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Hopefully you have started your financial path to, and possibly have already achieved, becoming a Capitalist.
Regardless of where you are in this journey at some point you will have a certain amount of money “sitting on the sidelines” and ready to be deployed as your untiring worker.
One of the scariest decisions is to take that hard-earned, and even harder to save, money and send it out in the world in hopes that not only will it return back to you but also bring more of its friends along in the process.
With so many investing opportunities out there an investor can be overwhelmed and easily suffer what is called analysis paralysis.
In essence a potential investor is paralyzed by indecision due to the fact that there are so many opportunities out there.
“Twenty years from now you will be more disappointed by the things that you didn’t do than by the ones you did do.” –Mark Twain
In order to make the investing world more manageable it is crucial to break it down into more manageable components, called asset classes.
The big three asset classes are Stocks, Bonds, and Real Estate, each with it’s own pros and cons for a potential investor.
Before you invest in anything, you truly have to understand it in order to avoid my foolish mistake 4a.
I feel a primer is therefore necessary to give you a very basic overall lay of the land.
Bonds:
Whereas stocks are buying an equity stake in the company, think of bonds more as a loan to the company.
Pros:
- Less volatile than stocks. Bond holders typically get priority payment over stock holders (If a company goes bankrupt, funds from liquidating assets go to paying bond holders first)
- More reliable source of fixed-income
Cons:
- Over the long run stocks outperform bonds with rate of return.
Terminology
- Maturity: Length of time until the bond amount is due
- Short-term is typically < 1 yr
- Medium-term is typically 1-10 yrs
- Long-term is typically >10 yrs
- Par value: This is the face value of the bond and the amount you receive at the bond’s maturity date
- Discount: Some instances you can buy a bond below it’s par/face value
- Premium: Some instances bonds can trade higher than it’s par/face value
- Coupon interest rate: The % interest the bond holder will pay based on par value
- Yield: True rate of return
- Example of where yield and coupon interest rate can differ:
- If buy a bond at par value ($1000k) at 5% interest rate, the yield and coupon interest rate will be the same and generate $50/yr
- If buy the same bond but at a discount ($750 for example), the coupon interest rate remains 5% but the yield increases to 6.7% ($50/$750)
- If buy a bond at par value ($1000k) at 5% interest rate, the yield and coupon interest rate will be the same and generate $50/yr
- Example of where yield and coupon interest rate can differ:
Classes of Bonds
- Treasury bonds
- Pros: Considered credit-risk free
- Cons: Lower yield
- Other US government backed bonds
- Investment-grade corporate bonds (high quality)
- High-yield/junk bonds (low quality)
- Pros: Typically give highest yields of any bond
- Cons: Backed by less reliable entities that can default on bond, thereby losing initial investment
- Foreign bonds
- Have to also consider currency exchange rate risk (if paying country currency subsequently drops relative to the US dollar)
- Mortgage backed bonds
- Typically require larger amounts ($25,000).
- Pre-payment risk (value drops when rate of mortgage pre-payment rises)
- Municipal bonds
- Pros: Interest from these bonds are typically free of tax implications
- Typically lower yields offered
- Tax bracket of investor major consideration if these lower yields are adequately compensated by the lack of tax implications.
External forces that can affect bond values:
- Market interest rates can influence prices which bonds trade at.
- Example: a bond has a coupon interest rate of 5%
- if interest rates drop (ex. 3%), investors will be looking to get gain 2% advantage by buying these bonds instead. With increased demand the bond value increases
- if interest rates rise (ex. 7%), investors in this bond are essentially missing out on 2% extra interest and hoping to sell this bond and get another one at this new higher rate. With increased supply the bond value diminishes
- Example: a bond has a coupon interest rate of 5%
Again with so many options, an investor looking to dip his or her toes in the bond market can face a daunting task.
Luckily there are similar solutions to what is offered in stocks, the ability to buy the entire bond universe with a simple total index fund (such as Vanguard Total Bond Index Fund (VBFMX).
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While no one has a crystal ball, it is highly likely that interest rates will be increasing over the next several years. This would lower the potential value of most current bonds, though somewhat less so with already lower yielding short-term bonds. To counter this probable very low return outcome, would it make some sense to have diversified holdings in some real estate debt ladder situation to achieve the ability to receive relatively continuous higher income, and decreased risk of default through diversification of multiple debt assets?
I have a similar fear regarding bonds as well. We have been enjoying a low interest rate for a long time and the Feds have already started incrementally raising the rates. I have taken a less traditional approach and in the past few years have decreased my bond allocation and instead picked up a higher percentage of REITS. Mind you I am not a financial advisor but for me it was a good solution as REITS are required by law to distribute 90% of the profits back to investors giving a yield that has been beating bonds with the chance… Read more »
Great primer. Bonds don’t get the same press as stocks for some reason, but I think they have a role in almost everyone’s portfolio. I’m too lazy to spend much time wringing my hands of the difference in yields (which is usually pretty small). I just put the portion of my portfolio that I want in bonds into the total bond index fund you mentioned above and forget about it. I’m sure that there are better approaches, but if you just don’t want to spend much time dealing with your bonds (like me), this system has worked well enough. -Ray… Read more »
Appreciate the comment Ray. Yes, bonds are the red-headed step child of the market. It is understandable because of the incredibly low interest rates we have been having, bonds have had minimal yields while their brother, the equities, have been on a tear with this bull market. It is nice to have some component in bonds just to provide a cushion when markets do turn (and they will).
Great primer on bonds. When I was younger, i was more interested in stocks and real estate. As I age and my net worth has increased, bonds have slowly creeped into my portfolio.
Thanks for the feedback. You are certainly doing it the right way. When you have won the game there is not as much reason to take risk (of course I always feel some equities still need to play a role in retirement to keep protect your nest egg from running out)
Hey XRV,
I plan to only look at bonds as “dry powder” to be used to rip funds into equities when the buying opportunities show up. Otherwise I tend not to waste too much bandwidth on it.
It’s all paper- you have zero control over it. Just make sure you do not buy junk bonds and it should be fine.
That definitely does sound like a plan. Although you are not supposed to “time the market,” if you are already in the market with bonds and the asset allocation % you want gets skewed, rebalancing it essentially implements your dry powder theory. Here’s to your success 🙂
Great primer on bonds… thanks so much for sharing this.
Currently we literally hold zero bonds… but we are currently holding on to a bit of cash so if anything we might take some of that and deploy into bonds to at least get a better return than our online savings account.
Cheers man!
My investing statement policy has me holding bonds at 5% (much lower than tradition for my age). In the poor interest environment with likely rising interest rates I actually moved majority of what I had in bonds into reits. Has better yield and I really don’t think I will sell so even if they go up or down I won’t lock losses