Should You Invest in Bonds?
Updated: Feb 16
Over the last 17 months, the American stock market has been on the roller-coaster of all roller-coasters. Due to the economic shutdown caused by the pandemic in March of 2020, the market set three records for the speed in which it dropped. Day one, the Dow fell 7.79%. Day two, it dropped another 9.99%. Day three was the worst drop of all, free-falling nearly 13% and tripping the limit-down “circuit breakers” which halted trading. The bottom dropped out of the market, and investors feared that this was 2008 all over again. Fast-forward to the very next month, and we are out of the bear market, seeing historic growth in all sectors. This was the fastest bear market in American history, clocking in at only 33 days. Of course, this was all brought to you by trillions of dollars of government spending, but hey, we made it!
The next thought you might have is: I thought this was about bonds? Stay with me. The above was to illustrate the absolute ride you can take with stocks. One day, you have $1,000 in the market and you’re riding high. In the above example, you would have $920 after day one, $828 after day two and $724 after day three. Let’s extrapolate this out to your retirement fund, which, if you’ve been following the correct tenants of personal finance, could have millions of dollars in it. Now all of a sudden, you could be losing hundreds of thousands of dollars extremely quickly, and could be staring down the barrel of a delayed retirement. How do you take this money and look to preserve it? Enter: The Bond Market.
What Is A Bond?
Apart from being a dope secret agent whose new movie just refuses to come out, a bond is, most simply, a physical representation of debt in the form of an IOU that pays you to hold onto it, and returns your money when it reaches maturity. Bonds can be issued by pretty much any corporate entity: banks, federal governments, state governments, municipalities, even private/public companies. A bond will indicate several crucial details within the object itself:
1. The issue price. This is the amount of money you are paying up front to receive the bond.
2. The face value. This is the amount of money you will receive upon the maturation of the bond.
3. The maturity date. This is when the contract of the bond is completed. This is what you see when you hear about “10 year” or “30 year” bonds on CNBC.
4. The coupon rate. This is the interest payed to you, as you are the person issuing the loan. If a bond pays you 3%, that means you receive 3% per year on your principal amount, making you the bank in this instance.
5. The coupon date. This may or may not be included, but it’s essentially the schedule in which you receive the coupon payments.
If you ever speak to an investment professional, you’ll typically see the following categories: equities, fixed income and real estate. You might see “cryptocurrency” nowadays if your investment advisor is rad, but probably not. Well bonds make up the mysterious “fixed income” facet of the investing diamond. That’s because they offer, well, fixed income. Makes sense, right?
The Characteristics of a Bond
Bonds are, in a word: safe. That’s why they’re recommended as part of an individual’s investment mix. They are a tool to preserve wealth, and to receive a fixed income (hence the above). There are two key characteristics of a bond that makes them appealing for investors:
1. The coupon
2. The stability
Let’s cover the coupon first. In my last piece where I provided the definitive guide on stocks, I mentioned dividends as a key characteristic for some companies. As a refresher, a dividend is money paid to an investor for holding a stock of a specific company, if the company issues dividends. Dividends are awesome, but they are potentially unsafe. Companies can pull dividends at any time, like if they are suddenly in need of cash or want to redirect those funds to a different project. Imagine if you are in retirement and you’re relying on that cash to live. This is a panicky moment for you, so there has to be a better way. Bonds are that better way. The coupon is not something the bond issuer can just stop paying. A bond is debt, and that debt carries with it obligation to continue the coupon payments. You also receive your principal back at the maturation, giving you a nice little chunk of change upon completion.
The next reason bonds are popular is because of their relative price stability. At the beginning of this piece, I outlined the heart-attack inducing roller coaster that is the American stock market. The bond performance over that time? Bonds saw an overall gain of about 7.5% in 2020, according to LPL Financial Research. While it didn’t return nearly as much money as the stock market did, it was relatively safe, which is much more important later in life. Also, it’s a little hard to get a read on how bonds perform, which is why I had to site a financial research firm above. Why? Because there are so many different kinds of bonds.
Understanding Bond Types
So I mentioned above that pretty much any entity can issue bonds. This leads to many different kinds of bonds, several of which you’ll probably run into in just everyday reading/investing/nerding out. Let’s define a few of the most common:
· Treasury Bonds – often referred to as “T-Bills,” these are backed by the federal government, which means they are inherently the “safest” of the asset class. You can purchase them in several different maturation types (10 year, 15 year, 30 year, etc), and they pay a modest coupon that typically floats around 1%.
· Treasury Inflation Protected Securities (TIPS) – these are fascinating. They are essentially Treasury-backed bonds that adjust their principal dynamically to match inflation or deflation. An issue with bonds is that, due to inflation, the money you provide up front is typically not worth as much when you get it back at maturation. This helps protect against that. The trade-off is deflation. If the economy experiences deflation, you’re SOL.
· Municipal “muni” Bonds – Municipal Bonds are government issued, but by state or local governments, not the federal one. These typically fund local projects in your community that the government needs help paying for, like new bridges or roads or schools. You can purchase short term or long term muni bonds with competitive coupons, and you could qualify for tax benefits as a result of owning one.
· Corporate Bonds – these are bonds issued by companies, rather than governments. These differ slightly to government-backed bonds due to the issue of credit-worthiness. I’ll cover this in a minute, but just know that this is a loan you are offering to a company, rather than a government entity.
· Junk Bonds – these are extremely high-interest corporate bonds that are again affected by credit-worthiness.
Let’s chat credit. I know; I just made a boring topic even worse, but stay with me. Just like you and me, companies are issued credit ratings. However, the scales are different. Whereas you or I are measured on scale up to 850 that indicates our creditworthiness and informs things like what interest rates we qualify for, companies are graded on a scale of BBB- through AAA.
AAA companies and governments are the highest level of creditworthiness, meaning that they are the most likely to pay back their bonds without defaulting or missing a payment. These are typically what you see when you purchase a corporate bond: great company, great rating, pretty low coupon. If you really want to buckle your seat belts, you can take a look at the bonds for companies less than BB+. These are below what’s called “investment grade,” and it’s where the fun begins on the coupons. We have now entered Junk Bond territory.
The highest profile recent example of this is good old Carnival Cruise Lines. The pandemic stopped the world, cruise ships were some of the first casualties. Ships had to be parked and the industry as a whole suffered immensely. In order to stay afloat (sorry), Carnival had to issue $4 billion worth of bonds. The problem with this was two-fold: their credit was already not great sitting at a B1 rating, and investors knew their company wouldn’t be able to generate cash anytime soon. As a result, Carnival had to entice investors with a pretty high coupon. Sorry wait *checks notes* ludicrously high coupon. Carnival ended up having to stick a 12% coupon on these bonds in order to actually sell them. The worst part? Earlier in 2021, they had to dip back into the bond market and again issued a very-high-but-not-as-bad coupon of 5.7%.
What’s The Downside?
We’ve talked a lot today about the benefits of bonds. They’re stable, safe, pay fixed income and you could even receive tax breaks. So are there any downsides? Hell yes. Let’s talk through them before you mortgage your home on a 30 year T-bill.
First, they under perform. 2020 was a bumper year for both stocks and bonds, as covered ad nauseum in this very article you’re reading. But look at the performance relative to each other:
· 2020 Bond Market: +7.50%
That’s an 11% difference. That’s huge for one year, but gets worse when you extrapolate over the course of a lifetime of investing. Yes, they’re stable, but too much stability too young will get you left behind, likely not being able to have enough to retire. This is a worst case scenario for many.
Second, inflation. Setting aside T-Bills for a moment, inflation is going to crush your returns in the bond market. Typically U.S inflation is between 2-3% per year, and is indicative of a healthy economy. 2021 is currently running very hot at 5.7%. This means that your principal is going to shrink in relative purchasing power by the time you receive it back at maturity.
Third, there is still risk to purchasing a bond. Bond issuers can default and fail to pay back the principal. The bond yield could increase too much, resulting in a bond that suddenly becomes illiquid. Bonds are not risk-free investments.
How Can I Purchase A Bond?
So you’ve decided you want to dip your toe into the fixed income market. That’s great! The first question you’re going to need to answer is: How old am I? Weird question, I know, but a crucial one. That’s due to “The Rule of 120.” This rule states that you should take the number 120, and then subtract your age. The number you’re left with should be the percentage of your investment portfolio you have allocated to stocks. The remaining percentage (out of 100) should be allocated to bonds. Let’s say you’re 30. This means that 90% of your portfolio should be stocks, and 10% should be bonds. This has been found to provide the highest risk-return ratio (also referred to as the Sharpe Ratio), as it maximizes your exposure to higher risk equities but still provides the foundation of the fixed asset.
Let’s say you don’t want to go in every year and re-balance your portfolio, doing the math on 120 and manually adjusting your allocations. To me, that sounds like fun. But you’re probably a normal person, so there’s a solution for you: a target date fund. A target date fund (or life cycle fund) is more of an investment strategy than an investment vehicle. Funds are available every 5 years, and really your only job is to pick the year you plan on retiring and this fund takes care of the rest! It automatically allocates your money between equities, bonds and cash equivalents to give you the proper mix of growth, income and stability. Thanks to the bond exposure, they can also give you some nice tax-advantages. Prior to tossing all of your cash at a target date fund, do some research as not all of them are created equal.
Finally, you actually have to make the purchase. Luckily, there are several ways to do it. The first, and easiest, is through your brokerage! The larger brokerages (not Robinhood) offer access to bond markets via individual bond purchases or bond ETF’s. You could also go straight to the source, purchasing government bonds from the government! Treasury Direct is the place to go for direct purchases, but they do have minimum purchase amounts so keep an eye out.
That’s it! That’s the bond market. You made it. Are you going to invest in bonds? Let me know in the comments below. And don’t forget to follow me on Twitter for more news and updates!