Do You Know These 7 Bond Market Basics?

MARK: I'm Mark Riepe. I head up the Schwab Center for Financial Research, and this is Financial Decoder, an original podcast from Charles Schwab. It's a show about financial decision-making and the cognitive and emotional biases that can cloud our judgment. 

The other day I was talking with some colleagues and it was pointed out that when it comes to investing, you're either an owner or a lender. Are you an equity holder? Do you own stocks? If so, you're in the owner camp. You own part of the business.

On the other hand, if you're loaning money to an entity for a period of time, for example a company, city, country, or person, and you expect to be paid pay back with interest, then you're a lender. 

And today, we're in the world of fixed income, which is a huge component of the lending market.

To guide us is Kathy Jones. She's a managing director here at Schwab and our chief fixed income strategist at the Schwab Center for Financial Research. 

Kathy has analyzed global bonds, foreign currency, and commodity markets extensively throughout her career as an investment analyst and strategist, working with both institutional and individual clients. Kathy makes regular broadcast appearances on CNBC, Yahoo Finance, Bloomberg TV, and many other networks and is often quoted by The Wall Street Journal, The New York Times, Financial Times, and Reuters.

Kathy also cohosts the On Investing podcast with Liz Ann Sonders. A new episode drops every Friday, and if you haven't listened, you should. They have great guests, and Liz Ann and Kathy always have useful insights about what's happening in the markets and economy right now.

MARK: Kathy Jones, welcome back to the Financial Decoder podcast.

KATHY JONES: Well, thanks for having me back, Mark.

MARK: So the premise of this episode is—what are some of that basic knowledge that you need to know before you start to invest in bonds? So we've got a great list of the seven things you need to know. And the first one really starts out with why, what's the point of bonds in a portfolio?

KATHY: Well, the major attributes that usually attract investors to bonds are income, capital preservation, and diversification from stocks and other asset classes. 

So if you take them one by one—income—most bonds pay interest at set times over the life of the bond. And that helps with planning cash flows and generating a steady flow of income.

Capital preservation—it just refers to, barring a default by the issuer, the investor in a bond will get the principal value of the bond back at par when the bond matures, and in addition to those interest payments along the way.

And then with diversification—because bonds, depending on the type of bond, often move in the opposite direction of stocks or other assets, especially during periods of volatility in equities, then investing in bonds gives you something that's going to offset—perhaps volatility—in other parts of your portfolio. Bonds tend to have much lower volatility than, say, equities and other types of asset classes.

MARK: So our second principle is something I've heard you say at client events—you've said it to me many times—that there's no one bond market. So what does that mean exactly? Explain why that matters to the bond investor.

KATHY: Yeah, you know, I think investors generally will think of the U.S. Treasury market when they think of the bond market. Or maybe they think of Treasury bills or I bonds that they might have bought along the way.

But the bond market is really quite large and varied. The size is about 140 trillion globally compared to 115 trillion or so for global equities. And within that number, there are Treasury bills, notes, and bonds issued by the federal government. Also, municipal bonds issued by state and local governments. There are corporate bonds, both investment grade and high yield issued by companies. And then there's just a myriad of other types of bonds. Some are backed by mortgages or the cash flows from other assets. International bonds of all kinds. There are just many, many categories of bonds, and they're not all created equal.

MARK: Yeah, I think a couple of the categories you mentioned, investment grade and high yield, and those speak to credit risk, which is our third principle that you need to understand. So explain why credit risk matters. How do investors think about that when they decide which bonds or which bond funds are they going to own?

KATHY: Credit risk refers to the likelihood that an issuer of a bond will default. So a default is when the issuer fails to make a timely payment of interest and/or principal. So for example, in the corporate bond market, a company with strong earnings, a low level of debt relative to equity, positive cash flow, and a history of paying on time will likely have a higher credit rating than a company with weaker earnings, a high level of debt, and a history of previous default.

So we have rating agencies that tend to give bond ratings on many types of bonds, and that reflects what their view is of the fundamentals of the issuer. So it's not only true of corporate bonds, but it's also true of municipal bonds, government bonds, to name a few. And it's important to an investor because you want to know what kind of risk you're taking when you're investing in those bonds.

MARK: And presumably the yield on the bond is going to try to account for that credit risk and it's going to be, I suppose, simplistically, it's going to compensate you for taking on extra risk. Is that right?

KATHY: Yeah, that's generally the way it works. If we look in the corporate bond market, which is kind of the easiest one to understand, you have what we call investment-grade bonds, and then you have high-yield bonds that are below investment-grade. And there's a big difference between the two categories, and there tends to be a big yield difference between the two categories.

So if you're going to buy the bond of a AAA-rated corporation—which there's only, I think, two left—but you're going to get a lower yield but a higher sense of credit quality and safety than if you buy a high-yield bond, or what's also known as a junk bond, that's issued by a small company. It's growing real fast, using up cash real fast. You should get compensated with a higher yield to reflect that difference in risk.

MARK: And I guess interest rates actually is our number four thing you need to know. So that's a nice lead in. And you talk about interest rates all the time when you're co-hosting the On Investing podcast. Explain that relationship between interest rates and bond prices. Why is it important to understand the way they interact with each other?

KATHY: Yeah, bond prices move in the opposite direction of interest rates. So if interest rates move up, the dollar value of the bond will likely fall, and vice versa. If interest rates come down, the dollar value of the bond will likely move up. And I think the easiest way to explain this is say you own a bond that was issued when interest rates were lower. Let's say a five-year bond with a 3% coupon rate—and coupon means it pays 3% interest annually on, say, a $1000 par bond. If interest rates rise to, say, 5% for a similar maturity bond, other investors aren't going to be interested in your bond paying 3%. They'll just go out and buy the 5% bond. They will, however, buy it if the price declines to offset it. So the market is efficient enough in most cases for the price change to offset the rise in interest rates. So your bond paying 3% will likely fall in price, but at that discounted price, it will probably produce a yield above about 5%, which is the prevailing interest rate.

Now, if you hold your bond to maturity, you're going to get your principal back at par in your 3% along the way. So if the price fluctuates, it may not bother you. But it's important to understand, especially if you're thinking of selling the bond or maybe your bond fund before maturity, if the interest rates move up and you sell the bond at a loss—a discount to par—you'll probably take a capital loss and vice versa. If rates fall, and your bond goes up in price, then you can sell it for capital gain.

Now in the first case, if you take a loss, you might reinvest in a bond that's yielding more—you'll earn more interest on the new bond—and you have to decide if that extra income is sufficient to offset the loss on the bond that you sold. In the second case, if you sell the bond at a premium to par, you'll be giving up that higher income stream. So again, if you hold a bond to maturity, barring a default, you aren't going to lose money unless you sell the bond before it matures.

You know, it's also a consideration if you invest in bonds through a fund instead of owning individual bonds. So what happens in a fund is the net asset value of the fund is going to move to reflect the changes in interest rates. So again, if interest rates move up, the net asset value will probably decline, and vice versa, because a bond fund is just a portfolio of bonds. Now, that may make funds sound unattractive on the surface, but it isn't always the case. Depending on how the fund is managed, it may be that the old bonds with the lower yields are swapped out for higher yielding new bonds by the manager and the fund produces more income. The income component of the fund can rise, possibly offsetting a decline in principles. So it isn't always the case that a fund will underperform a portfolio of individual bonds in a rising-rate environment or outperform when rates fall—like so many things in investing, it kind of all depends.

MARK: And of course, with the funds, they are typically owning a lot more bonds than probably the typical individual, so there's a diversification component there as well. Speaking of interest rates, there's a term that pops up in every article that you read about bonds. It's related to interest rates, and it's our kind of fifth thing that you need to know, and that's duration. So what does duration refer to, and how does it factor into assessing different types of bond investments?

KATHY: Yeah, duration is a term that describes a bond's price sensitivity to changes in interest rates. And sometimes I think this industry just likes to make up words that make things more complicated than they need to be—but there's various forms of duration. But basically it takes into account the yield, the maturity of the bond, and call features. So in general, the longer the maturity of the bond, the higher the duration, the higher the sensitivity to changes in interest rates. And the reason is that if you're tying up your money for 10 years instead of two years, you're likely to see a lot more volatility in the 10-year bond than in the two-year bond due to the prospect of changing interest rates over the life of the bond. So therefore, the bond's price will be a lot more sensitive to changes in interest rates than one that matures in a shorter period of time.

We usually suggest you match up the duration in your bond portfolio close to your time horizon and your risk tolerance. So if you have a really long-term time horizon, you might be very comfortable with long-term bonds and be able to ignore the fluctuations in prices. But if you have a shorter time horizon or you just aren't comfortable with volatility, then you might want to consider shorter term bonds. And if you think interest rates are going to move up, you probably want to stay with shorter term bonds and keep that duration down.

Now, other considerations to take into account are what is the slope of the yield curve? So for a few years, short-term rates were actually higher than long-term rates. It's called an inverted yield curve in that environment. A lot of people wanted to keep the duration in their portfolio short because, you know, why invest in a 10-year bond paying less than one that's a two-year bond? That sounds very sensible. At times it can make sense, but you know, there's always a prospect that you're going to see a big change in interest rates. So why bother if you're not getting compensated for it? That's very different over time if you have a normally upwardly sloped yield curve, then you do get paid more in the way of yield for taking on that risk. So it's something that people really need to consider is how is the yield curve slope and shaped, and what is the outlook going forward?

MARK: I'll get back to Kathy in a few minutes. But first I wanted to take a short detour into the science behind a psychological barrier to making sound investing decisions. Let's start by going back to Pittsburgh, Pennsylvania, in April 1995. In broad daylight, a guy robbed two banks.[1] No mask or scarf. No baseball cap or sunglasses. Nothing covering his face, and the security cameras recorded clear images of that face. This was back when everyone watched the 11:00 news, and they showed the robber on the newscast, and he was quickly identified. 

When the police went to his house to arrest him that same night, McArthur Wheeler (that's the name of the robber) was flabbergasted, and he said to police, "But I wore the juice!" "The juice" was lemon juice. He said he rubbed lemon juice on his face to make it invisible to bank cameras. He did it because he knew that lemon juice is used in invisible ink, and he thought it would work on his face, too. 

He tested his theory by taking a picture of himself with a Polaroid camera—a kind of primitive selfie. When he looked at the picture, his face didn't show up. Now, no one knows what happened there, but something obviously went wrong with the camera. Unfortunately for Mr. Wheeler, the bank cameras picked up his face just fine. Wheeler went to jail, and his story went into the 1996 edition of the World Almanac, where a psychology professor at Cornell University read the story. And it sparked an idea. 

David Dunning and a graduate student, Justin Kruger, set to work to study a tendency of people who lack skills or knowledge to appreciate how much they don't know. Their work led to a bias now known as the Dunning-Kruger Effect. Here's how the first study went. 

Dunning and Kruger quizzed undergrads on grammar, jokes, and logic. They then asked the students to say how well they thought they did compared to each other. Here was one of the questions for the jokes section of the test—just so you can get a feel for it. The goal was to rate how funny each joke would be to an audience. In other words, it wasn't about whether you thought the joke was funny; it was how funny you thought the joke would be to an audience. The task was to decide which joke the majority of people would think was funnier than the other joke. 

A panel of professional comedians rated the jokes. And the average of their opinions was considered to be the correct answer. Joke number one—which is technically a riddle, but who's counting?—was this one: What is as big as a man but weighs nothing? The answer: His shadow. 

Then the second joke was: If a kid asks where rain comes from, I think a cute thing to tell him is, "God is crying," And if he asks why God is crying, another cute thing to tell him is, "Probably because of something you did." 

The professional comedians serving as the judges didn't think the "shadow" joke was funny at all. The second joke was rated as very funny. And incidentally, for you listeners of a certain age, it was written by Saturday Night Live writer Jack Handey. The quiz takers who scored lowest when it came to deciding which one would be the funniest to an audience thought that they had done extremely well. In other words, they were confident in their knowledge of humor.

Dunning had expected this, but the results were so over-the-top, his first reaction was to say, "Wow." Dunning and Kruger first published their results in a paper called "Unskilled and Unaware of It: How Difficulties in Recognizing One's Own Incompetence Lead to Inflated Self-Assessment." Over 100 studies confirm the Dunning-Kruger Effect.[2] For example, 88% of drivers think they're above average, which obviously can't be true. And as the research says, those with the least ability are the most likely to overestimate their skills.

It's easy to say that the people in these studies are just egomaniacs? But it's not that simple. We all have pockets of the Dunning Kruger effect inside us. Here's how this seems to work in practice: Someone who knows absolutely nothing about a topic learns a little bit. A thimbleful of knowledge, let's say. Armed with that, they feel like they know quite a lot.  Crucially, what they don't know is how much more there is to learn.

Then there's the person who's competent—let's say somewhere between a beginner and expert. They have the opposite feeling and amount of confidence. They know how much they know, but they also know how much they don't know. So they feel less confident in their knowledge than the person who knows much less. 

Finally, there's the real expert. They know a lot—far more than those who are merely competent. But they also understand they could still learn more because they know better than anyone how vast the topic is. 

Like many of these biases, it's hard to fix this one. I like the advice given by David Dunning himself. He said, "I try to be a little more intellectually humble. A good question to ask is, 'What is missing? What don't I know?' I've found that's an excellent way to think through real, substantive issues." 

In this episode, we're covering the most basic of basics when it comes to bonds. The bare bones if you will. After you're done listening, you can go further and look at the other resources we have available. Because when you cut through the psychological mumbo jumbo of the academic studies, the Dunning-Kruger Effect is summed up by an old saying: "A little knowledge is a dangerous thing." To fix that, you can go to schwab.com/learn and click on "fixed income" or "bonds." You'll find many articles by our fixed income team, and many articles written by Kathy herself. The written reports include charts and graphs and cover lots of different facets of the bond universe. Now, let's hear more of my conversation with Kathy. 

MARK: So Kathy—duration—it's pretty important, but for that investor who, they want to get out of the market-timing game of either going short because they think interest rates are going to rise or go long because they think they're going to fall or switch back and forth—what are some of the strategies they can use to kind of manage that on an ongoing basis?

KATHY: Yeah, that's a good question. A lot of people do sort of get stumped at that point, and they don't all want to be their own bond fund managers at home. They'd rather go play tennis or something. So one of the strategies that we think most people find useful is a bond ladder. And all that means is you spread out the maturities of the bonds in your portfolio evenly over time. So an example, a one-to-10-year bond ladder—you'll have bonds, 10% will mature in the first year, 10% in the second year, third year, etc., all the way up to 10 years. So that means that you have a maturity spread out over time, and your average duration is going to be somewhere in the middle.

The second step to that is when the one-year bond matures, you can reinvest in the 10-year—and your 10-year now is a nine-year, your nine year an eight-year, eight-year a seven-year, etc. So you're always maintaining 10 years evenly spread out over time. So your duration's roughly going to be pretty much still in the middle. So you've got a 10-year bond, but you aren't looking at the sensitivity associated with just 10-year bonds. It's reduced that sensitivity.

It also has the advantage, actually, if interest rates rise, when you reinvest, you're going to be reinvesting at a higher yield. So over time, if interest rates go up, you actually end up generating more income in the portfolio, which is handy when you see a lot of fluctuation in interest rates. You can kind of sit tight and say, "OK, well, to tell you the truth, this might be to my advantage if I'm investing in bonds for income." And even if they stay the same, if the yield curve is upward sloping, you're still going to generate more income over time. And of course, if interest rates fall, the value of your bond portfolio is going to go up, but you will probably not be generating as much income, so that's something to be aware of. But the advantage is you're sort of always invested, you have a strategy, you don't really need to pay attention to day in and day out, and it keeps you in a kind of steady space without having to worry about it day by day.

MARK: Got it. You mentioned call features. So what are call features? Why is that something you need to understand about whether your bond … if it has one or if it doesn't have one?

KATHY: Yeah, these days a lot of bonds have call features, especially in the municipal bond market these days. Almost every issuer now puts in a call feature. So a call just means that the issuer has the right to call in the bond, redeem the bond at a given date in the future. It's usually prior to maturity.

So you might buy a 10-year bond with a five-year call feature, meaning for five years, it's going to be just as it looks on the surface—but at the end of five years, say interest rates fall, the issuer may say, "Oh, I want to redeem that bond so I can issue a new one at a lower interest rate." So it's something you need to be aware of because it affects the price of the bond. It affects your planning. If you really want a 10-year bond, make sure you buy one that doesn't have a call feature. And you have to be really careful if the call is really close. So you don't want to buy one that, generally speaking, if the call is six months away, and you don't even get a coupon payment in that timeframe, you could get pretty badly hurt on that. So the idea is to just be aware of the call feature. The price of the bond will kind of adjust for that. But in a falling-interest-rate environment, it becomes very important because you may have to replace the bond that you own with another bond that may yield less.

MARK: Very good. I want to talk a little bit more about the yield curve because that's our thing you need to know number six. And something, actually now that I think about it, is important to equity investors as well as bond investors. So tell me a little bit more about what the yield curve represents, and what kind of insights you can derive from looking at it and how its shape changes over time?

KATHY: Yeah, the yield curve captures the yields of bonds of the same type with different maturities over time. It's a snapshot of yields in time.

So let's look at the Treasury bond market because that's usually the easiest. We look at the yield curve to see the difference in yields from very short-term rates of, say, one-month T-bills all the way out to 30-year Treasury bonds and all the maturities in between. It can tell you a lot about the market's expectations about Fed policy and about inflation. So typically, the yield curve is upward sloping. That is, short-term rates are lower than long-term rates. You know, and as I mentioned earlier, that's because if you invest in a longer-term bond, you're taking more risk that interest rates will change over time than you do with very short-term bonds. So usually, you'll get compensated with a higher yield.

Now, again, typically the yield curve will reflect the market's collective expectations about the path of Fed policy—and since we have a high level of confidence about what the Fed's policy is in the short term, those yields tend to be very close to the fed funds rate. But as you get out into maturities as two, five, or 10 years or longer, we have less certainty about that, less insight into that. So the yields are higher typically to compensate for the risk that policy will shift from current expectations. How much higher those yields are compared to short-term interest rate, often a function of inflation and inflation expectations as well. The higher expected inflation, the higher the yield, and vice versa in normal circumstances. And then an inverted yield curve is seen usually during periods of weaker growth and when we're expecting the Fed to cut rates pretty aggressively.

MARK: And that's why an inverted yield curve is often associated with impending recessions. Not a perfect indicator, but sometimes people use it that way. Is that right?

KATHY: Yeah, that's correct. It has a very good track record of being a signal of an impending recession.

MARK: All right, to cap off our list, we've got number seven, and that is the Federal Reserve. We know the Fed plays a major role in kind of the greater world of finance, the economy, regulation of banks—but what exactly is its role in the bond market, and to what extent should a bond investor be paying attention to what the Fed is doing and saying it's going to do?

KATHY: Well, I think as a bond investor, you should really pay attention to what the Federal Reserve does. So one thing they do at the Federal Reserve is determine the target range for the fed funds rate. And the fed funds rate is a rate that banks charge each other to borrow money, usually just for overnight. So it's the interest rate that nearly all other interest rates are based on. It's kind of the base lending rate in the economy.

Now, the Fed also manages the amount of reserves in the financial system. Reserves are the cushion that banks hold to assure that they have enough money to handle transactions. It used to be that the Fed used the level of reserves to manage short-term interest rates. Today it's a little bit different. The Fed tries to maintain enough reserves so banks have ample liquidity that they need so there isn't a supply-demand imbalance. But, you know, the Fed is the biggest influence on short-term interest rates.

Now, the Fed also holds some bonds on its balance sheet, which can affect long-term rates. Now, during the financial crisis, the Fed expanded its holdings of bonds to drive down longer-term interest rates. It hit zero on the fed funds rate, couldn't go into negative rates as we saw in Europe. So what they did is they bought a bunch of Treasury bonds and mortgage-backed securities to put on their balance sheet to drive down or hold down those interest rates. Now today, the Fed is reversing that process, and they're allowing their balance sheet to shrink, and short-term rates, of course, are a long way from zero. So the Fed does have pretty big influence on interest rates throughout the marketplace.

MARK: So those were our seven concepts that you need to know if you're going to be a bond investor. A couple more questions, though, before I let you go. And the first one is, you know, you're communicating with investors all the time through client events, your social media account, @KathyJones—so what are some of the misconceptions that you hear again and again about the bond market? And this is your opportunity to kind of clear everything up for people.

KATHY: Well, one question I get is, "Why buy bonds?" And we did talk about this—but I think people need to understand, in general, bonds tend to be a lot less volatile than stocks because you usually have a legal claim to the interest payments and the principal, so they tend to be less risky. But there are lots of different kinds of bonds, and it depends on the type of bond and the environment.

Not all bonds are the same. There are many different types of bonds. It's true even among major categories. So for example, in the government bond market, there are issuers that are considered very safe, like the U.S. or Switzerland government. But there are countries with a history of defaults that aren't considered safe. So not all government bonds around the world are considered risk-free as they are in the major developed markets.

There are also those bonds that can be called early, where the issuer can retire the bond ahead of its stated maturity date. That can be risky. I think the most important thing is to know what you own. Bonds are not all alike, and it's important to have a good understanding of the ins and outs of the bonds that you hold.

And then finally, I guess one thing many people don't know is you can make money in a bond bear market. So even when interest rates are rising, you can earn money in your bond portfolio and have a positive total return—and the reason is that the income, or the coupon payments, can often offset the price change in the bond. So when you get that income, you also have an opportunity to reinvest if rates have moved up. So you don't have to always be concerned, "Oh, are interest rates going up? Maybe I should sell all my bonds." You can still earn a positive return holding bonds even in a bond bear market.

MARK: Last question for you, Kathy. Obviously, we've just kind of scratched the surface of all the different things that people can look into. So what's the next step for somebody who wants to learn more? Where should they go?

KATHY: Well, we have a lot of resources on Schwab.com. You can go to the Learn tab, and there'll be a drop-down menu with articles on all kinds of investing topics. So look for "fixed income" or "bonds" there. For Schwab clients, when you sign in, you can go to the Research tab. And there, if you look under "Bonds" and scroll down, you'll find plenty of information about understanding fixed income. And we have a really good frequently asked questions page, which I often refer people to who are trying to get a little bit more understanding and education about the bond market.

MARK: Kathy Jones is our chief fixed income strategist here at Schwab and the co-host of the On Investing podcast. Kathy, thanks for being here today.

KATHY: Thanks for having me.

MARK: Kathy, as always, gave us some excellent information. But there's more to learn. 

You can follow Kathy on X where she's @KathyJones—that's Kathy with a K—and on LinkedIn. For more on bonds, fixed income, and your financial journey in general, go to schwab.com and click "Why Schwab?" 

There are courses, insights on market trends, and what the latest developments could mean for your portfolio. We've got lots of smart folks here who love to share their knowledge and experience with investors. We'll put links in the show notes, as usual. And don't forget to listen to the OnInvesting podcast, if you don't already. 

That wraps up this episode. Thanks for listening. I'll be back in a couple of weeks with another show. In the meantime, if you'd like to hear more from me, you can follow me on my LinkedIn page or at X @MarkRiepe. That's M-A-R-K-R-I-E-P-E. 

And if you like the show, we'd be grateful for a rating or review on Apple Podcasts or comment on the show if you listen to it via Spotify. We always like new listeners. And if you know someone who might like the show, please tell them about it and how they can follow us for free in their favorite podcasting app. Personal recommendations are especially effective.

For important disclosures, see the show notes and schwab.com/FinancialDecoder.

[1] Poundstone, William, "Head in the Cloud: Why Knowing Things Still Matters When Facts Are So Easy to Look Up," excerpted in medium.com, June 14, 2016, "I Wore the Juice"- The Dunning-Kruger Effect | by Little, Brown and Company | Medium

[2] Dunning, David, "Why Incompetent People Think They're Amazing," TED Ed video.