Bonds 101

Some bonds are sexy, but most are not. James Bond may be sexy, but investment-grade bonds are not. Personally, I would rather have the latter than the former, but not everyone would agree. I don’t dare ask my wife which one she would choose.

But back to investing: stocks seem to reign supreme in all investing conversations these days. Real estate is a close second. Bonds are the red-headed stepchild that isn’t discussed. 

On the other hand, there are trillions of dollars invested in bonds across the world. Some of your money should likely be invested in this asset class.

Beginning Bonds

Let’s review some bond basics. After all, knowledge is power, and we need to start with the fundamentals.

I Owe You

What is a bond? Ultimately it is an I-owe-you. You are loaning money. For example, if you invest in a corporate bond that the company is borrowing a thousand dollars from you. They will pay you interest payments twice a year. At the end of the term, several years down the road, they will also return your original investment.

Are You Mature?

As an investor, you get interest-payments and then at “maturity” you get your original money back. That is a safe and predictable bet. That is why bonds are a great way to invest and to produce passive income.

Clipping Coupons

The interest payment is paid at the “coupon rate.” If you buy a $1,000 bond and it pays you $25 every six months, then your coupon rate is $50/$1,000 or 5%. The $1,000 is the “par value” or original price. That is also the amount that will be returned to the owner at “maturity.”

The Bond Teeter-totter

If interest rates go up, then the price of the bond will go down. If the price of the bond goes down it will sell “below par.” Why does the price go down when interest rates go up? Well, think about it. How could it not?

Let’s say you are enjoying your $50 income on your $1,000 bond. That is a 5% coupon rate. But interest rates have gone up to 6%. If you must sell your bond before maturity, how much would you get for it? Do you think someone would pay you $1,000 for a 5% bond when they could buy a different bond for $1,000 and get a 6% coupon yield?

No. To make up for the lower coupon payments they will expect a bigger return at maturity. If they pay $950 for the bond, they would still receive $1,000 at maturity giving them another $50 at the end to help make up for lost earnings while they owned the bond.

If on the other hand, the interest rates fall to 4% your bond now pays a higher coupon rate than other $1,000 bonds being issued. Your bond will be so desirable that you can charge a premium. They could pay $1,050 and take a small loss at maturity when they receive the $1,000. That loss was offset by the higher coupon rate during the life of the bond.

This helps explain why so many investors are nervous about buying bonds in a low-interest environment. It is a double whammy. You receive a low coupon rate and then there is a risk of principal loss when interest rates rise again.

Bond Safety

Bonds are often described as a ‘safe’ investment. Compared to stocks this is generally true. Taken by itself that statement is a bit deceptive though. Bonds are a financial instrument and therefore have risks. There are default risks since the company or bond issuer may go bankrupt. Bond prices fall when interest rates rise resulting in interest rate risks. Foreign bonds are subject to currency risks.

Despite these risks, bonds are still safer in the short-term and medium-term. But you could invest in a high-yield (aka “junk”) bond that could soar or crash with more extremes than any given stock or stock fund. You still must understand your investments.

Measuring Risk

Price variation can be measured and plotted on a bell-curve. Bond standard deviations (a measure of price variation) is about 10% over the long-term. This is half of the stock market variation of 20%. The standard deviation for short-term bonds is closer to 5%. This dampening of price variation is why bonds are considered safer. As JL Collins says, “Bonds smooth the ride.” This smoother ride leads to more restful nights for the investor.

The sooner you will need the money, the more it makes sense to park your money in bonds. If your wedding or house down payment is only 2-3 years away, you won’t want to take the risk of having to sell stocks after a market decline. Bonds or cash would better serve the purpose. Also, you may consider matching the duration of the bond with the time horizon of your need. For example, if you will need the money in 5 years, invest in 5-year duration bonds.

Length Matters

One of the main determinants of bonds is the duration. Longer bonds are IOUs for a longer period and thus should return a higher return on average overall. Shorter bonds act more like cash with less return and less risk. Longer duration bonds are more susceptible to interest rate risk since there is a longer period for interest rates to rise.

Stocks versus Bonds

There is no guarantee that bonds will return a positive value in any time-period. There is no guarantee that stocks will outperform bonds. The longer the timeframe the more likely that will be the case. It can still take 4 decades to achieve a reasonable degree of certainty of stock’s superiority.

How do bonds fair as an investment compared to stocks? Not well. Three London School of Business professors studied a century of data and compared investment returns. The long-term real (after inflation) return is 1.6%. Stocks (conservatively calculated and inflation-adjusted) put out 6.7% over the same timeframe. For bills (less than 1-year duration) the rate was 0.9%.

Types of Bonds

There are 6 different categories of bonds. Although they work on similar principles, the risk, return, and taxes vary. They come in six flavors: treasury bills, treasury bonds, corporate bonds, high yield, inflation-adjusted, and municipal bonds.

1. Treasury bills are the safest of all options. They are backed by the full credit of the U.S. government. Since the Federal Reserve has a printing press, they could literally print the money they owe you: there is no risk. The short timeframe of T-bills also reduces risk since interest rate changes won’t significantly affect the value.

This safety is offset by a lower coupon rate. If you are more interested in avoiding loss, consider T-bills. Although the payments are low, throughout history they have beaten inflation.

2. Treasury bonds are longer bonds. They are also backed by the credit of the U.S government. Since they are longer, they are more sensitive to interest rate changes. If interest rates shoot up, the resale price of the bond will decline. Given this slight interest rate risk, there is some increased yield to make the investor “whole” for taking on this minimal risk.

3. Corporate bonds don’t have the backing of the U.S. government. Their default risk depends on the financial status of the corporation issuing the bond. Credit rating services such as Standard and Poor, Moody’s, and Fitch are helpful when estimating default risks.

The default risk is low in a normal economy. That rate can shoot up during a severe recession. Although there is an increased risk of corporate bonds, the higher coupon yield may offset this enough to make this investment worthwhile.

4. High-yield bonds are also called “junk bonds.” Their quality is low since their default risk is high. The underlying fundamentals of the companies are so poor that the company may never be able to pay the par value at maturity. In fact, by then the company may be bankrupt. Because of this increased default risk, junk bonds pay a much higher yield. Those who need a high income now may invest in high-yield bonds.

5. Inflation-adjusted bonds are very safe. One of the risks of investing in traditional bonds is that the coupon payments may not keep up with inflation. The payments are fixed throughout the life of the bond, but that amount will buy less and less as inflation ravages its purchasing power.

Inflation-bonds, such as I-bonds or TIPS, are guaranteed to return at least as much as the inflation increase. This eliminates one of the major risks of bond investing. Since this reduces the risk, it reduces the coupon rate as well.

Are you seeing a pattern yet? Lower risk equals lower return. Higher risk equals higher return. That is a pattern seen throughout all of investing.

6. Municipal bonds are securities issued by public municipalities like a city, county, or state. They have a low default risk in a normal economy but are not completely exempt from bankruptcy risk.

Their primary appeal is to the high-income investor. The interest paid is not taxable at the federal level. If you are in the same state as the bond issuer the payments aren’t taxed at the state level either. For those in a high marginal tax rate, this can make an enormous difference. For example, for a 35% marginal tax rate, a municipal bond paying 3.9% would be equivalent to a taxable bond paying 6%.

So, are you convinced that bonds should be part of your portfolio? Which category appeals to you the most? Do you want to concentrate on one or two types of bonds? Or diversify across all categories?

10 Comments

  1. Wealthy Doc said:

    I received this by e-mail from PlaneDoc earlier:
    Subject: bonds vs cash

    Message Body:
    (didn’t see a place to comment on the blog)
    Could you comment on why bonds, vs cash? As I approach retirement, I keep a significant amount of money in bonds and cash. I hate just sitting on cash..but it seems that bonds have a higher risk in the short term than cash does…

    Would appreciate your comments.

    thanks

    October 1, 2018
    Reply
    • Wealthy Doc said:

      PlaneDoc,
      Thanks for pointing out that I had inadvertently turned off the comment section. I appreciate your (and Dr. Cory Fawcett) telling me that. I believe I fixed the problem.
      I agree with your assessment about cash and bonds. It is indeed hard to sit on the sidelines with cash when stocks and other investments are doing so well. For better or worse there is a direct link between risk and reward through almost all of finance. Long-term bonds have more interest-rate risk. Short-term bonds have less interest rate risk, but the returns are also lower. I see cash not as an investment, but as a storage area. I want money for emergencies, unexpected cash needs, or investment opportunities that arise more suddenly. I expect most of my gains to come from stocks, businesses, and real estate. I invest in bonds more for the stability and reduced volatility. In 2000 and in 2007-2008 my bonds were about the only part of my portfolio that went up. I like having a predictable growth to my portfolio rather than large swings in both directions. It is more emotional than mathematical.

      October 1, 2018
      Reply
  2. Thanks for the nice summary. I have never purchased a bond or bond fund and I am now retired. I thought about doing it a lot. Every time I read an article like yours, I thought about it some more. I have steady income coming in through real estate and tend to keep a good cash reserve so I felt I would not be forced to sell stocks in a down market. So I kept all my investment money in stock mutual funds. Only time will tell if I should have put some of it into bonds.

    Dr. Cory S. Fawcett
    Prescription for Financial Success

    October 1, 2018
    Reply
    • Wealthy Doc said:

      Cory,
      Thanks again for letting me know my comment section was off this morning and thanks for going back to the site to share your comment. That is truly going above and beyond.

      Personal finance is personal. I like to have a lot of bonds (short duration) because I want minimal volatility. It is more to appease my personality than my wallet. In fact, if I had mostly all stocks I’m sure I would be much richer now from nearly a decade of equity growth. I’m fine with that. No regrets.

      I approach the market in a different direction from most. I don’t ask “What asset allocation will maximize my wealth.” I ask “what is the minimum amount of risk/volatility I need to take in order to meet my goals?” I have nothing to gain but a lot to lose. If I have another million in my portfolio nothing in my life would change. If I lost 75% of my portfolio, I may no longer be FI. I haven’t run the numbers lately to see if that is true, but you get the idea.

      At any rate, knowing what I know from your financial situation, you are fine. I wouldn’t necessarily change your portfolio. You have consulting income, retirement funds, real estate, etc. All of which is more than you really need so I think you will be fine no matter what.

      October 1, 2018
      Reply
  3. Bill Wolkstein said:

    Well written and understandable primer on bonds. I was a surgeon in private practice for 17 years when I left at 52 years old to become the managing partner and portfolio manager of a healthcare fund followed by years as a healthcare equity analyst. I occupy my time now as a private healthcare investor and have knowledge of equity investing at a high level. At 65 years old I am at a dilemma as where to invest large amounts of cash in a rising interest rate environment ex equities. Municipal bonds/bond fund may be the best choice. I am a recent follower of your thoughts and welcome your effort. Bill

    October 1, 2018
    Reply
    • Wealthy Doc said:

      Dr. Wolkstein,
      Thank you for the comment and kind words.
      You have an interesting background. I have thought about getting into portfolio management, healthcare funds, or working as an analyst as you did. From what I have heard though it is hard work and requires long hours. I’m really enjoying my part-time work now. Being Financially Independent has given me options.
      My base asset allocation is about 40:40:20 Stocks:Bonds:Other. I had a lot more equity investments in the past, but have increased my short-term tax-free bonds and my real estate investments. A lot of this is highly personal and dependent on circumstances.
      I think you would like https://drcorysfawcett.com/ if you haven’t read him yet. Cory worked as a private practice surgeon and then went part-time. He is now retired from medicine in his fifties but enjoys coaching and blogging about financial issues.

      October 2, 2018
      Reply
  4. Thanks for that informational overview. I do own some Vanguard total bond index fund. Mainly to smooth the ride of the more turbulent index stock funds. It owns 30% corporate bonds and 70% US government bonds of all maturities. I’m a little wary of a rising interest rate environment though.

    October 3, 2018
    Reply
    • Wealthy Doc said:

      Millionaire Doc,
      You can’t go wrong with that mix of bond index funds. They tend to be in the intermediate range. That provides some tradeoff between higher returns (from the longer duration) and the interest rate risks (price decline from rising interest rates). I prefer government bonds, inflation-adjusted bonds, and short-duration municipal bonds (or bond funds) that are less subject to interest-rate risk. Realize though that the return will be minimal or zero when adjusted for inflation. For me it is more like a storehouse of value and protection on the downside. More like an emergency fund. I’m not looking for good returns there either. I also agree with you that interest rates are likely to go higher. I just don’t know when or how much.

      October 3, 2018
      Reply
  5. EM Doc said:

    Thank you for your primer on bonds. I know that one should not time the market but currently I feel uncomfortable with the value of the market and have decreased my equity exposure significantly. I have about 6 years to the age of 62, when I plan on decreasing my current workload and possibly retiring. I want to “park” that cash until the time I feel comfortable increasing my equity exposure. What is your recommendation for this cash – T-bill, ultrashort term bond, money market, CD? I don’t want to just let the money sit and lose value to inflation, but I don’t want it to lose value by investing in intermediate term bonds with our Fed’s plan to increase interest rates. I don’t have real estate (except our home), side jobs, or other income – just my ability to do clinical work as a full time EM MD. With my current investments (mutual funds/cash), anticipated pension (in 6 years), and social security – I think we will be where we want to be at age 62 – as long as we don’t lose what we have saved.

    October 16, 2018
    Reply
    • Wealthy Doc said:

      I agree with you EM Doc.

      You are prudent to reduce your financial risk. A lot of bloggers (especially those of the young FIRE variety) disagree with me on this. I was invested in 1987, 2000, and 2007-2008 and that was not a pleasant experience. As we get older, replacing the losses is more daunting. Also if we sell after a decline (out of necessity to pay living expenses or out of fear of further losses) then we lose many more shares than we should. Those shares are not then available to enjoy growth, even if there is a rebound. The rebound isn’t guaranteed either. Or it might take 25 years as it did after the great depression.

      I don’t see reducing your portfolio risk as “timing the market” as many do. I see it as not wanting to pay a high price for something that shouldn’t cost that much. Or selling an item after someone offers me more than it is really worth. Another way to think of it is to ask yourself, “What is the minimum amount of volatility and equity risk that I need to take to meet my financial goals?” For many physicians who are high earners and high savers that answer is, “Not much risk at all.”

      I’m usually at 40% equities. Currently, I’m closer to 30% It may be suboptimal for long-term growth but it is meeting my financial needs and I have minimal volatility. I’m fine with that.

      So back to your question. As my disclaimer notes, I’m not giving specific actionable financial advice to individuals. I’m not a licensed professional in this arena. I do think physicians should have a substantial emergency fund. Only 70% of doctors have an emergency fund. Most planners recommend between 3-6 months. Some doctors and advisors recommend 1-2 years. That can be in a money market fund (or short-term municipal bond fund). Beyond that emergency cash, shorter-term TIPS and T-bills are good choices. One can add in some corporate AA or AAA bonds and/or intermediate bond fund/ETF to boost the return some. You do want to beat inflation but the point with these funds isn’t to boost returns, it is to reduce fluctuations and to provide cash when needed after a market downturn.

      One final comment, you may want to consider exploring real estate or a side business. I have always had both. They have provided challenges, growth, tax advantages, and cash flow. As you transition and reduce your clinical work you may find you enjoy some of those other areas. It isn’t required, but just food for thought.

      October 16, 2018
      Reply

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