Guestpost by Liz
Stocks have been discussed quite broadly in several posts and podcast interviews now and I intend to do more deep dives into certain individual stock analyses as well, nevertheless, it is true that its often associated safer investing alternative, bonds have been neglected here.
Stocks and bonds are often associated when talking broadly about investing: “You should invest in stocks and bonds”, “The right asset allocation* should include a percentage of bonds corresponding to your age”,… but are they perfect alternatives? How do they differ? Should you consider bonds in your investment portfolio?
Well, my friend Liz from Minding My Thirties is our guest today and she will help us understand the basics of bonds: What they are and how they work, how they differ from stocks, what the risks are, etc. She explains it very clearly and in a practical way, enjoy!
* Your split of investments per type of assets (if you own 50K of company shares and 10K of bonds, Your asset allocation for company shares is 83%).
Bond Basics for Beginners
Today I’d like to about the b-word.
Bonds! (What were you thinking?)
Let’s banter about the beautiful, bountiful, brilliant world of bonds! Alliterations are fun. Bonds may get a bad rap for being boring and basic, but they are certainly beneficial for a balanced portfolio. Now, brace yourself for a brimming badinage about bonds for beginners. Okay, I’ll stop.
Bonds 101: What is a Bond?
Wordplay aside, let’s dive in.
The easiest way to think of a bond is like a loan or an IOU. Let’s say our dear friend, Jonathan, asks to borrow money from me (careful loaning money to friends unless you plan on never seeing that money again [Jonathan: or that friend]). But in this case, Jonathan is a responsible guy and I know he’s good for the money. In this scenario, Jonathan is the bond issuer and I am the bondholder.
We work out a deal:
I loan Jonathan $1,000 so he can buy a new water heater for his home. In this case, the $1,000 is the face value of the bond. He will pay a coupon rate of 5% each year until the bond matures in five years, at which point he will pay back the principal of the bond. Woah, I just threw some finance jargon around so let’s break it down.
[Jonathan: First time I heard facial value at university, I was totally lost as well 😅]
Bond Interest, Principal and Maturity
When Jonathan and I make this deal, we both agree that he will pay me 5% interest of the bond’s face value every year. In the bond world – the interest rate is also known as a coupon rate. And the face value is just how much I loan to Jonathan, $1,000 in this case. So, each year, for five years, Jonathan will cut me a check for $50, or 5% of $1,000.
Five years go by and the bond is now mature, meaning Jonathan is due to pay back the original $1,000 principal (or face value) of the loan. When all is said and done I will have $1,250: the original loan of $1,000 plus the five years of $50 interest payments.
The example with Jonathan demonstrates a low-risk bond investment. He provided regularly scheduled interest payments each year and paid back the principal in full. In other words, he held up his end of the deal. In the real world, this might be similar to bonds issued by the government as many believe a government institution will never default (fail to pay back) a bond. Because these are very stable, low-risk investments, the coupon rate (or interest rate) from these types of bonds tends to be lower, meaning you’ll make less money by holding these bonds. Less risk = less reward.
However, if Jonathan lost his job right before issuing the bond or had a history of bad credit and failure to repay loans, I would consider this a higher risk. As a result, I might require a higher coupon rate, of let’s say, 10%. I stand to make more money but risk not making any if he defaults.
In the real world, this might be a corporation. Corporations can, and do, file for bankruptcy. But not all necessarily pose the same risk. For example, the risk of a startup company is different than the risk of Coca-Cola. To better assess and manage risk when investing in bonds, credit ranking agencies assign credit ratings to bonds. This is where you may have seen those acronyms that look sort of like grades: AAA, AA+, B-, etc… This indicates how likely it is for an issuer to default on the bond. Although, it’s still important to do your due diligence and research as credit ratings are not always accurate. ::cough:2008subprimehousingcrisis:cough::
Other Risks to Consider With Bonds
The risk I just referred to is what’s known as default/credit risk. However, there are several other risk factors to consider when purchasing bonds, and more importantly, to consider when selling bonds prior to reaching maturity. Despite their notorious nature of being low risk, promising investments – that is not always the case.
Interest Rate Changes
When interest rates go up, the value of the bond goes down and when interest rates drop, the value of the bond goes up. They move inversely to each other. If you sell a bond before it reaches maturity, the bond may be worth more OR less than the face value depending on the interest rate.
With Jonathan, I locked in a fixed coupon rate of 5%. But let’s say interest rates rise to 7% and I need to sell my bond before maturity. I will have a difficult time finding a buyer because a bond with a 5% coupon rate will earn less than a bond with a 7% coupon rate. Investors looking to buy bonds will look for newly issued ones that have a rate of 7%, not my measly 5% one. I may have to sell the bond at a discount to be appealing to new investors. This means I will sell the bond for less than the $1,000 face value and take a loss.
The opposite is more favorable. If interest rates drop, bond values can go up. Let’s say interest rates fall to 3% and I need to sell this same bond before maturity. New investors would be interested in my bond because of the higher coupon rate of 5% is more attractive (meaning they will earn more with that bond). In this case, I can sell the bond at a premium, higher than the $1,000 face value.
But keep in mind, these are things you cannot predict and the best strategy is to hold the bond to maturity or avoid selling when interest rates climb.
Liquidity risk refers to how easy or difficult it is to sell. Stocks, for example, are highly liquid and can be sold at any point during the day when markets are open. Real estate or art on the other hand is less liquid and could take weeks, months, or years to find a private buyer. Bonds fall somewhere in between on the liquidity risk scale. Liquidity risk for bonds is similar to what happens when interest rates rise and you’re trying to sell your older bonds with lower, less attractive, rates.
If interest rates drop, the bond issuer (Jonathan in this scenario) may redeem the bond. In this case, he would pay me the $1,000 back, but I may miss out on a few years of interest payments depending on when he redeemed the bond. I’m stuck having to reinvest the money in a less favorable market where interest rates are lower. But Jonathan is now in a more favorable position. He can find a bondholder at a lower coupon rate, meaning he’ll pay less interest over the life of the bond. This is a more common practice with corporate-issued and municipal bonds. US treasury bonds are not (usually) callable.
Inflation (the rising cost of goods and services in the economy) destroys the buying power of not only the principal of the bond but also the fixed interest payments you receive as well. Depending on the coupon rate and time of the bond to reach maturity, you may be barely beating or keeping up with inflation rates. However, there are what’s known as inflation-linked bonds. In this case, the premium or face value of the bond along with the coupon rate will adjust in value based on inflation. The downside is that your coupon rate may be lowered in exchange for fixed-income that beats or keeps up with inflation.
Different Types of Bonds
Now, while my deal with Jonathan is not uncommon among individuals, we would actually just call this a loan between private parties, not a bond. Actual bonds are really only issued by two entities: government and corporations. So let’s quickly look at the umbrella types of bonds you can purchase.
Government Issued Bonds
Government bonds can be issued by federal, state, and local governments.
US treasuries are bonds issued by the federal government and are said to be the highest security available as there is little to no risk of the US government defaulting on a bond (and if they do, we probably have bigger issues). This might have been the type of bond you got from your grandparents as a kid and had absolutely no idea what it meant.
The maturity dates usually range from 10-30 years with coupon payouts every six months. Certain federal agencies may also issue bonds for specific purposes, but let’s save that for another post.
Municipal bonds are issued by state and local governments. They might be issued to fund projects like new roads, schools, parks, etc… The benefit of municipal bonds is that they are tax-exempt on a federal and state level (if the bond issuer is the state you live in). It’s also a great way to support local projects while earning a little bit of money yourself!
Corporate Issued Bonds
Corporate bonds are issued by – you guessed it – corporations. They may be used to fund an investment or business expansion. It’s likely you’ll have higher coupon rates (therefore higher earnings) with corporate bonds, making them more attractive to investors. But these types of bonds tend to carry greater risk. There are several sub-types of corporate bonds with various structures and rates, which you can check out here.
Including Bonds in your Portfolio
So now you have the gist of what a bond is, but is it right for your portfolio? Before diving into that I’d like to preface this next part with the fact that I am not a financial advisor and do not endorse any financial strategy. This is merely my own opinion and research. Not to mention – this is a tough question to answer in a vacuum. So much depends on this like your age, risk tolerance, retirement plans, and long term financial goals.
But I’ll give you the pitch from my perspective. I’m 31 years old and while I am striving for financial independence, I don’t necessarily plan on retiring early. Or at least – I don’t plan to rely solely on my investments much before standard retirement age. I have a high-risk tolerance (a few cringes during the COVID crash, but for the most part felt fine) and want to be very aggressive in my investments as I’m focused on wealth accumulation. I also have a few decades to build wealth and recover from any hits, so it’s a great time for me to be heavily invested in stocks.
[Jonathan: same here]
With that said, for me personally, I am invested primarily (near 100%) in stocks (with a little cash reserve for rainy days). Within 7-10 years (close to 40) I will start to allocate some of my funds into bonds, with an 80-85-stocks to 15-20-bond ratio. Some advisors would probably consider this too aggressive for a 40-year-old. In fact, some would tell most 30-somethings to invest with this allocation. But, hey, I like to live dangerously! As I approach 50, I will shift to an allocation of 65-70-stocks to 30-35-bond ratio. I will probably cap off at a 60-40 ratio when I’m coming close to standard retirement age.
And because I’m a Vanguard Lover, I will go for their VBTLX index fund when it comes to bond investments. One and done – minimalist approach. I’m all about keeping it simple when it comes to investing.
The Rule of 110
Even though I don’t currently advocate for myself to invest in bonds, I still think they are a great asset for any portfolio (and a much-needed one as you get older). A good rule of thumb for determining stock-bond asset allocation for yourself may be the rule of 110. The rule states that the percentage of stocks invested in your portfolio should be equal to 110 minus your current age. For a 30-year-old, that would mean an asset allocation of 80% stocks, 20% bonds (110 – 30 = 80). I don’t believe in applying blanket rules like this and calling it a day. But I do agree this is a great place to start if you have no idea about asset allocation.
As you spend more time in the market, learn about risk and return, and understand how to manage it – it would be beneficial to re-evaluate this allocation. And, of course, always be sure to rebalance your portfolio at least once per year!
Personal Finance is Personal!
I’d like to end on this note – personal finance is exactly that – PERSONAL. Like most things in life – there’s more than one way to handle your finances. Start by doing a little research so you understand the foundations (like reading this very post), finding a community, and starting slowly. But like anything else, it’s a process and you won’t know everything right away. The important thing is just to start while your young and invest often.
About the author
Liz is a 30-something US expat living in Germany (and soon Norway) exploring a more mindful approach to finances after paying off $70K in debt. Be sure to connect with her through her blog Minding My Thirties or Twitter account: @MindingMy30s
I would like to thank Liz once again for helping us to understand the basics of what Bonds are and how they work, and from a seemingly boring topic, she made it an enjoyable read!
It is true that I did not cover them to a large extent yet here on the blog and that is most probably because I follow the aggressive accumulation path like Liz 🙂
If like Liz you wish to collaborate for guest posting or sponsored posts please do not hesitate to reach out by e-mail firstname.lastname@example.org and of course, for everyone, do follow us on social media as well for more great content, check our Facebook, Instagram, Twitter, and join our e-mail list. I would love to connect with you!