Stocks — Part XII: Bonds, and a bit on REITS

Well.  Here we are in Part XII of our series on Stocks.  And the subject is Bonds.  What’s up with that??

When I first began this series the plan was for maybe four or five segments.  Sure enough, those focused on stocks. But then we looked at some portfolio ideas and some other stuff, like bonds, got added to the mix.  Next thing you know we looking at different kinds of investment buckets, the prospect of Vanguard getting nuked and asking if everyone can retire a millionaire.  (Clearly, I should have called this my series on Investing.  Note to self:  make the change for the book.)

So now adding Bonds to the mix seems not such a stretch.  They 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.

In any event, since we have included Vanguard’s Total Bond Market Fund, VBTLX, to the Wealth Preservation and Building Portfolio we should take a little closer look at the things.

The challenge is the subject of bonds is a BIG topic.  Most of the details are unlikely to be of interest to the readers of this blog on simple investing.  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 info is enough?  Beats me.  So here’s what we’ll do.  In this post 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 end, the point where I’m too bored to write more, still hungry — google is your friend.

Info Stage I

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 REITS (real estate).  Ying and yang.

Bonds also tend to be less volatile than stocks and they serve to make our investment road a bit smoother.

Info Stage II

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 to the government.

Since deflation is when the price of stuff falls, when you get paid back the money you’ve lent 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, so money owed to you loses value.  When you get paid back your cash buys less stuff. Better then to own assets that rise with inflation.  Real estate fits that bill and REIT funds allow us to own a broadly diversified portfolio of properties without the hassles of hands on management.  Our REITs should rise in value even as inflation erodes the value of the money tied up in our bonds.

We’ll only see this sharp rise in the one and fall in the other in times of rapid inflation or deflation.  Both of which are bad times.  In the more normal times of modest inflation our bonds and REITS will still serve us well.  Bonds will pay their interest and REITs their dividends.

Info Stage III

Since we own our bonds in VBTLX, a broad-based bond index fund, most of the risks in owning individual bonds go away.  The fund holds 5248 bonds, all investment grade and none rated lower than Bbb (see Stage IV).  This reduces default risk.  The fund holds bonds of wildly 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:  If you are going to hold bonds, holding them in a fund is the way to go.  Very, very few individual investors opt to buy individual bonds.  US treasuries and bank CDs being the exceptions.

Info Stage IV

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).  The term is simply for how long the money is being lent.  So, if you were to buy a $10,000 bond at a 10% interest rate with a 10 year term from XYZ company, each year XYZ would pay you $1000 interest (10% of 10k) and at the end of 10 years they would repay the full $10,000.  If you hold the bond until the end of the 10 years, or to the Maturity Date, the only thing you have to worry about is the possibility of XYZ defaulting.

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 credit worthiness.  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 shoulder more risk.

So, default risk is also the first factor determining how much 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.

Info Stage V

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 the term.  Here’s why:

When you decide to sell your bond you offer it to buyers on what is called the “secondary market.”  Using our example above these buyers might offer more than the 10k 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 risen.  Confusing, no?  Look at it this way:

You decide to sell your bond from our example above.  You paid $10,000 and are earning 10%/$1000 per year.  Now, let’s say interest rates have risen to 15% and I have $10,000 to invest.  Since I can buy a bond that will pay me $1500 per year, clearly I’m not going to be willing to pay you $10,000 for your bond that only pays $1000.  Nobody would, and you’d be stuck.  Fortunately, however, the secondary bond market 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 $10,000 will only buy me a bond paying $500 per year.  Since yours pays $1000, clearly it is worth more than the $10,000 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.

Info Stage VI

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 the term of a bond 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.  Looking at US Treasury Securities for example 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 type, you’ll graph this on a chart and create what is called a Yield Curve.  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 a flutter.

Info Stage VII

Inflation is the biggest risk to your bonds.  Inflation is 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 rates are higher than long rates, investors are anticipating low inflation or even deflation.

Info Stage VIII

If you’ve read this far, I have a secret to share and a confession to make.  I no longer hold my personal bond allocation in VBTLX.  For now, I’m using VFIDX.  This is Vanguard’s Intermediate-Term Investment Grade Index Bond fund.

This change is buried here because it doesn’t fit with the basic concept of the Simple Path; namely an investment strategy that can be set and left to run with minimal attention.  Meeting that parameter is best served with VBTLX and its coverage of the entire bond market.  That’s still the recommendation I stand by for the Simple Path portfolios, and I’ll personally be returning to it in the future.

But if you have a more active investing inclination, as I do, you might want to consider VFIDX for the time being. Here’s my thinking:

  • A few short years ago we were teetering on the brink of a deflationary depression like that of the 1930s.  Very scary stuff.
  • The antidote is a nice solid bit of inflation.
  • This is exactly what the Fed is trying hard to spark.
  • The Fed has been aggressively pumping money into the system and has taken short term rates to zero.  Historic lows.
  • Surprisingly inflation has remained low, but that is sure to change.
  • Likely fast and hard.

In this environment short-term bonds are paying next to nothing.  Long-term bonds will get hit hard when inflation reignites.  Intermediate bonds pay a decent interest rate and their term makes them less vulnerable than long bonds to inflation.  It’s like Goldilocks and the Three Bears.  Papa’s bed is too big.  Baby’s bed too small.  But Mama’s medium term bond bed is just right.  For now, I’m hangin’ with Mama.

Info Stage IX

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 its rating is downgraded.  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.  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.  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.

Info Stage X

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. Further….

…and here’s where my interest in writing about these things drifts away.  ~2200 words is enough.  Nothing further matters for us index fund bond investors.  But if you just have to know more, Google is your friend.  Be sure to report your findings in the comments.

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