Bond Market Basics

Why Invest in the Bond Market?

Financial Advisors usually suggest that investors allocate some percentage of their investment portfolio to the bond market. The general rule of thumb on bond allocation is referred to as the 100-your age rule: So this rule for a 30-Year old would indicate that 100-30=70 suggesting a 70% allocation to equities. The balance or 30% would be invested in the bond market.

This rule indicates that as the investor gets older, the allocation to equities (more risky) should decline and a larger percent of the portfolio should be invested in bonds (less volatile and less risky). Advisors are drawn to the positive attributes of the bond market which are sometimes referred to by the mnemonic SLY:

• S: Safety
• L: Liquidity
• Y: Yield

The Bond See-Saw

Bond prices and the level of interest rates move inversely. This is referred to as interest rate risk.

As shown in the see-saw diagram, when interest rates fall bond prices rise. On the other hand, when interest rates rise bond prices fall. This is the case because most bonds have fixed coupons which means that when market interest rates change, the current rates move away from the bond's coupon rate. Therefore the bond price needs to adjust so that they remain in line with market interest rates.

Pros and Cons of Bond Market Investing

In this chart we are discussing the largest bond market-US Treasuries.

Other large segments of the US Bond market other than US Treasuries are:

• Municipal Bonds
• Corporate Bonds
• Mortgage-backed Securities
• US Agency Bonds

Key Terms Used in US Bond Market

The Basics of Bond Duration

Duration measures a bond's interest rate risk given its maturity, yield, and coupon. It is the weighted average time (in years) before the bondholder would recoup a bond's cost based on the Present Value of future cash flows.

Bonds with the highest durations have:

• Long maturities
• Low coupons

For example, zero-coupon bonds have durations that equal their maturities.

Bonds with low durations have:

• Short maturities and/or
• High coupons

There are two main types of duration:

1. Macaulay Duration (the metric in years described above)
2. Modified Duration

Modified Duration measures the price sensitivity when there is a change in the yield to maturity. It takes Macaulay Duration and divides that number by 1+Yield to Maturity over the number of coupons per year.

Higher duration bonds are more sensitive to movement in interest rates (have higher price volatility) than shorter duration bonds. In our example on the left our 3-year 4% bond which is trading at 4.25% YTM would have a market price of $993.03 and a Macaulay Duration of 2.9 and a Modified Duration of 2.8. So it interest rates moved by 1%, this bond's price would change by 2.8%.

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"Bonds as an asset class will always be needed, and not just by insurance companies and pension funds but by aging boomers." - Bill Gross