What are Bonds?
Bonds are a fixed income instrument that represents a loan made by an investor to a borrower, typically to raise money to fund a specific project. A bond is essentially an IOU between the lender and borrower which includes details of the loan and its payments. Owners of bonds are debtholders of the issuer.
Categories of Bonds
Bonds come in a variety of different forms, corporate bonds for example tend to have a higher interest rate paid to the bond holder but they aren’t as secure as holding government issued bonds. Municipal bonds are issued by cities or local government to finance public projects such as roads etc. Treasury bonds are issued by the government and as previously mentioned, generally offer less of a return than corporate bonds. There are also agency bonds which are issued by government-affiliated organisations.
Within these categories there are different varieties of bonds available
- Zero-Coupon Bonds
- Convertible Bonds
- Callable Bonds
- Puttable Bond
When referring to bonds people often think of ‘premium bonds’. Yes, that’s what your grandparents had hidden away in their roof space for 30 years. Premium bonds are essentially a type of savings account you can put money into where the interest paid is decided by a monthly draw. Each bond costs £1 and the more premium bonds you have the better your chances of winning. It’s similar to the lottery in the sense you have about as much chance of winning the maximum prize of a million as Boris Johnson has of getting a proper haircut.
The maturity date of bonds vary. Short term bonds are more resistant to rising interest rates but they offer less protection during a market crash. Long term bonds can offer a significant gain if interest rates drop but on the flipside can experience a significant loss if interest rates increase. Intermediate bonds are often used to get a blend between the two.
Bonds that are not considered investment grade, but are not in default are called high yield or junk bonds. These bonds have a higher risk of default in the future and investors demand a higher interest payment to compensate for the risk.
What are the Historical Returns?
Historical data doesn’t necessarily represent future results but it’s good to compare historical returns of bonds to compare them to stocks. Since 1926 bonds have averaged a 5-6% gain compared to 10% for equities. It’s generally recommended that young people who can stomach market volatility should invest almost exclusively in equities as they will experience a better return over the long run.
Advantages of Bonds
Bonds are seen as a relatively safe investment. They don’t tend to fluctuate the same way as equities and can therefore reduce the volatility of your investment. This is generally the main reason people tend to increase their bond allocation closer to retirement as the diversification of stocks and bonds reduces your financial risk. When the dot com bubble burst, bonds increased 14% from 2000 to 2002 when stocks sank over 40%. Similarly, in 2009 when the world stock market decreased approximately 35%, bonds increased 14%. Another benefit of bonds is that they offer a fixed income of interest (albeit) usually smaller than what you would made on equities. A lot of people who invest in bonds also like the idea that you might be helping to build public services such as schools, roads etc.
Disadvantages of Bonds
Bonds, like every other assets do have negatives. Whilst bonds are often described as ‘safe’ it’s not always the case. As previously mentioned, long term high yield bonds still experience significant volatility. Equities also experience a better long term return so if time is on your side it’s probably not worth considering bonds just yet. There is also the issue of credit risk which means that issuers could default on their interest and principal repayment obligations if they experience cash flow problems.
A Bond Market Crash?
Is it possible the bond market could crash? ‘Experts’ have been predicting a bond market crash for many years. The debate about interest rates returning to ‘normal’ rages on and there’s plenty of room yet for negative yield bonds. If we look historically, bond corrections happen much less than in equities. There’s only been three years where the annual loss of bonds exceeded 20%. Stock market corrections on the other hand tend to happen on average every 1.9 years.
What are Series I Bonds?
A Series I Bond is a savings bond that earns a combined fixed interest rate and variable inflation rate adjusted twice a year. Series I Bonds have increased in popularity recently due to the fear of high inflation. These bonds are meant to give investors a return plus protection against inflation to maintain their purchasing power. These bonds are considered low risk as they are backed by the US government and their redemption value cannot decline. With that safety usually comes a low return, comparable to a high interest savings account.
Where to Buy Bonds
You can buy bonds from most brokers similar to stocks. Treasury bonds are the exception which you can buy from the US government.
Bonds can be a good investment depending on who you are. If you are a bit more risk adverse you may want to consider bonds. Bonds can diversify your investment portfolio if you are all in on stocks although depending on your age it may not be necessary. If you look online you’ll find many suggesting that the ‘standard’ bonds to stocks ratio should be to take your age and that’s how much of a bond allocation you should have in your portfolio. If you’re 30 you should have 30% bonds and 70% stocks for example. This is very conservative and you can find many who would suggest you should take your age away from 120 and that should give you a good bond to stock allocation. 120-30 = 90% stocks and only 10% bonds for a 30 year old. It’s really a personal preference, there is no question that over the long haul stocks do outperform bonds so if you are still a long way off from retirement perhaps you should just consider investing in equities and stay away from bonds altogether until a later date.
The views expressed in this post are the authors and should not be construed as financial advice
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