Chapter 12
Bonds
So far we’ve spent a fair amount of time looking at the stock market— stocks and the index funds we’ll use to invest in them. Makes sense. They will serve as our wealth-building tool and will most likely be the largest part of our holdings.
But at various times we’ll be adding bonds to the mix to smooth the ride, add a bit of income and provide a deflation hedge. Let’s take a closer look.
Bonds are, in a sense, the more steady and reliable cousins to stocks. Or so it seems. But as we’ll see, bonds are not as risk-free as many believe.
The challenge is that the subject of bonds is a BIG topic. The details are endless and most are unlikely to be of interest to the readers of this book.
Heck, they’re not all that interesting to me. Yet, unless you are comfortable just taking my word for it, you might want to know just what these things are and why they’ve found their way into our portfolio.
But how much information is enough? Beats me. So here’s what we’ll do. In this chapter I’ll talk about bonds in stages. Once you’ve read enough to be comfortable owning the things (or not) you can just stop reading. If you get to the chapter’s end and you want more, entire volumes have been written on the subject that can take you further.
Stage 1
Bonds are in our portfolio to provide a deflation hedge. Deflation is one of the two big macro risks to your money. Inflation is the other and we hedge against that with our stocks. You’ll recall from earlier that deflation occurs when the price of goods spirals downward and inflation occurs when they soar. Yin and yang.
Bonds also tend to be less volatile than stocks and they serve to make our investment road a bit smoother.
Bonds pay interest, providing us with an income flow.
Sometimes the interest is tax free, for example:
Municipal Bond interest is exempt from federal income tax and the income tax of the state in which the bonds are issued.
U.S. Treasury Bonds are exempt from state and local taxes.
Stage 2
So what are bonds anyway, and how do they differ from stocks?
In the simplest terms: When you buy stock you are buying a part ownership in a company. When you buy bonds you are loaning money to a company or government agency.
Since deflation occurs when the price of stuff falls, when the money you’ve lent is paid back, it has more purchasing power. Your money buys more stuff than when you lent it. This increase in value helps to offset the losses deflation will bring to your other assets.
In times of inflation prices rise and so money owed to you loses value.
When you get paid back your cash buys less stuff. Then it is better to own assets, like stocks, that rise in value with inflation.
Stage 3
Since we own our bonds in VBTLX—Vanguard’s Total Bond Index Fund— most of the risks in owning individual bonds go away. At last count, and this will vary a bit, the fund holds 7,843 bonds. All are investment grade (top quality) and none rated lower than Baa (see Stage 4). This reduces default risk. The fund holds bonds of widely differing maturity dates, mitigating the interest rate risk. The fund holds bonds across a broad range of terms, reducing inflation risk.
In the next stages we’ll talk more about these risks, but what’s important to understand at this point is this: If you are going to hold bonds, holding them in an index fund is the way to go. Very few individual investors opt to buy individual bonds, with U.S. treasuries being the main exception, along with bank CDs which act like bonds.
Stage 4
The two key elements of bonds are the interest rate and the term. The interest rate is simply what the bond issuer (the borrower) has agreed to pay the bond buyer (the lender—you, or by extension the fund you own). The term is simply the length of time the money is being lent. So, if you were to 6 buy a $1,000 bond at a 10% interest ratewith a 10 year term from XYZ
company, each year XYZ would pay you $100 in interest (10% of $1,000) for a total of $1,000 over the life of the bond ($100 a year x 10 years). If you hold the bond until the end of the 10-year term it reaches its maturity date and the bond issuer is obligated to pay back your original $1,000 investment. The only thing you have to worry about is the possibility of XYZ defaulting and not paying you back.
So default is the first risk associated with bonds. To help investors evaluate the risk in any company or government bond, various rating agencies evaluate their creditworthiness. They use a scale ranging from AAA on down to D, kinda like high school. The lower the rating, the higher the risk. The higher the risk, the harder it is to find people to buy your bonds. The harder it is to find people to buy your bonds, the more interest you have to pay to attract them. Investors expect to be paid more interest when they accept more risk.
So default risk is also the first factor determining how much interest your bond will pay you. As a buyer of bonds, the more risk you are willing to accept the higher the interest you’ll receive.
Stage 5
Interest rate risk is the second risk factor associated with bonds and it is tied to the term of the bond. This risk only comes into play if you decide to sell your bond before the maturity date at the end of its term. Here’s why: When you decide to sell your bond you must offer it to buyers on what is called the “secondary market.” Using our example above these buyers might offer more than the $1,000 you paid, or less. It depends on how interest rates have changed since your purchase. If rates have gone up, the value of your bond will have gone down. If rates have gone down, the value of your bond will have gone up. Confusing, no? Look at it this way: You decide to sell your bond from our example above. You paid $1,000 and are earning 10%/$100 per year. Now, let’s say interest rates have risen to 15% and I have $1,000 to invest. Since I can buy a bond that will pay me $150 per year, clearly I’m not going to be willing to pay you $1,000 for your bond that only pays $100. Nobody would, and you’d be stuck.
Fortunately, however, the secondary bond market (where bonds are traded after they have been originally issued) will calculate exactly what lower price your bond is worth based on the current 15% interest rate. You might not like the price, but at least you’ll be able to sell.
But if interest rates drop, the roles reverse. If instead of 10% they fall to 5%, my $1,000 will only buy me a bond paying $50 per year. Since yours pays $100, clearly it is worth more than the $1,000 you paid. Again, should you wish to sell, the bond market will calculate exactly what your higher price will be.
When interest rates rise, bond prices fall. When interest rates fall, bond prices rise. In either case, if you hold a bond to the end of its term you will, barring default, get exactly what you paid for it.
Stage 6
As you’ve likely guessed, the length of the term of a bond is our third risk factor and it also helps determine the interest rate paid. The longer a bond’s term, the more likely interest rates will change significantly before it matures, and that means greater risk. While each bond is priced individually, there are three bond term groupings: short, medium and long.
For example, with U.S. Treasury Securities (the bonds our federal government issues) we have:
Bills — Short-term bonds of 1-5 year terms.
Notes — Mid-term bonds of 6-12 year terms.
Bonds — Long-term bonds of 12+ year terms.
Generally speaking, short-term bonds pay less interest as they are seen as having less risk since your money is tied up for a shorter period of time.
Accordingly, long-term bonds are seen as having higher risk and pay more.
If you are a bond analyst, you’ll graph this on a chart and create what is called a yield curve. The chart on the left is fairly typical. The greater the difference between short, mid and long-term rates, the steeper the curve.
This difference varies and sometimes things get so wacky short-term rates become higher than long-term rates. The chart for this event produces the wonderfully named Inverted Yield Curve and it sets the hearts of bond analysts all aflutter. You can see what that looks like in the illustration on the right.
Stage 7
Inflation is the biggest risk to your bonds. As we’ve discussed, inflation occurs when the cost of goods is rising. When you lend your money by buying bonds, during periods of inflation when you get it back it will buy less stuff. Your money is worth less. A big factor in determining the interest rate paid on a bond is the anticipated inflation rate. Since some inflation is almost always present in a healthy economy, long-term bonds are sure to be affected. That’s a key reason they typically pay more interest. So, when we get an Inverted Yield Curve and short-term rates are higher than long-term rates, investors are anticipating low inflation or even deflation.
Stage 8
Here are a few other risks: Credit downgrades. Remember those rating agencies we discussed above? Maybe you bought a bond from a company rated AAA. This is the risk that sometime after you buy the company gets in trouble and those agencies downgrade its rating. The value of your bond goes down with it.
Callable bonds. Some bonds are “callable,” meaning that the bond issuer can pay them off before the maturity date. They give you your money back and stop paying interest. Of course they would only do this when interest rates are falling and they can borrow money more cheaply elsewhere. As you now know, when rates fall the value of your bond goes up. But if it gets called, poof! There goes your nice gain.
Liquidity risk. Some companies are just not all that popular and that goes for their bonds as well. Liquidity risk refers to the possibility that when you want to sell, few buyers will be interested. Few buyers = lower prices.
All of these risks are nicely mitigated simply by owning a broad-based bond index fund. That’s why VBTLX is our choice.
Stage 9
Municipal Bonds are bonds issued by governments and government agencies at the state and local levels. Typically these fund public works projects like schools, airports, sewer systems and the like.
While offering lower interest rates than corporate bonds, they have the advantage of being exempt from federal income taxes. They are also generally exempt from state income taxes for the state in which they are issued. This makes them appealing to folks in high income tax brackets, especially if they live in a high income tax state. It also makes them less expensive in interest payments for the governments that issue them.
Vanguard has several funds devoted to municipal bonds, including several focused on specific states. Anyone interested can check them out on www.vanguard.com.
Stage 10
There are precisely a gazillion different types of bonds. Basically they come from national governments, state and local governments, government agencies and companies. Term length, interest rates and payment terms are limited only by the imagination of the buyers, sellers and regulators. But since this is The Simple Path to Wealth, we can comfortably end this discussion here.