What is the Deal With Bonds?
A frequent question among new or young investors is what is the deal with bonds? What’s the difference between stocks and bonds? How are bonds priced? And how much should I own in my portfolio? As the lender, what am I entitled to? These are valid questions and they deserve solid answers. They more we know about the various investing tools at our disposal the better decisions we can make and the faster we can accumulate and build wealth.
Here is the outline for today:
What is a Bond?
The Quick Explanation:
In the investment world, a bond is a contract of indebtedness between a lender and the issuer (borrower). When you buy a bond, you are in essence lending your money to the borrower who agrees to pay you interest and return the principle on maturity. Because debt has value, bonds can be priced and the debt can be bought and sold on exchanges for investment purposes. Bonds are much easier to price and value than stock because their future payments are usually fixed and predictable. Because of their increased certainty and security, they perform well when stocks underperform and they are an excellent diversification tool for your investment portfolio. Bonds do not give the owner or lender an ownership stake in the company and therefore the lender is not entitled to any future profits the company generates. They are only entitled, and owed, the interest payments as agreed to in the bond contract.
If you are just getting into investing and looking for some great resources, I would suggest this fantastic article on Rinkydoo Finance: What is Investing? The Beginners Ultimate Guide.
What is investing? The beginner’s ultimate guide
What is a Bond?
The Detailed Explanation:
We’ve all heard that we all need to invest in bonds and that bonds are an important part of our portfolio. But what exactly is a bond? In the most simple of terms, a bond is really a loan between a borrower and a lender; it represents debt. Think of the bond as the paper contract between lender and borrower. In this contract it will stipulate the following terms:
- Face value or Par value is the stated value of the amount borrowed
- Maturity date or when the principle is owed back
- Coupon rate or how much will be paid as interest
- Coupon dates or when the interest will be paid
When you issue the bond you are the borrower and when you buy the bond you are the lender. So when people say you should “buy bonds” what they are really saying is you should lend your money.
Common Issuers of Bonds
Who is issuing the bond is important, or as we learned above, who is borrowing the money. Because as you can imagine, not all borrowers are equal and this will be reflected in the parameters, risk and ultimately the price you would be expected to pay as the lender.
- Governments are the largest issuer of bonds. They issue bonds to finance deficit spending programs and to invest in public infrastructure.
- If the duration of the bond is under one year these are often referred to as “Bills” or “T-Bills“
- If the duration is longer, but under 10 years they are referred to as “Notes“. You hear this often quoted on CNBC or CNN: “The ten year note is yielding 1.5%”
- If the bond is longer than 10 they are called “Bonds“
- The entire category of bills, notes and bonds, is called “Treasuries” because the debt is issued from the US Treasury
- Bonds issued by another country is commonly called “sovereign debt” or “foreign bonds” and are issued in that nation’s currency
- Municipal Bonds or “Munis” is debt issued by states or cities. They commonly offer preferred terms such as tax free interest payments to attract investors.
- Corporate Bonds is debt issued by corporations to help finance capital projects that promise good profits and returns for their owners and shareholders. These projects are often capital intensive, meaning they needs lots of upfront money, and they will commonly go to the bond market to get these funds. Issuing a bond, instead of borrowing from a bank, is often preferred because the bond market will offer better terms and lower interest rates, often with no security or collateral required.
Debt has Value
The first time you hear this it might seem strange but it is true nonetheless. Debt has value and because it has value it can be priced. The principle or amount borrowed, along with the predicted future stream of payments, can easily be rolled into one price and issued to investors.
Bonds are seen as a relatively safe investment because the terms are specified ahead of time and a lot of the pricing variables are known or at least quantified. So long as the borrower and lender agree to these terms, and things go smoothly, both parties will be happy.
How are Bonds Priced?
Now that we know what type of bonds there are, and that debt has value, lets look into how bonds are priced.
Par Value
First and foremost we need to know the par value or face value of the bond. This will be the amount we receive back from the lender when the bond matures and the principle is due. Regardless of the price we pay for the bond, the par value is what is due upon maturity. It is very common to pay more or less than the par value because the future value of the interest payments will change over time when the central bank changes interest rates or when the credit rating for the borrower changes.
When central banks raise or lower interest rates, the face value of the bond and the interest payments do not change. What changes is the market value placed on the future value of interest payments relative to the par value but expressed in today’s dollars. In other words, what is the new value of the future interest payments plus the par value due at the end of the term? So while these fluctuate, they are very easily and quickly calculated and the debt repriced.
Time to Maturity or Duration Remaining
How long will it be until the bond matures? The longer the duration, the more time the borrowed money is at risk of not being paid back or the lender not making an interest payment. You want to see the value of a bond crater, watch when the borrower doesn’t make an interest payment. There are other risks at play too, but the important thing here is that the longer the duration of the bond, the higher the interest payments will be. I think we can all relate to this. Longer termed mortgage rates are higher than shorter term. Same principle at play here too.
Risk free interest rate
This is the interest rate I could get if I took no risk with my money. The most commonly used rate here for this is the 3 month treasury bill. If this interest rate is 3% then all bonds will need to have an interest rate higher than this because why would you take on more risk and get a lower return? It’s not logical. All interest rates will be set higher than this based on the bond duration and credit rating of the borrower. When this interest rate is lowered through actions taken by central banks, the value of all other loans and bonds shift along with it. You can get the current risk free interest rate by clicking here. At the time of this writing it is 0.08% So, what is the deal with bonds? — Ya, not a great deal!!
Credit Rating of Issuer
Just as private citizens have a credit score and rating, so too does every government and corporation. The better the rating, the lower the interest rate and vice versa. If a government or corporation is seen as carrying a higher risk of default or bankruptcy the borrower will need to pay a higher interest rate as compensation for this risk. Sometimes the lender will require collateral as security against the loan so in the event of a default they get first claim on an underlying asset that can be sold off quickly to raise back the principle amount lent.
Ratings Agencies
Calculating credit ratings for government and corporate debt is difficult; but getting them right is critical to both lender and borrower. The borrower does not want to pay more than what is reasonable, and the lender wants adequate compensation for the loan. Standard and Poor’s and Moody’s rating agencies do just this and are regarded as the best in the business for accurately rating the credit worthiness of both governments and corporations.
Perceived inflation risk going forward
Inflation is a huge risk that bonds must face head on. Except taxes, nothing erodes an investment return like inflation. If future inflation is believed to be high or could increase, lenders will demand a higher interest rate to compensate them for this risk. If it is perceived to be benign or low, then no premium will be required and could even create a discount. Make no mistake, when inflation is running high bond holders get clobbered while debtors win.
Market fear or confidence
Nothing moves an investment market quite like fear and uncertainty do. Honestly this is where bond investing shows its true value because when fear and uncertainty run rampant in the market, government bond prices will typically rise while stock prices struggle and fall. Likewise, when confidence and appetite for risk return, these same bond prices will go lower. Again, the face value and interest payments do not change. What is changing is the price investors are willing to pay for that same bond.
Moving Interest Rates Change Bond Prices
Once you know Bonds are debt instruments that are bought and sold by investors, there are 2 more things you need to know:
One: The price for a given bond is perfect and there is almost 0% chance of it being under or over valued. So the price you are required to pay is fair given all the available known information today. This is partly due to the fact that they are relatively easy to price and the bond market is incredibly liquid. In 2018, the global bond market was valued at $102.8 trillion while global equity was $74.7 trillion
Two: The prices of the bonds you hold will rise in value when central bank interest rates are lowered, and conversely lower when interest rates rise. At first glance this makes no sense. But on further inspection it makes perfect sense.
Example: You own $10,000 worth of bonds with a 3% interest rate, meaning it pays $300 a year. If interest rates rise to 4% nobody would by your bond unless it also yielded a 4% interest rate. The only way to do this is to lower your asking price. In order to make your $10,000 bond yield 4% you lower the price to $7,500. Because your $300 a year interest payment on $7,500 is 4%.
Now this is a gross oversimplification but it serves to illustrate the point. You can use this bond calculator to see what the fair value of any bond would be.
How Much Should I Own?
This is a very good question and the subject of much debate lately. Given where interest rates are today (low) and where they are likely to go (up) it makes little sense to hold a large portion of bonds. Because like I mentioned above, when interest rates begin to rise they can have a very dramatic impact on the total value of a bond.
In my Four Pillars for Investing Success I outline the portion of bonds you should have in your portfolio. In summation there is not much room left for bonds to buffer against falling stock prices and offer meaningful diversification. For this reason I recommend an allocation to gold and a smaller portion to Bitcoin. Gold will do well during uncertainty and fear, while Bitcoin should do well for inflation and as an alternative asset.
Putting it Into Action
Let’s put this into action and buy some bonds. We will be keeping this extremely simple and using ETF bond funds as our investment tool.
DIY Investor Type
If you’re the type who wants ultimate control over the allocation and the buying and selling of the ETFs, I recommend use the following:
American Investors: TLT and TIP
Put 66% of your bond allocation into AGG and the other 34% into TIP. I don’t believe short term bonds are of much value over cash now; so no SHY. If you follow my Four Pillars Investment approach you know I want 10-15% of the portfolio in cash after you’ve built the allocation tabled above. This is more than enough hedge against rising interest rates.
Canadian Investors: XBB and ZRR
Put 66% of your bond allocation into XBB and the other 34% into ZRR. I don’t believe short term bonds are of much value over cash now; so no XSB or ZST. If you follow my Four Pillars Investment approach you know I want 10-15% of the portfolio in cash after you’ve built the allocation tabled above. This is more than enough hedge against rising interest rates.
All-In-One ETF Portfolio Solution
These are my favorite ways to invest because they keep fees ultra low and the investment super simple. I like super simple investing so I have time to pursue other interests without having to babysit my portfolio. You can read more about this approach in my Get Rich by Keeping it Super Simple article.
American Investors:
Here is your all in ETF approach determined by your age:
Canadian Investors:
Here is your all in ETF approach determined by your age:
Next Article Will Be on Stocks
After touching on stocks here on how to implement the all in one portfolio approach we will be covering stocks in the same detail we did here today with bonds. Stocks are the wealth catalyst we need to propel our wealth into the millions. I’m already looking forward to writing about it.
Summary
I hope you have learned a little about bonds and how they are priced. Although they are very simple, they can be a very powerful diversification tool for your portfolio. However, given where we are at with interest rates and the future potential for very high inflation, they may not offer much opportunity. Sure we should all have some but keep them simple and keep the allocation low.
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