by Doug Drabik, Fixed Income, Raymond James
September 26, 2016
The top circulated financial newspaper in the country (The Wall Street Journal) posted a news story talking about “Bond Basics”. It said, “A bond’s yield shows how much income it will generate annually. This yield, derived by dividing the contractual interest payment by the current price, falls as the price rises.”
The implication, or the way I viewed it, makes it sound like an investor should be cautious owning a bond because its income is sure to fall when prices go up. If this is any reader’s interpretation, there is yet another erroneous message being delivered. As a matter of fact, I will argue that this couldn’t be much farther from the truth.
First of all, interest divided by current price is the current yield. That’s it. It is a point-in-time calculation. The current price of a bond has nothing at all to do with the yield or income that an investor is achieving on their holdings. One of the most powerful reasons an investor holds bonds within their portfolio is for its protective qualities: 1) predictable cash flow, 2) defined income, and 3) known time period when face value (barring default) will be returned. These 3 qualities do not change when a bond is held to maturity regardless of any changes in interest rates! When interest rates change, prices change but an investor’s bond portfolio cash flow, income and maturity DO NOT CHANGE! What is changing is the moment’s opportunity or the current entry point into the market.
Articles from well-read/accepted periodicals and well-known financial figure-heads seem to carry considerable weight with casual and sophisticated investors alike. We all are influenced by what we read making it more important to decipher wording. The slant and relevancy of the information is often “awkward” or can easily be taken out of context. Famous wealthy financial figure-heads typically possess dissimilar portfolio goals and needs and often manage money from a total return perspective. The message and applicable audience can easily be blurred. Just because it’s in print or uttered from famous lips, doesn’t make it true and/or appropriate for all investor types. Understanding the basics is essential. Knowing what you own and why you own it, even more so.
Copyright © Raymond James
