, you buy longer ones, maintaining the ladder. This is a relatively conservative approach, as it reduces your exposure to interest rate risk: because your bonds are continuously maturing and the proceeds being reinvested, you’ll be investing across a range of interest rate environments rather than parking a monolithic chunk in a potentially unfavorable market. And you’ll also have regular income coming in, making it perfect for people like retirees who want predictability.

With a barbell portfolio, your money isn’t split across the whole spectrum of maturity dates. Instead, you invest at either end: half your money in short-term bonds (with a maturity of less than five years), and half in long-term bonds (those maturing in more than 10 or 15 years’ time). This dual-pronged strategy lets you take advantage of the better yields offered by longer-term bonds, while also giving you the freedom to adapt to the current interest rate situation when your short-term bonds mature. It’s a particularly useful strategy when interest rates are rising, because your short-term bond holdings can be rolled over into new, higher-yielding issuances.

Then there’s the excitingly named bullet portfolio, which invests everything in bonds with the same maturity date – typically intermediate-duration bonds (so it’s the exact opposite of the barbell approach).** **You’ll also tend to buy the bonds over a period of time, rather than all at once, in order to reduce your exposure to any one interest rate environment. For instance, you might buy one five-year bond today, and then next year buy some four-year bonds. If rates have gone up in between, you’ll have been right to wait. So if you know you’re going to need a big sum of money on a particular date – if you’re planning on buying a house in five years, for instance – a bullet portfolio can ensure you have the money when you need it. But it does mean that you won’t get the exposure to higher-yielding long-term bonds that the other strategies offer.

Choosing a strategy that’s right for you depends on your personal circumstances – whether you’re investing for the long term or know you’ll need the money in five years, for instance. But you should also look at the macroeconomic environment. Bond investors will often talk about the yield curve – a chart plotting bonds’ different maturity dates against their yields. When expectations for future inflation are rising, longer-term bond yields will rise more than shorter-term ones, so the yield curve will steepen – and when inflation expectations are falling, the yield curve flattens.

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When the yield curve is steepening, a barbell portfolio is very exposed: while half your portfolio is in short-term bonds that’ll gain in value, your longer-duration bonds are falling significantly more in price. In this scenario, a bullet portfolio invested in intermediate-term bonds that won’t change much should do better. But when the yield curve’s flattening, the opposite is true. A bullet portfolio won’t move much, but a barbell portfolio, which contains long-term bonds that’ll see their prices rise significantly, could do well. A laddered portfolio, of course, offers a more middle-of-the-road approach by exposing you to more of the entire yield curve.

All of these are semi-active bond investment approaches, but you can also invest in bonds in a manner more akin to stock trading: making bets on what’s going to happen in the future and how that might affect prices. If you think an emerging market’s about to experience booming growth and become less risky, you might think its bonds are undervalued and buy them now, only to sell in a few years for a higher price. Or you might predict falling interest rates, leading you to buy longer-duration bonds that will gain the most in price when rates fall. To do any of this, though, you’ll need to actually buy bonds. Press on to the final session to learn how to do just that…

The takeaway: There are different ways to construct a bond portfolio depending on what maturity exposure you want, with ladders, barbells, and bullets all popular.

How to buy bonds

Buying bonds isn’t quite as simple as buying stocks, but it’s not much harder. If you want to buy US bonds directly and are a US citizen, you can buy straight from the Treasury at TreasuryDirect.gov. UK citizens can similarly invest in auctions of UK government bonds, known as gilts, through the Debt Management Office.

An easier way to buy bond issuances, especially outside of your own country, is through your broker – and this is also the place to go for secondary market trading. Not all brokers offer bond trading, but with those who do, you can buy and sell just like you do stocks. You’ll have to pay transaction fees, however, unlike if you buy directly from the government.

A third option is to invest in a bond fund – a pot of money which buys a range of different bonds. The iShares Short Treasury Bond ETF, for example, invests in US Treasuries that mature in less than a year, while the iShares 20+ Year Treasury Bond ETF lets you invest in long-term bonds. Investing via a fund diversifies your portfolio, and also lets you take a more hands-off approach to bond investing. But the approach does have its downsides compared to buying individual bonds. A fund has no maturity date, and its managers tend to sell the bonds before maturity. That means that unlike buying an actual bond, where your initial investment is always relatively safe (bar inflation), a bond fund has the potential to lose you money.

Whatever you choose, many investors will find bonds to be a useful part of their portfolio. Ray Dalio’s All-Weather Portfolio (for more on which, see our dedicated Pack) has around 40% in long-term US bonds and 15% in 3-to-7-year Treasuries. Warren Buffett’s family money, meanwhile, is in a 90/10 portfolio: 90% in an S&P 500 tracker, and 10% in short-term government bonds. Buffett’s portfolio is riskier, but will grow more if stocks keep rising. If you’re younger and can afford to potentially suffer a setback on the road to retirement, that might be right for you; but as you get older, you might begin to favor the relative stability of bonds.

Thanks to this Pack, you’re now well placed to invest in them smartly – and help your government repay its debts at the same time, too…

In this Pack, you’ve learned:

🔷 Government bonds can offer security, diversification, and consistent returns – which is why they’re often seen as crucial to forming a balanced investment portfolio.

🔷 Higher interest rates, inflation, and increased risk drive bond prices down – which means bond yields rise. But price changes for any given bond are transient: at maturity, it’ll simply be worth its par value.

🔷 Yield to maturity, duration, and credit rating are three key things to consider when evaluating a bond.

🔷 There are different ways to construct a bond portfolio depending on what maturity exposure you want, with ladders, barbells, and bullets all popular.

🔷 You can either buy bonds directly from their government issuers, trade them on the secondary market, or invest in bond funds. Either way, bonds’ potential percentage of your overall portfolio depends on individual circumstances.

Now see how much you've learned with this quick quiz!

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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