Understanding Bond Investing: A Foundation for Investors
May 26, 2025
Understand the basic tenets of bond investing.
Understanding Bond Investing: A Foundation for Investors
Fixed income investments play an important role in diversified portfolios, providing opportunities for income generation, capital preservation, and portfolio diversification. This article explores the basic tenets of bond investing to help build a foundation of knowledge about this essential asset class.
In our follow-up piece, Bonds in Transition: Adapting Fixed Income Strategies for Today's Volatile Markets, we'll examine how bond portfolios performed during recent market challenges and provide strategies for navigating changing economic conditions.
The Role of Fixed Income in Portfolios
Fixed income can play several important roles in an investment portfolio, though the specific allocation will vary based on each client's unique situation. For many investors, bonds provide some combination of steady income, capital preservation, and diversification against stock market volatility. Think of bonds as the reliable foundation of a well-constructed financial house—not as eye-catching as the decorative elements, perhaps, but providing stability to the overall structure.
(For a deeper exploration of how these traditional roles have been tested in recent market conditions, see our companion article Bonds in Transition.)
What Exactly Is a Bond?
Before diving into today's complex market environment, let's establish a clear understanding of what a bond actually is.
At its core, a bond is a debt security that represents a loan. When you purchase a bond, you're lending money to the issuer—whether that's a government, municipality, or corporation for a defined period of time. In return, the issuer promises two things:
- Regular interest payments (called "coupons")
- Return of your principal investment when the bond matures
For example, if you purchase a $1,000 bond with a 4% coupon rate and a 5-year maturity:
- You'll receive $40 per year in interest ($1,000 × 4%), typically paid in two $20 installments every six months as most bonds pay interest semi-annually.
- After 5 years, you'll get your $1,000 back (the “loan” is repaid)
This contractual arrangement provides the predictability that makes bonds valuable, but also creates vulnerabilities in certain economic environments, particularly during periods of rising interest rates or inflation. We'll explore these risks in more detail later in this article.
Bond Basics: How Pricing Works
Bonds trade in the secondary market at prices that can fluctuate above or below their face value:
- Par (100): The bond trades at exactly its face value ($1,000 for a $1,000 bond)
- Premium (>100): The bond trades above its face value ($1,050 for a $1,000 bond)
- Discount (<100): The bond trades below its face value ($950 for a $1,000 bond)
When interest rates rise, the prices of existing bonds typically fall. When rates fall, bond prices typically rise. This inverse relationship is fundamental to understanding bond market behaviour.
Why does this happen? A bond's price reflects the value of the income it provides through regular coupon payments. When prevailing interest rates fall, existing bonds with higher coupon rates become more attractive because they pay more income than newly issued bonds. Investors are willing to pay a premium for these higher-yielding bonds. Conversely, when interest rates rise, existing bonds with lower coupon rates become less attractive compared to new issues paying higher rates, causing their prices to fall and trade at a discount.
Key Risks Every Bond Investor Should Understand
Understanding the specific risks in fixed income investing is essential for building resilient portfolios:
Inflation Risk
Inflation erodes the purchasing power of fixed interest payments. When inflation rises, bonds with fixed coupons become less attractive because those payments buy fewer goods and services.
Interest Rate Risk
When interest rates rise, existing bonds with lower coupons become less valuable compared to newly issued bonds offering higher rates. This inverse relationship between rates and prices is a fundamental principle of bond investing.
Understanding these risks isn't merely theoretical—they materialized significantly during the market volatility of 2022, when both bonds and equities declined simultaneously. Our companion article explores how these risks manifested in real market conditions and offers strategies for addressing them.
Duration
Mathematically, duration represents the weighted average time it takes for an investor to receive all the future interest and principal payments they are entitled to. Duration is used to measure a bond's sensitivity to interest rate changes, expressed in years. For example, a bond with a duration of 5 years would lose approximately 5% of its value if interest rates rose by 1%, or gain about 5% if rates fell by 1%.
While related to a bond's maturity, duration is typically shorter because it accounts for both the final principal payment and the interim coupon payments. Higher coupon payments decrease duration, reducing interest rate risk, while lower coupons increase it.
How Duration Affects Bond Price Changes:
As this table illustrates, bonds with the same maturity but different coupons have different duration, and therefore different price sensitivity to interest rate changes.
This measurement helps investors anticipate how their bond holdings might perform in different interest rate environments and can be calculated for individual bonds or entire portfolios.
Credit Risk
This is the risk that a bond issuer will fail to make interest or principal payments when due. Bonds with higher credit risk typically offer higher yields to compensate investors for taking on this additional risk.
The Fixed Income Landscape
The bond market encompasses a diverse range of securities with varying risk and return characteristics:
The Risk/Return Spectrum
Different types of bonds offer varying levels of risk and potential return:
Credit spreads—the additional yield investors demand for taking on credit risk above risk-free government bonds—fluctuate based on economic conditions and investor sentiment. These spreads are an important barometer of how the market is pricing risk.
Foreign exchange risk is a key consideration when investing in bonds outside of Canada. When currencies fluctuate, the returns on foreign bonds can be impacted. If a foreign currency weakens against the Canadian dollar, both your interest income and principal investment may lose value upon conversion, potentially erasing gains. This is why most actively managed fixed income funds hedge to the investor’s home currency.
Understanding the Bond Market Opportunity Set
The fixed income universe offers a range of opportunities:
1. Income generation: Bonds provide regular interest payments that can be particularly valuable for retirees or those seeking steady cash flow.
2. Diversification benefits: Bonds generally have a low correlation to equities over long periods.
3. Capital preservation: High-quality bonds held to maturity offer a return of principal.
4. Total return potential: A comprehensive approach to bond investing can capture both income and price appreciation.
Active vs. Passive Fixed Income Management
Fixed income portfolios can be managed through two primary approaches:
Active Management Approaches:
- Total Return Focus: Seeking both income and capital appreciation by actively trading bonds based on market opportunities.
- Credit Analysis: Identifying bonds that may rise in value due to improving issuer quality or market perception.
- Duration Management: Adjusting a portfolio's sensitivity to interest rate changes based on economic outlook.
- Sector Rotation: Moving between different bond sectors (government, corporate, etc.) based on economic cycles.
- Yield Curve Positioning: Positioning investments in specific parts of the yield curve expected to perform best .
The Yield Curve
The yield curve is a graph showing interest rates of bonds with equal credit quality but different maturity dates. Typically, longer-term bonds offer higher yields than shorter-term bonds to compensate for greater risk – they are more exposed to the uncertainty that interest rates or inflation could rise at some point in the future . This creates an upward-sloping or "normal" yield
curve. When the curve flattens or inverts (short-term rates higher than long-term), it often signals changing economic conditions, creating different opportunities along the curve.
Passive Management Approaches:
- Buy-and-Hold Strategy: Simply purchasing bonds and holding them until maturity to receive regular income and the eventual return of principal.
- Index-Based Investing: Using funds or ETFs that track broad bond market indices, aiming to match market performance with lower fees.
- Laddered Portfolios: Spreading investments across bonds with staggered maturities to manage interest rate and reinvestment risk.
Active management potentially offers enhanced returns and risk control but typically comes with higher fees and requires specialized expertise. Passive approaches provide market exposure with lower costs but may miss opportunities available to active managers.
The Enduring Value of Bonds
Despite changing market conditions, fixed income investments remain an essential component of well-diversified portfolios. They continue to provide income, potential stability, and diversification benefits, though the specific approach may need to adapt to current conditions.
The fundamentals of bond investing haven't changed, but the market environment continues to evolve. By understanding these fundamentals and key risks, investors can make more informed decisions about their fixed income allocations.
In our next article, Bonds in Transition: Adapting Fixed Income Strategies for Today's Volatile Markets, we'll explore specific strategies investors can use to navigate today's landscape, including unconstrained approaches, duration management, and how different types of bonds can work together in a modern portfolio.
Disclaimers:
This communication is an overview only and it does not constitute financial, business, legal, tax, investment, or other professional advice or services. It is not intended to be a complete statement of the law or an opinion on any matter. If you (or any of your family members) are a U.S. citizen, hold a U.S. green card, or are otherwise considered a U.S. resident for U.S income/estate tax purposes, the Canadian and/or U.S. tax implications could be substantially different from those outlined herein. No one should act upon the information in this communication as an alternative to legal, financial or tax advice from a qualified professional. No member of Mawer Investment Management Ltd. is liable for any errors or omissions in the content or transmission of this email or accepts any responsibility or liability for loss or damage arising from the receipt or use of this information.
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Mawer Investment Management Ltd. provides this publication for informational purposes only and it is not and should not be construed as professional advice. The information contained in this publication is based on material believed to be reliable at the time of publication and Mawer Investment Management Ltd. cannot guarantee that the information is accurate or complete. Individuals should contact their account representative for professional advice regarding their personal circumstances and/or financial position. This publication does not address tax or trust and estate considerations that may be applicable to an individual’s particular situation. The comments are general in nature and professional advice regarding an individual’s particular tax position should be obtained in respect of any person’s specific circumstances.
