"Bond yields go down, bond prices go up."

I can't tell you how many times my good friend and longtime colleague Dan Burrows had to explain that relationship to me as I was learning the ropes of financial markets.

It seems so simple. Once you know it, it is simple.

However, as a former sports copy editor trying to wrap his head around something that wasn't WAR or QBR, it took some hammering home. Bonds were difficult! And boring! And heck, when I opened up my 401(k), everyone around me told me that I was so young I probably didn't even need to hold any, so I really had some resistance to learning about them.

More than a decade later, I'm here to tell you that … well, bonds are still boring, and don't let anyone ever tell you otherwise.

But they're also important to understand and monitor, no matter where you are in your investing lifecycle—even if you don't own a single bond.

The Tea

First, a quick primer for any readers who are very fresh:

A bond is debt issued by some sort of entity—the U.S. government, a multinational corporation, the township you live in. When you buy a bond, you're buying that debt, and that entity is promising you that they'll pay you a stream of interest income until some date in the future, at which point they'll return your initial investment (your principal). Bond prices generally also don't move nearly as much as stocks—because of this promise, bonds tend to trade in a band around their "par value" (the price the bond was issued at).

A stock is a piece of ownership in a company that allows you to share in its profits (and conversely, losses). A stock might pay you income in the form of a dividend, but nothing is promised. Thus, stocks tend to move much more drastically based on the company's finances, future prospects, and other market conditions—not great when those factors are lousy, but it provides much more upside potential when those factors are in the company's favor. 

OK, primer over.

Young and the Invested Tip: Want to learn more about bonds? Check out our breakdown of various income-generating investments.

Think about the homepage of MarketWatch, Yahoo! Finance, or any other market-news site you visit frequently. Think about what you hear and see on CNBC or Fox Business. Think about the last few conversations you had about "the market."

Good. Now, what percentage of all of that involved bonds?

Hardly none, right? We retail investors are a stock-centric bunch, and for several good reasons, all of them related:

• Stocks have more potential for growth: Consider this: Since 1975, three-month Treasury notes have returned 621%. Longer-term Treasury bonds? 1,749%. Medium-investment-grade corporate bonds? 5,427%. Meanwhile, the stock-centric S&P 500 Index, with dividends included, has returned 18,900%. Bonds do occasionally enjoy periods of outperformance, but for the most part, stocks are king.
• Companies are interesting, and stocks reflect that—bonds do not. That growth potential is a byproduct of how stocks and bonds work: Stocks are more volatile, and their movement is more closely tied to the company's financial performance, sentiment about the company, and so on. Thus, when we read about companies, we tend to read about their stocks as well. How often do you read about Nvidia (NVDA), Tesla (TSLA), and Apple (AAPL)? See how there are stock tickers there? But you'll almost never read about their bonds.
• Brokerage infrastructure: Many online brokers will allow you to buy individual stocks, but far fewer allow you to buy individual bonds—often, your only option is to buy exchange-traded funds (ETFs) or mutual funds that hold bonds. And even when brokers do let you buy bonds, the tools and research available for stocks tend to be much more robust than for bonds. That's because … 
• There's relatively little information available about bonds: Investing data sites are largely built to provide stock data first. That's not to say you can't find bond info anywhere, but most research outfits, screeners, and data portals will typically have a wealth of available information and analysis on stocks … and precious little on bonds.
• Retail investors tend to invest in bonds in batches: Because of all of the above, most of us just throw our hands in the air and say "forget it, I'm just letting an index or fund manager deal with it" and get our bond exposure through ETFs and mutual funds.

Great! I've made the case for why no one cares about bonds.

Now, I'll let our guest for this week make the case for why you should care about bonds.

The Take

The reasons for investor bond apathy that I listed above are very real, but if you haven't caught it yet, my general tone about bonds is very much tongue-and-cheek.

Bonds might be more difficult to wrap your head around because there's less available information about them and investor education tends to center around stocks. But they not only play a vital role in most portfolios (if not for you now, eventually), they also are a helpful measuring stick for both the stock market and general financial purposes!

Here to explain this today is Michael Brenner, Research Analyst at FBB Capital Partners, which provides customized wealth management solutions for financially established individuals and institutions out of lovely Bethesda, Maryland. 

Young and the Invested: Let's start simple: What does the bond market offer investors?

Brenner: It offers security. In the equity market, if something goes wrong with a company and it goes out of business, there's a high probability you'll lose every penny you've got. The way you get cash flow out of your equities is that companies pay you a dividend, but those dividends are discretionary—they can be raised, lowered, the company is not legally obligated to pay. 

But the bond market provides investors with security in a number of ways.

A bond is a contract between you and the borrower, between the lender and the borrower. So when you invest in bonds, you have a contractual right to get cash flows and your principal back from the borrower. And then the other difference between stocks and bonds is that bonds have a finite life, so almost every bond will eventually end and you'll get your principal back. 

Young and the Invested Tip: One of the simplest ways to start investing in various assets—bonds, yes, but stocks, commodities and more—is to buy an index fund.

Because a bond is a series of payments and then your principal, the value of that contract doesn't change as rapidly as the value of the future dividend stream that comes off of equities. Thus, bonds' value doesn't change nearly as much as stocks do; they bring stability and ballast and income.

Young and the Invested: What's something a beginning investor might not realize about the bond market?

Brenner: The bond market is in some ways more diverse than the equity market. The stock market is made up of companies that use the stock market to raise capital to finance their operations. The bond market is a loan from a lender to a borrower of any type. So the bond market includes governments. It includes national governments, state and local governments, and companies.

Young and the Invested: Let's say I'm an investor who owns nothing but stocks. How do I get started investing in stocks?

Brenner: You can buy individual bonds, but you'll run into issues because the bond market is so much more diverse. It has so many more issuers and structures and bond types, so it can be hard for an individual investor to own enough different types of bonds in the portfolio to be properly diversified. It also would have a minimum capital requirement [you'd need a certain amount of money to build a diversified bond portfolio with only individual bonds].

The other way to get involved would be through exchange-traded funds (ETFs) or mutual funds. Those are a great way to get just a taste of bonds. And in particular with the world of ETFs, you can really target to get exactly what you're looking for in terms of exposure because there are a lot of different options out there, many of which are very low-cost and well-designed. 

Much like the S&P 500 or the MSCI All Country World Index (ACWI) covers the equity market, there are indices that cover the bond market. The most basic introductory bond index would be the Bloomberg US Aggregate Bond Index ("the Agg"), which holds what we call intermediate-term bonds of various types. That index is going to focus on investment-grade bonds, which are bonds that have a very high probability of returning their principal back to investors. It's going to focus on largely government-guaranteed bonds, along with some bonds from companies and also mortgage securities.

Most investors could have a core exposure to the Agg, then [build satellite positions in] other areas of the bond market that might offer more income or have a different maturity profile.

Another strategy that investors can employ is a bond ladder. A bond ladder takes a group of bonds and structures the portfolio by maturity, so you can invest portions of your assets in bonds that mature in various years. What you do is guarantee that you're going to get a cash flow in each year in which a bond matures, and then you can reinvest that cash flow or use it for personal expenses. At our firm, we use both bond ladders for clients that have more capital, and we use ETFs and mutual funds for clients that have smaller amounts.

Young and the Invested: Are there any tax considerations when investing in bonds?

Brenner: If you're investing money on which you have to pay taxes on the income, you can buy bonds in state and local governments. Those bonds are going to be exempt from federal taxes, and may, depending on the type of bond you buy, be exempt from state and local taxes. So if you're paying a high tax rate, it could be advantageous to buy bonds from municipal issuers. You also have tax advantages with Treasuries [their income is exempt from all state and local taxes].

But, say, corporate bonds, that would be something you'd put in an individual retirement account (IRA).  

However, there's one wrinkle there, which is, this decision depends a little bit on your tax rate.

Young and the Invested Tip: For higher-flying investors, direct indexing can help you maximize tax savings across your investment accounts.

If you're paying, say, a 20% tax … well, if you take the 20% tax out of a corporate bond's yield, it might still out-yield an equivalent municipal bond. Of course, corporates, even at the same credit rating, have higher default rates than munis, so you have to take your risk tolerance into account, too.

If you're paying the full 35% marginal tax rate, in most market environments, you're probably going to be better off investing in municipals. If you're paying more in the 20s, even if you only invest in a brokerage account, you might be better off investing in corporates. You just have to look at your tax situation and the bonds' tax-equivalent yield.

Young and the Invested: Should you pay attention to the bond market if you don't invest in bonds?

Brenner: The bond market has a lot to say about what's going on with the state of the economy. 

So first, inflation. Most U.S. government debt has nominal interest rates—interest rates that are just printed on the prospectus of the bond, and that's the interest rate the government pays. However, the U.S. government, and governments around the world, also issue inflation-linked bonds—bonds where the interest rate is variable depending on the level of inflation. The difference in returns and interest rates between inflation-linked bonds and nominal bonds can give us an assumption about what inflation is going to look like.

Inflation has a big impact on interest rates, and it's something that we can directly read out of the bond market. If inflation is going up, we would expect that the difference in yield between inflation-linked and nominal bonds is getting wider. And if inflation is narrowing, we can see that narrowing in the bond market.

There's also underlying economic growth. After the financial crisis, economic growth slowed quite a bit. Interest rates fell quite a bit. That had an impact on what investments and asset allocators might select, because the income we associated with bonds was much lower than typical, and that affected investor interest in stocks. This idea went around that bond returns are going to be so low that you had to invest in equities. So, economic growth has an impact on the bond market. And we can try to get insights about where the bond market thinks economic growth will be.

The other component of this that might be interesting is in the corporate bond market. We can see different types of companies are borrowing money at different interest rates, and we can look at the difference in interest rates across companies, and the riskier it becomes to lend to a company, that can have an impact on their equity price. 

Young and the Invested: Can you look at the bond market as a proxy for, say, a mortgage, or the cost of an auto loan? If a consumer has a big purchase coming up, how might they observe the bond market?

Brenner: In the bond market, we think of the Treasury yield curve [the interest rates of U.S. government bonds at different maturities] as being the base. Then everything else, based on how risky it is, prices off of those Treasury rates.

The Federal Reserve sets the "overnight interest rate" (the interest rate at which it costs to borrow money overnight). That interest rate is very important because it is the shortest-term, lowest-credit-risk interest rate in the economy. Interest-rate risk is priced off of the Fed funds rate—the longer it takes you to get your money back, the more risk that's going to entail, because we don't know what $100 is going to be worth next year, next month, or in the next 30 years. From there, you price out the Treasury curve, and then you price up credit risk [in other words, you determine loan terms based on perceived credit risk]. 

Young and the Invested Tip: Treasury bonds are a relatively safe investment, but there are "right" times to buy and "wrong" times to buy.

Auto loans, mortgages—those products aren't directly tied into what the Fed does. When you get a mortgage, you're going to pay your principal back over a 30-year period, but the Fed funds rate is really only an overnight interest rate. So what the bond market does is it looks at what the cost of financing is going to be over one month, one year, 10 years, 20 years, 30 years, and sets a base rate, then all those consumer products are going to get priced off of that base rate. 

Young and the Invested: If you walk into your financial advisor and say, "I'd like to know more about what bonds can do for me," I'm sure a request that simple is going to be enough to get them talking. But I wonder: Is there anything a client could ask their financial professional that would help shape the conversation better?

Brenner: I think any conversation about bonds is going to be a conversation about risk, because bonds are the most straightforward way to reduce the risk in your portfolio. 

When you're asking your advisor, "Should I be invested in bonds?" that's really going to be a question "How much risk do I want to take in my portfolio?" If you start with an all-equity portfolio, the more bonds you put in there, by and large, you're going to be taking down the risk of your portfolio. 

The second question to think about is your tax situation. As we mentioned, there's a lot of different types of bonds out there, and they do have an impact on your taxes. The income you get from bonds is taxed as ordinary income. So you want to make sure that your bond strategy is in line with where you think your tax rate is going to go and what your tax situation looks like. 

Then the other piece to think about is diversification. I mentioned at the beginning that the Agg is the broad bond market index, but the Agg doesn't cover all of the asset classes within the bond market. The Agg doesn't include inflation-linked bonds, the Agg doesn't include municipal bonds, junk bonds, a lot of floating-rate bonds. The Agg is only tradable bonds, so it's not going to include strategies like private credit or asset-backed lending. So make sure you're getting the full exposure and diversification of the bond market. 

Riley & Kyle

Young and the Invested

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