December 16, 2019
We often hear that an investment portfolio should have an appropriate balance between stocks and bonds. While determining how stocks gain or lose value is relatively straightforward, bonds can be a little trickier. Cape Cod 5 Chief Wealth Officer Jason Lilly shares some of the basics to help you better understand how the bond market works.
1. Value fluctuates
Generally, face value (usually in increments of $1,000), coupon, and maturity date do not change. What does change is market value. Factors that influence market value include time until maturity, supply and demand, changes in credit, investor preference, covenants (the fine print when issued) and of course, changes in interest rates (or expectations of a change).
2. Interest rates and market value move in opposite directions
Think of a seesaw, if rates are on one side and market value is on the other - as one goes up, the other goes down. The longer the maturity, the greater the swing.
3. Duration is important
Duration is a measure of the bond's sensitivity to changes in interest rates -- approximately equal to the percentage change in price for a given change in yield. For example, a bond that matures in 10 years with a duration of seven years would fall roughly seven percent in value if the interest rate increased by 1 percent (all else equal).
4. Principal guarantee doesn't mean return of principal
If you buy a treasury bond at face value and hold to maturity, you will receive your initial principal back. Along the way you collected interest (coupon) payments. In reality, most bonds are bought and sold through the large and liquid secondary market, meaning the price may differ from face value. In today's environment most bonds are bought at a premium, or above face value, implying something less than invested principal will be returned at maturity. On the surface this seems like a bum deal, but in fact there is an advantage - higher interest payments. In a perfect world the differences net each other out.
5. Rising rates are not always bad
The largest contributor to long-term returns is the compounding effect of reinvested yield. Higher yields mean greater compounding and better long-term returns. Make sure your holding period (average weighted maturity) is in line with your goals. You can find maturity and duration data on your fund manager’s website, or ask your advisor.
Author: Jason Lilly, Cape Cod 5's Chief Wealth Officer
These facts and opinions are provided by the Cape Cod Five Trust and Asset Management Department. The information presented has been compiled from sources believed to be reliable and accurate, but we do not warrant its accuracy or completeness and will not be liable for any loss or damage caused by reliance thereon. Investments are NOT A DEPOSIT, NOT FDIC INSURED, NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY, NOT GUARANTEED BY THE FINANCIAL INSTITUTION AND MAY GO DOWN IN VALUE.