Abacus: Trust In Bond Investments
As the second quarter of the year begins, the stock market continues to stagger as trade tension between the Trump administration and China escalates. Investors face uncertainty as tariffs on Chinese imports, those enacted and proposed, and China’s tariffs on U.S. agricultural exports will undoubtedly affect stocks relevant to these industries. As such, investors have given the bonds market more attention as of late. With more government spending to be implemented and the Federal Reserve’s plan to increase interest rates more regularly, this may be the right time for you to diversify your investment portfolio with bond investments.
For those unfamiliar with how the bond market works, the government and various companies issue fixed-income securities, or debt securities, known simply as bonds. You may purchase these bonds through brokers and mutual funds, or directly from the U.S. Treasury Department which is exclusive to government securities. By purchasing the bond, you essentially loan these issuers the funds indicated on the bond known as the face value of principal of the bond. These funds are used by the issuers for various operations, from business expansion to public projects. As a bondholder, or creditor, you are paid a contractual interest for the bond called the coupon rate. This interest is received periodically for the duration that the issuer uses these funds until the bond matures, at which time the principal will be paid back to you.
Some more well-known government securities include treasury bonds (T-bonds) and treasury notes. A main difference between the two bond types is that T-bonds have periods of duration, or maturity, that are longer than those of treasury notes. Common T-bonds could have a maturity of 10 or 30 years while treasury notes could have a maturity of two, three, five, or ten years. Interest payments for the treasury notes and T-bonds are paid semi-annually until the bonds maturity date.
A treasury bill (T-bill) is another type of government security which differs from those previously mentioned in that the maturities for this bond type are much shorter at one month, three months, six months, or one-year maturity. Another difference between T-bills and other government securities is that due to the shorter maturities, the interest collected on the bond isn’t paid to the bondholder until the time it matures.
Treasury inflation protected securities (TIPS) are the last type of government security that differ even more from the other securities as they’re the only ones that protects against inflation. The principal for the security is adjusted for inflation semi-annually when the bondholder receives their interest payment. It’s worth noting that with TIPS, only the amount of the face value changes when inflation rises or falls while the interest rate remains fixed.
These government securities benefit from being low-risk investments since they’re backed by the U.S. government and hence are unlikely to default. They also have the added benefit of being exempt from state and local taxes, having to only worry about being taxed at the federal level. Bonds are also very liquid assets, having the ability to be converted to cash quickly with hardly any effect on its sales price.
Although these are considered very safe securities, bonds issued by the Treasury Department have a constant but minimal return rate. As such, bonds with a higher interest rate are more sought out in the bonds market. Interest rates and bonds also have an inverse relationship, where the change in interest rates affects the sales price of the bond – not to be confused with the bond’s face value which remains unchanged. Essentially, the sale price rises when rates decrease and falls when rates increase.
Investors can see this very clearly in the current bond market as it reflects recent federal actions. The Federal Reserve increased rates by 0.25 percent last month, which is realized in the bond market as an increase in coupon rates and can be seen in the one-month and one-year maturity rate graphs depicted before. Concurrently, the Treasury Department is auctioning off almost $154 billion in securities in the coming week which reflects only a portion of the near $1.3 trillion deficit in large spending deals that have passed through Congress in the past several months. Hence, these new securities will become highly desirable and sought after as they are issued at the highest coupon rate in the market. As for older government securities at lower coupon rates, their sales price drops as attention is shifted towards government bonds with higher returns.
This is very advantageous to investors who own bonds with short maturities such as treasury notes and T-bills, as the addition of new securities with high returns in the market is less detrimental to bonds with short durations than bonds with long durations. Since government securities have a fixed-interest, those with longer durations with a set coupon rate must deal with diminishing yields for their entire duration while interest rates continue to increase for newer securities issued. However, there are still market conditions where securities with longer maturities prevail over others. If predictions that inflation will rise quicker than interest rates persists, investors will find TIPS to be especially beneficial since longer maturities are adjusted for inflation. Moreover, the government’s increasing need to borrow due to the growing deficit challenges the Treasury Department to issue new T-bonds with higher yields.
Yet the bond market has other options available to investors looking for greater returns in exchange for a bigger risk investment. Corporate bonds work similar to government securities except they are issued by individual corporations. This makes corporate bonds riskier as the yield is dependent on the success of the corporation’s operations. Investors can suffer a loss on their corporate bond investment should the corporation experience challenges that decrease their revenue or worse, cause them to default on the loaned funds. Though even if the company were by some misfortune left with little choice other than to file for bankruptcy, they are held accountable to pay back their investors before its stockholders – making it a safe investment nonetheless. Thus, corporate bonds have higher interest rates than those backed by the government to offset the high-risk investors take with their business.
The choice for which government security to add to your portfolio depends on your requirements as an investor and how those requirements meet predictions for inflation. Investors can infer if there’s rising inflation by reviewing the Fed’s plans on raising interest rates as well as looking to the Bureau of Labor statistics report on the Consumer Price Index – the Fed’s main tool to indicate whether inflation rates are rising. Even though the Fed has decided to increase rates more regularly, the Treasury Department is still outpacing them by how fast they issue government securities due to the sheer amount of government spending planned. Thus, it would be in a bond investor’s best interest to stay abreast of the Treasury’s auctions for securities. With these fiscal changes on the way, the bonds you choose to invest in will ultimately depend on how patient you are for your returns.