Lately, many investors have been dragging money out of bonds and stashing it in more risky investments. Why you ask? Well, interest rates have been at rock bottom. Low interest rates make investors run away in the opposite direction due to the possibility of future elevation. Despite a low interest rate environment, bonds are not necessarily a “bad investment”. By the end of this reading, your brain should have a firm grip on bonds as well as whether your asset allocation could benefit from them. You could continue going through life without bond knowledge but why would you want to?
What are Bonds?
Bonds are a form of debt. I know, debt often gets a bad rap and is shunned by many personal finance personalities (wow that was a mouthful). Debt; however, is something that businesses and corporations use to acquire capital to boost value. Governments are no different. Government is in essence a business as well; a business that needs debt to fulfill its obligations. We could squabble about the ability of the government to appropriately use debt but that is another topic in itself. Governments issue debt securities similar to corporations in the forms of treasury bills, notes or bonds depending on maturity date. Because bond interest rates are fixed, you may find bonds referred to as “fixed income.”
There are a slew of unique words used when discussing bonds. In fact, it can be downright confusing. The good news is you don’t have to be an expert on the vocabulary to be a bond investor. If you wish to know everything about bonds, there are a number of resources out there. But in order to avoid a headache, let’s only focus on three things; par value, coupon rate and maturity date. These will get you started but they are certainly not inclusive.
- Par value – Otherwise known as the “face value”. It is the amount of money an investor will receive when the bond matures. Par value should not be confused with market value. The latter is based on the current market interest rates. We will discuss this more later.
- Coupon rate – The interest rate the borrower will pay the investor at a specific interval. For example, a bond with par value of $1000 may pay 5% coupon rate, or $50/year. This coupon rate is fixed for the life of the bond.
Maturity date – when the borrower must return the par value. It signifies the end of the consistent influx of interest rate payments. Some bonds are “callable” meaning that borrower gives back the par value prior to maturity date. Callable bonds give the borrower more flexibility but often demand a higher coupon rate.
Now, that you have you gotten your feet wet with bond terminology, you can stop being a bystander when others are talking about bonds. You finally will be able to participate in daily water cooler conversation. But, what if someone asks you about bond risks? Don’t let yourself end up with a blank stare. Read on to learn of the risks.
Why Can They be Risky?
Stocks can be very risky, especially if you are investing in small countries without a lot of economic power or stability. Historically, bonds have less volatility than stocks and are considered less risky. It is not a free lunch though because bonds do suffer from 2 forms of risk: credit and interest rate.
Credit risk is the chance a borrower will default on its debts. Corporate bonds are more concerning than government. I guess government bonds could theoretically fail but it would be extremely rare. For the more risky corporate bond arena, there are rating systems that can help an investor determine credit worthiness. Otherwise how would you know if a bond is a good investment? There are a number of rating systems including Standard and Poor’s, Moody’s and Fitch. Through these rating systems you can determine if your bond investment lines up with borrowing to Warren Buffet (investment grade) or your broke uncle (junk bond). Generally, the lower the credit rating, the higher the interest rate demanded.
A more difficult concept to understand is interest rate risk. When a bond originates, the par value and coupon rate are both set in stone as the borrower and lender enter the agreement. But what happens if the going interest rate changes during the bond agreement? This has an interesting affect on the bonds market value. There is an inverse relationship that occurs. If interest rates go up, market bond prices drop and if interest rates drop, market bond prices increase. The best way to explain it is with an example.
Assume you buy a $1,000 bond with a coupon rate of 10% that will mature in 20 years. For 20 years, the bond will pay you $100 and at the end you will get back your $1,000 principle. Now, let’s say the interest rate ballooned to 15%. This means a similar 20-year bond would now pay $150/year. Well, that changes the market value of your bond and it is worth less. Wah, wah, wah. Why would I pay you full value for your 10% bond if I can readily get 15%? I need a discount to recoup the 5% difference. The only way this all matters to you is if you want to sell your bond. You do always have the option of holding onto the bond and getting back your full $1,000 principle and 10% yearly return.
Here is an eye opener; stocks can suffer from interest rate risk as well. Let’s not pretend that stocks will go on unaffected if interest rates elevate. The underlying companies which stocks are tied live and die on their ability to obtain capital. This capital is often attained through debt. When interest rates go up, a company’s stock can take a hit due to the extra expense of its debts. It is hard to hide from increasing interest rates.
Bond Length and Risk
A bonds length can be a huge determinate of risk. Think about it. With a longer bond, there is a higher likelihood of interest rate changes as well as possible default. Imagine your credit stricken uncle asks you for a loan. If you had to loan him money, would you rather do it over 2-3 years or 25 years. The latter seems much more risky if you ask me. My guess is if given 25 years he may simply forget about his debt.
Short term bonds (0-3 years) certainly are a way to reduce interest rate risk. However, this is done at the cost of a lower coupon rate. If stability and the lowest risk possible is your goal, then short term bonds may be the answer. Unfortunately, most investors are not willing to sacrifice the possibility of higher returns. Some even refuse to invest in the bond market all together because of subdued returns. The solution may be intermediate term bonds (4-9 years) which can offer a good tradeoff between risk and return. Remember, investing is not only about making as much money as you can. Yes, making money is the main goal but it is important to also protect yourself from possible market meltdowns.
The Case for Bond Funds
Bonds usually pay interest every 6 or 12 months. On the contrary, bond funds, which are a collection of bonds of variable maturity dates and coupon rates, distribute income payments on a monthly basis. Since 1976, the vast majority, around 90% of bond returns came from income payments vs changes in price. In a time when interest rates are going up, the reinvested monthly income payments can help offset the drop in bond value. This is likely a direct result of buying higher yielding bonds created by the elevated interest rate.
Bond funds offer you increased diversification that would be exhausting to attain through individual bonds. Because bond funds are essentially a collection of bonds, it goes to say they are less risky than putting all your money in a single bond. Think of the old adage of “don’t put all your eggs in one basket”. They also give an investor more liquidity and flexibility. Assuming monthly payments are reinvested and you can stick with it for several years, the income payments can oversight a loss in bond fund value brought on by rising interest rates.
All these risks, then why invest in bonds at all? Some people may choose to sit on the sideline and keep everything in cash. At least it won’t lose value in the bond market, right? Wrong. The risk here is with inflation. It may actually be riskier to hold cash. Why? Because inflation could eat 3% of your cash value each year.
All investments carry inherent risk. A great way to minimize risk is to diversify your assets. It is not about the individual pieces but how they work as a whole. Low correlation between assets provides a decreased risk and the prospect of more return. If assets are correlated perfectly, the asset values move together and have no risk reducing benefit. Yes, using bonds to diversify could lower your total return; however, there are years an allocation with bonds actually beats 100% stocks. Bond investment is meant to provide protection against a bear market and can help calm some volatility. Let’s face it, volatility is the enemy of the rational investor. You need to balance your needs with a willingness to lose money.
Current low interest rates have perplexed investors as to whether they should park a percent of assets in bonds. In the end, the decision to invest in bonds is a very personal one. When embarking on an investment journey, bond allocation is often times the first question that needs answering. It can be a difficult decision because there are a number of issues to consider.
Vanguard founder, Jack Bogle, recommends an allocation based on your age. Specifically he recommends bond allocation equal to your age or age minus 10. So he would recommend a 30 year old hold 20-30% in bonds. Most individuals, myself included, may view this as overly conservative at such a young age. Depending on your risk tolerance, at 30 years old, you may believe a position completely in stocks to be the most appropriate. You are by no means wrong in this belief as long as you understand the risks and likely volatility.
There are allocation questionnaires that can certainly give you an idea of an appropriate bond allocation based on risk tolerance. The problem is these questionnaires cannot predict what you will actually do in a time of poor stock market performance. What if tomorrow the stock market dropped and you were 100% invested in stocks. Could you handle the gut-wrenching stress of standing by as your accounts decreased by 50%? You may say you would stick with it but actually doing it is a different story. The best allocation for an investor is one that he/she can stick with in any stock market.
When deciding your bond allocation, I recommend not doing so in a vacuum. It is vital to consider your entire financial situation. Do you have a mortgage, auto loan or student debt? How much cash do you have on hand and is your emergency fund stacked? Do you own real estate that supplies you with monthly cash flow? These questions combined with your job stability should give you a better idea of your risk tolerance. Based on your risk tolerance, you should be able to figure out a bond allocation.
The last bit of advice is to make sure costs are low. Use bond index funds whenever possible to reduce expenses. If low expenses are important in stock funds, then minimizing them in bond funds is even more essential. A 1% expense on a bond fund could eat a large portion of your returns. Be smart about expenses and get every dime you deserve by minimizing them.
Don’t rule out bonds as a possible investment without carefully considering your risk tolerance, long term goals and financial situation. Bonds are not all bad, even in today’s low interest rate environment. Truth be told, there is no definitive way to predict future interest rate behaviors. Use bonds as a tool to diversify, reduce portfolio volatility and provide supplemental income. The main goal is not necessarily to make huge gains.
With any investment, it is important to keep costs low but especially when investing in bonds. Higher expenses equal more sacrificing of returns. If you plan to invest solely in bonds, then yes there is a fair amount of risk involved. However, if they are part of a balanced investment portfolio, then it may be advantageous to consider bonds to diversify some risk away.