Bond Investing
A bond is a loan with a fixed schedule. How yield, duration and credit risk work, and what bonds are actually for in a normal portfolio.
Bond Investing
Two numbers describe every bond you will ever be offered. One is printed on the certificate and never changes. The other moves every day, and it is the one that decides whether the next five years are pleasant.
A fund holding euro government bonds and advertising a yield of 3.6% is not promising you 3.6% this year. It is describing what happens if every bond in the portfolio is held to maturity and every coupon is reinvested at today's rates. That is not income, and it is where most bond buyers stop reading.
The coupon is a fact, the yield is a price
Buy €10,000 nominal of a Bundesanleihe with a 2.5% coupon. The issuer pays €250 a year, and it will keep paying €250 a year until maturity. That number cannot change. It is a contract.
Now suppose rates rise, and the bond has five years left. New issues pay more, so nobody pays full price for a 2.5% bond. It trades at €9,500. Three different numbers are now true at the same time:
| Number | What it means | In this example | Moves with rates |
|---|---|---|---|
| Coupon | The fixed payment on the nominal amount | 2.5%, or €250 a year | No |
| Current yield | The coupon divided by what you would pay today | 2.63% | Yes |
| Yield to maturity | Coupon plus the gain from getting €10,000 back for a €9,500 purchase, spread over the remaining years | 3.61% | Yes |
The distance between 2.63% and 3.61% is the €500 of pull-to-par, earned over five years, and it exists only because you bought below face value. Price a bond at face value and all three numbers collapse into the coupon.
So the yield on a fund fact sheet is a scenario, not a promise. It assumes you hold every bond to maturity and reinvest every coupon at that same rate. Change either assumption and the number you earn is different.
Duration is the risk measure, not the label
Duration is quoted in years, and it does one job: it approximates the percentage price change for a one percentage point change in yields. Double it for two points. Flip the sign when rates fall.
| Duration | Price change if rates rise 1 percentage point |
|---|---|
| 2 years | about −2% |
| 5 years | about −5% |
| 7 years | about −7% |
| 10 years | about −10% |
| 20 years | about −20% |
A mainstream euro government bond fund has an average duration of roughly 7 years. If rates rise by one percentage point, €10,000 of that fund is worth about €9,300 the same afternoon. That is not the fund malfunctioning. It is arithmetic, and it is the reason "government bonds are safe" is only half a sentence — safe from default, not safe from repricing.
The whole move happens without a single borrower missing a payment. Only the yield required by the market changed.
Illustrative. Modified duration of 7, applied linearly; real large moves are slightly smaller because of convexity.
And then the second half, which the alarming version of this story always leaves out. The year is not −7%, because the fund still collects its coupons. On €10,000 that is roughly €300, so the twelve-month result is nearer −4%. Better still, the loss unwinds on a schedule you can calculate. After the rate rise the fund yields 4%. €9,300 compounding at 4% for 7 years comes to about €12,238. The same money left in a fund yielding 3% comes to €12,299. Duration is not only the size of the hit. It is the time it takes to earn it back.
What bonds are for, and what that costs
Bonds are not a return engine in a young portfolio. They do two jobs, and both are behavioural as much as mathematical.
The first is crash arithmetic. Take €100,000 split 80/20: €80,000 in equities, €20,000 in bonds. Equities fall 40%. You now hold €48,000 of equities and €20,000 of bonds, a total of €68,000 — a 32% drawdown instead of 40%. To restore the mix you sell €6,400 of bonds and buy equities at a moment when nobody else wants to. That is the entire mechanism, and it is worth more than the return difference in the year it happens.
The second is that a portfolio which falls 32% is one people leave alone, while a portfolio that falls 40% produces phone calls to the bank. Most investors do not have a returns problem. They have an abandonment problem.
The price of the cushion is easy to compute, and it is larger than the fund industry admits.
- All equity
- 80/20 with bonds at 3%
€2,200 apart after ten years and €92,700 apart after thirty-five. Both portfolios did exactly what they were designed to do.
Illustrative. €300 invested monthly, 7% annual equity return and 3% annual bond return, compounded monthly, no fees or taxes.
€92,700 is about 17% of what the all-equity portfolio ends with. That is the premium on an insurance policy you may never claim, and unlike most insurance it pays a yield while it waits.
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