What are Bonds Anyway and Do I Really Need Them??

[social_warfare]

One really common question that I get asked is, “do I need to add bonds to my portfolio?”  In order to answer this, we need to consider what are bonds and how they work.

If you don’t know, you’re not alone.  A recent survey found that 92% of Americans can’t clearly define what exactly is a bond.

Read on to break out of the 92% and see how bonds fit into your portfolio.

Bond Basics

Basically, a bond is a loan. You’re lending money. You can think of it as lending money to friends.  When you lend money to friends everyone says, “oh, get a contract. You got to put all the terms in a contract.” You put in writing how long is the loan for, how much the interest rate is going to be.

When you invest in bonds, it’s the same thing.  Except for lending to friends, it’s a contract between you and a Corporation or a Government.

In terms of what’s different between a bond and a stock is that bonds are an obligation.  When you owe someone money and you have a contract, if you don’t pay, then there are legal consequences.

If you own equity, you own a part of that company.  Like all businesses, they will want to pay their debts first, before paying themselves. This way, they can stay in business.  Or put another way, we would first pay our mortgage before saving up for vacation. A mortgage is just another type of bond.

Let’s say the business is in so much trouble that it can’t stay in business.  They file for bankruptcy.  In this case, as the owners, they get whatever is left over (if anything) after all the outstanding bills have been paid.  That means the bonds get paid back first before the equity.  This is generally why bonds are thought of as “safer” investments.

Bond Basics: Yield

If you lend money incurs an opportunity cost.  You could have invested in other things, but because your money’s tied up there is that possibility that you’re missing out on a great opportunity.  Every day, people who have money are making loans to those people asking for loans. So, every day, a new interest rate is set that is based on that opportunity cost. When you string together everybody’s interest rates altogether, you get a “yield curve”.

If you think about high yield savings accounts. You’re basically making a one-day overnight loan to the bank and they’re paying you an interest rate. And you would think that the longer you don’t have your money to invest in other things, you’d want to make sure you’re getting an adequate interest rate to pay you for that time. So normally, the longer you lend out money the higher the interest, you would request.

In this way, the yield curve usually slopes upwards.  That is, rates are low when it’s short term and the rates get higher and higher as we add months and years to the loan.

Bond Basics: Credit

Another consideration is how creditworthy is your friend. So for example, if you’re lending a friend to someone who’s kind of a flake and, you know, hopping from job to job. You might want to say, I don’t want to lend you any money, or you do lend to them you’d want to charge them high-interest rate for that money.  You are taking a risk on them, after all.

As opposed to if you lend money to a friend that is always stable; they go to bed early they wake up early. They have a great job. The only problem is that maybe they had an unexpected expense and they just need money for a little while and you know that they’re absolutely going to pay you back.

In that case, the risk isn’t really that high. That’s how we view lending money to the government when we buy government bonds. That is considered a “risk-free rate of return.”

The additional amount that you would charge your flaky friend, as opposed to your stable friend, that’s called a “credit spread.” That credit spread is compensating you for the flaky nature.

Bond Basic: Fixed Income

The interest rate you’d get on the loan is a function of the amount of time you lend it out for and how creditworthy is that entity.  The interest rate is paid either once or twice a year.  This amount doesn’t change.  It’s income and it’s “fixed”; hence the term, fixed income.

Historically, retired folks have a lot of bonds in their investments and they live on that “fixed income”.  That fixed income replaces their salary from when they were working.  Because of this, many people don’t think bonds are for them.  This may be true to some extent, but again, I don’t believe in hard & fast rules in investing.

Bond Basics: Behaviour

One of the biggest influences on bonds is the prevailing interest rates.  This is one of the reasons that people are always talking about whether they think interest rates are going to rise or fall, if the Central Banks are going to raise or lower interest rates.

The interest rate is the cost of borrowing.  But one thing to keep in mind is that we can’t create more money out of thin air.  Let’s say today, the interest rate on lending money is 4%.  You lend your money and your contract says you get 4% a year until the loan is due.  But tomorrow, the interest rate is 5%.

You can’t get the money you loaned back because you signed a contract. In order to make a new loan out for 5%, you need someone to buy the existing contract off your hands.

If I have money today, I can make a loan for 5% or I can buy your 4% loan.  I would be a fool to take the lower percent loan for the full price.  But I might take it if you offered me a discount so that the discount and the interest gets me to 5%.

The reverse happens if the interest rate falls to 3%.  Now I want to buy your 4% loan because that interest rate is higher than what I can get currently.  The tables have turned, you’d be the fool to sell your bond to me for the price you paid.  You’d want to sell it to me for more than you paid.

So as you can see, bond prices move the opposite way than interest rates.

Bonds In Action: Supply & Demand

The reason bonds might be good for diversification is because if everyone wants out of equities, they have to invest in something. They go buy bonds because they are safer than stocks.

Stocks and bonds all live in a giant market place. The more something is in demand and the more people want it, the higher the price they are willing to pay to get it.   Like a bidding war on a house, each offer tops the other offer until the highest one is accepted.

On the other hand, if you have a house that no one really wants to buy, you might start lower the price once, twice or more just to get it off your hands.

When there is more demand for bonds, their prices go up. So people want safety and want to sell stocks, causing their prices to fall, bond prices actually rise.

Bonds in Portfolios

Let’s consider 3 different portfolios.  Portfolio A only has stocks.  Portfolio B only has bonds and Portfolio C has a bit of stocks and a bit of bonds.

If the economy is good and stocks are going up, then portfolio A is doing really well.  Portfolio B is missing out on all the gains in the stock market, and the opportunity costs are mounting.  Portfolio C is getting some of the gains in stocks, but suffering a few opportunity costs.

If the economy is tanking and stocks are going down, then portfolio A is suffering losses, and portfolio B is doing well.  It’s owning things that people want to buy.  Portfolio C is getting some of the gains in the bonds and suffering some of the losses in stocks.

As we see, portfolio C is having a bit of the best of both worlds, it doesn’t gain as much when stocks are going up, but it doesn’t lose as much when stocks are going down.  It’s more “stable”.

Conclusion:  Should I Have Bonds?

As we see, bonds can offer safety and stability. Or they can be just risky investments. There are many different kinds of bonds out there.

Many different entities are looking for loans.  Some are very stable institutions like Governments.  Some are very shaky institutions like a start-up.  Some loans are for many many years, and some are for just a few days.

Generally, the further out you are from needing to use the money in your investments, you can have fewer bonds.  A 20-year-old wouldn’t need as many bonds in their investments as a 70-year-old.  But that’s just a rule of thumb.  The 20-year-old might need a stable income while looking for work or taking care of family.  In that case, bonds might be an option.

On the other hand, the 70-year-old might have lots of resources including a fat pension and is planning on leaving their investments to the grandkids.  In that case, they might want more growth stocks and almost no bonds.

So now we know a little more about bonds, how they work and how they behave relative to stocks, we can get a better sense of if we feel we need stocks in our portfolio.