Asset Class IIIA: BONDS

Never forget these two axioms:

 

Money frees us, but its pursuit may enslave us.

It’s not about how much you have at the end; it’s how much you could have made.

 

Asset Class IIIA

 

Bonds

James Bonds…

Sorry, I couldn’t resist.

What exactly are bonds?

Your whole life is based on being a debtor—college loans, med school loans, car loans, home loans, etc., etc.

For once in your life—and likely for the first time—you can be the lender (i.e., the creditor).

By far the most common types of bonds are either corporate or municipal (usually cities or states, but obviously the federal government issues bonds as well).

This is how it works.

A bond is a simply a security of debt—an IOU—where the one issuing the bond not only owes the value of the bond to the person (or institution/mutual fund, etc.) who bought the bond, but also some interest that is agreed upon.

Congrats! You’re the bank…for once.

First some terminology…

Creditor: the person who bought the bond AKA the bond holder AKA the lender

Debtor: the issuer of the bond AKA the borrower

Face Value or Par Value: the original value of the bond alone AKA the principal

Yield or Coupon: the interest that the issuer of the bond/the borrower owes to the bond holder (not like 25 cents off Little Debbie’s coupons)

Default Risk: the likelihood that the debt won’t be paid back to the bond holder

Default risk influences yield/coupon. The higher the default risk (i.e., the more likely the bond issuer/debtor cannot pay back the creditor/bond holder/lender (you)—i.e., the more risky the investment), the higher the yield (interest) will likely be to attract people to buy such bonds. The lower the default risk, the lower the coupon/yield.

(In the good old days [for some of you that’s the 1960′s; for others, that’s sadly the 1990’s], each bond was represented by a physical certificate where the paper document had actual coupons that were cut out for which interest was paid.)

Not all bonds have coupons. These so-called “zero coupon bonds” are bought at a discount and then redeemed at a known higher value on their maturity date (see below for this terminology explanation).

Bonds allow companies or even governments to borrow millions (or hundreds of millions) for long-term expansion or research and development on the corporate side and current projects (usually listed as exactly which construction project for example) on the government side.

The amount of money needed for such projects is usually way beyond what a bank would ever lend and would also make the bank (even the few that would be big enough and brave enough to lend such a large amount of money) put such stringent requirements on the borrowers that it wouldn’t be feasible for the borrower to accept such terms.

As a stock holder, you own (probably a tiny piece) a part of that company. When you’re a holder of a corporate bond, you’re a creditor/lender to that company including all the shareholders. (If you owe both shares and bonds of and from the same company, in a sense then you owe yourself money…and interest.)

News flash: Bond holders take priority over shareholders.

In other words, if a company is going bankrupt, bond holders are paid before shareholders.

So if you think you’re a big deal hot shot because you own stocks…you’re not.

Also, bonds have a defined term AKA maturity after which the total payout (value of the bond originally AKA the principal plus all the interest owed) is given to the bond holder. (There are securities known as irredeemable bonds which is known as a perpetuity—i.e., a bond with no maturity.)

Interest is usually payable at fixed intervals (annual, semiannual, or quarterly; less often monthly).

Bonds are known as fixed income securities since the lender can accurately predict how much money he or she will make by a fixed time (i.e., the maturity date).

Another feature of bonds are their negotiability (not true of all bonds—the issuer will tell you if it’s not) meaning that the ownership of the bond can be bought and sold on the secondary market.

Dr. Unwise: Uh…what now?

Dr. Scared: This is it! This is how they screw you!! Money under the mattress is the only way to go!

PWT: Steady, guys…and settle down.

Once your bond is stamped (i.e., the physical certificate used to gets its stamp of ownership), you can sell it for a nice tidy little profit if it’s desirable enough among those seeking bonds, sometimes even years after the bond was originally issued.

Buying it from the issuer is done on what is known as the primary bond market.

Buying bonds from bond holders is done on what is known as the secondary market.

Here’s how bonds work.

Imagine you buy a $10,000 bond with a 5% coupon (or yield) with a ten year maturity date.

You’d get $500 a year as the bond holder. How that is paid depends on the issuer, but corporate bonds typically pay semiannually.

You get $500/year for ten years or $5,000 for the entire decade.

Then, you get back your principal—$10,000—on the maturity date ten years after you bought the bond.

So, all told, you get $15,000 total (over ten years) for buying a bond for $10,000 a decade ago—just like a bank.

Now you can see how banks make their money. 

So, you got a 50% return on your money over ten years. And it was as safe as any security.

Pretty great right?

Yeah…maybe.

Dr. Scared: See! See!! This is it! This is the path to true wealth!! It’s the only way to go!!

Dr. Know It All: How the hell do we shut this idiot up?

PWT: Fellas, calm down. And Dr. KIA, I know it’s hard, but stop being such a jerk. 

Anyway…

Depending on when your bond is being held/its maturity date is, you may do well and better than the stock market. But usually, bonds perform worse than the broad stock market over time generally speaking.

Don’t get me wrong. 50% return over a decade with no effort and not worrying about the gyrations of the market over that ten years is pretty grand.

Only you (and your spouse) know what returns you want, how much risk you’re willing to take, and how easily you sleep with what you’ve invested in and where your money is. (Much more on this in a later post.)

But, realize this, with few exceptions, you are trading solid returns for peace of mind.

Bonds=Securities with security.

Also, realize this:

This example only highlights the bond with a fixed interest rate (the majority) whereas a sizable number of bonds have variable interest rates where they can fluctuate as often as daily.

Back to our example though:

If you had the above bond (50% return over a decade), then you would have come out way ahead from 2001-2010* (S&P 500 total return with dividends: 11.971% or 1.147%/year for the decade) compared to the stock market.

(*January 2001-December 2010)

However, if you had the same above bond again (50% return over a decade), then you would have come out way behind from 2008-2017* (S&P 500 total return with dividends: 136.909% or 9.087%/year for the decade) compared to the stock market.

(*January 2008-December 2017)

(On purpose, I didn’t index this to inflation. Also, I didn’t take fees out of the stock investor’s return because the fee depends on how you invested in the stock market—by yourself, financial advisor, mutual fund, ETF, etc. But, if you invested in the broad stock market by a low fee mutual fund like Vanguard, the expense ratio [remember that?] ranges from 0.04%-0.14% [i.e., $4 charge for every $10,000 invested-$14 charge for every $10,000 invested]. So, in this example, the dent fees would make is quite low though I never want to discount fees or say they are negligible.)

The biggest problem with bonds is the generally low return you get from them. Five percent is great if you can get it, but you’re often not likely to do so with bonds.

The average yield on corporate bonds is 3.83% as of December 2017.

The average yield on municipal bonds is hovering in the 3.6-3.65% range as of December 2017.

And, finally, the US Treasury bonds, the safest and worst paying of them all, is ranging from 1.29% (1 month) to 2.81% (30 years) depending on the maturity dates (noted in parentheses). (These rates are as of January 2, 2018. Believe it or not, these rates fluctuate daily.)

Now factor in these possibly (likely) much lower returns and bonds clearly take a backseat to stocks and funds, especially if the latter two are kept in a low fee environment.

Investing…not easy stuff, huh?

Moody’s       S&P/ Fitch        Grade                        Risk 

Aaa                  AAA               Investment             Highest Quality

Aa                     AA                 Investment             High Quality

A                       A                    Investment             Strong

Baa                BBB                Investment             Medium Grade

Ba, B              BB, B                Junk                        Speculative

Caa/Ca/C      CCC/CC/C       Junk                        Highly Speculative

C                        D                      Junk                         In Default

 

Dr. Unwise: What in the name of all that is holy is this abomination?

 

Dr. Scared: This it! This how they screw you!!

 

PWT: This is a bond rating table. 

 

For corporate bonds, there is a standardized bond rating system, based on the analysis of the three major US credit rating agencies (Moody’s, Standard and Poor’s (Hi again!), and Fitch Ratings) to help potential bond buyers determine a company’s default risk. This is essentially the company’s credit rating. Like the letters in the above table, this is the report card for a company (more specifically, the credit rating of that company).

You may have heard of junk bonds. These are instruments of debt (that’s all bonds are, after all) that are put out by companies in financial trouble. The companies in question are banking on raising money to start a new venture, expand business, etc. that will right the ship for the company. These bonds have a high yield to attract potential investors. This is precisely the scenario in which bonds can be riskier than any other security, even stocks.

I think we’re at a good stopping point for now before we finish our discussion on bonds in the next post.

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Talk to you soon.