Financial Planning 101 - Bonds
Updated: Jan 29, 2020
In my last installment I started getting into the details of investment vehicles with a focus on stocks. With this installment the focus shifts to bonds and the fixed income category. When constructing a portfolio it is best to have a mix of different asset classes including bonds so it is important to understand what value they provide to your overall investment mix.
When an entity needs extra money they have a few options: they can sell stock, borrow money from a bank or sell debt to the public. Bonds are what corporations and governments use to sell debt to the public. Bonds are issued for a specific period of time with a stated interest rate paid to the purchaser. Bonds are usually sold in $1000 face amounts with interest paid semi-annually and then the face amount is repaid when the bond matures.
There are three primary types of bonds. The most common are those issued by the U.S. government. These bonds are sold by the government primarily to fund budget deficits. As you see news stories about annual deficits or the mounting government debt this has been funded by the selling of bonds. The government then is responsible for paying the interest to the bondholders. U.S. government bonds are considered the safest investment available because they are backed by the full faith and credit of the government. In theory there is no risk of these bonds not being paid because the government can always print more money. These bonds are available in a variety of term lengths from 1 month to 30 years.
The second type of bond is also issued by government entities but instead of the federal government these are issued by state and local governments and are better known as municipal bonds. These are often issued to fund items such as schools, infrastructure or other special projects.
The final type of commonly issued bond are those issued by corporations. Companies may issue bonds because they want to raise money but don’t want to dilute equity.
Pricing of a bond
Bonds can be purchased on an individual basis or a mix of bonds may be purchased together within an ETF or mutual fund. Since mutual funds and ETFs hold a mix of bonds their pricing is completely different than individual bonds. As stated earlier, individual bonds have a face value of $1000 but are rarely sold at this price once issued. The reason for this is because interest rates change over time and that changes the value of the bond. Think about a bond selling for $1000 when it is issued and paying 6% interest. This would provide the bondholder with $60 interest per year. But if interest rates go down to 5% and new bonds are paying $50 per year to the bondholder a bond paying $60 per year becomes more valuable. A bond paying 6% at that point is worth $1200 as at that price a new bondholder would still be receiving a 5% interest payment.
On the flip side if the interest rates go up to 7% and a new bondholder would be in line to receive $70 of interest per year from new bond why would they pay $1000 for a bond paying $60 per year? They wouldn’t and the 6% bond would then sell at a discount. To still get a 7% return on the $60 interest the 6% bond would have to sell for about $850.
What this shows is that as interest rates go up the price for existing bonds goes down and as interest rates go down the price for existing bonds goes up. This is only a factor if a bond is sold on the secondary market. If you hold a bond until maturity the interest rate fluctuations are irrelevant and you would get your $1000 back.
Prices for bond mutual funds or ETFs has nothing to do with the $1000 face value. Instead they package a group of different bonds and sell slices for something that is more reflective of an individual stock price or mutual fund.
What determines the interest rate?
Like with any investment the rate of return is going to be driven by the risk of that investment. If you hold a bond to maturity the primary risk is that the entity issuing the debt will not be able to repay the principal or make the ongoing interest payments. As stated previously the US Treasury bonds are considered a risk free investment so in turn they have lower interest rates. There are rating agencies like Fitch, Moody’s and Standard & Poor’s who assess the ability of the bond issuer to repay the debt. The higher rating the entity gets the less risk there is determined to be with their ability to make payments which leads to lower interest rates. Entities that are deemed more risky have to pay a higher interest rate to make the investment worthwhile since there is a greater likelihood of them defaulting. This is really no different than an individual having to pay higher interest rates on a loan because they have a lower credit score.
Another risk with bonds is interest rate risk. This is the risk that as time goes by interest rates will change and you may be left with an investment that is paying less than current market rates. The longer the maturity of the bond the more risk there is of interest rate changes during the life of the bond and therefore they will tend to pay a higher interest rate.
Why hold bonds in your portfolio
As discussed in the previous installment, stocks are known for their volatility and historically produce high returns which comes with a higher amount of risk. Bonds historically are a much more conservative investment asset. The returns tend to be much lower but this comes with much less risk. That’s not to say bonds aren’t subject to loss. As noted earlier if interest rates go up sharply an individual bond may lose a lot of its value. But, if like most investors, you are purchasing a bond fund that risk tends to go way down. Over the last ten years the largest bond fund, Vanguard Total Bond Market Index (VBMFX), has lost money in just two of those years and the worst single year performance was -2.26% while the best year has so far been 2019 which has seen a 7.61% gain. Note that over ten years the entire range of returns is right about 10%. On the other hand, the largest stock fund, Vanguard 500 Index (VFIAX), has had its worst year of -4.43% and a best year of 32.33% for a total range of return of 36%. This has been during a historically strong stock market period. In 2008 the VFIAX was down 37% while our bond returned 5.05%.
Having bonds in your portfolio provides diversification in your overall holdings. One way to achieve diversification is by having multiple asset classes in your portfolio. This helps smooth things out in your portfolio so if one asset class, say stocks, goes down sharply your entire portfolio isn’t at risk as illustrated in the paragraph above.
In addition, bonds produce income. Earlier I mentioned that bonds pay interest twice per year. This interest income can be helpful especially in retirement as it is steady and reliable even if the price of the bond itself is fluctuating. Combining this interest income along with Social Security and dividends from stocks can help inflate your income and help you not have to draw down as much of your retirement assets. When you are younger, this interest can be reinvested to help purchase additional bonds and grow the overall portfolio.
Downside of Bonds
The main downside to bonds is the smaller rate of return when compared to stocks historically. That said, you shouldn’t be buying bonds with the thought they will give you the best return. Over the long run stocks will provide the best return but in a short term scenario bonds may do better if it is a volatile stock market.
One other downside is related to the interest income I mentioned earlier. While it is nice to get the income from bonds, this income is taxed as regular income. Dividends from stocks on the other hand are usually taxed at the same rate as long term capital gains or 15% for most tax payers. Depending on what your income is level bond interest can end up being taxed at a much higher rate.
While bonds are generally thought of as being a safer investment than stocks, that really depends on who is issuing the bond. As mentioned earlier, bonds from the US Government are considered risk free but depending on the financial health of a particular company or other government entity there can absolutely be risk that that entity may not be able to pay back the bonds or make the interest payments. Again, bonds are rated so something in the AAA or AA class is very safe. When getting down to the BBB rated bonds you should be aware of the increased risk. This risk should come with a greater interest payout buy but a greater chance the issue could default.
How to purchase bonds
Very few regular investors go out and purchase individual bonds. Instead most people buy bonds through a mutual fund or ETF. These larger holdings will put together a mix of bonds and you are just buying a small piece of whatever is in the fund. This gives you access to bonds from different issuers, bond durations and interest rates. Examples of the most popular bond funds are Vanguard Total Bond Market (VBMFX), Vanguard Total International Bond Fund (VTABX) and PIMCO Income Fund (PONAX). These and similar bond funds are available in your IRA, 401k plan or your brokerage account. Individual bonds are available via a brokerage such as Vanguard, Fidelity, Schwab or TD Ameritrade.
What types of accounts should you use for holding bonds?
So you want to go ahead and make bonds a part of your portfolio. Great. But where is the best place to hold them? Bonds can be placed in any of three main types of accounts, 401k/IRA, Roth and taxable brokerage account. That said, in my opinion, bonds make the most sense in a 401k plan or a Traditional IRA. This is because the interest income being generated while the account is growing before retirement isn’t taxed and instead is used to purchase additional bonds. A Roth account on the other hand has its assets grow tax free so it makes sense to put more aggressive assets in that type of account so you can take advantage of tax free growth.
In a taxable account, it depends on the type of bond holding. Since interest income is taxed as regular income on bonds in this type of account that is makes holding bonds in a taxable account much less appealing. But, if you hold onto municipal bonds, which are tax free, then they can be a great fit and provide tax free income from a taxable account.
Bonds are a great way to add diversification to your portfolio and smooth out some of the risk you take on from the stock market. Just don’t expect the same type of returns you get from stocks and understand this may cause your portfolio to have an overall return of less than “the market” for a given period of time. That’s okay. Remember, you are not always trying to maximize every dollar of return. Instead, your focus should be on having your portfolio do what it needs to do for you and your individual situation. As with other parts of your portfolio look for diversification within your bond holdings by buying bond funds containing different maturities.
If you have any questions about how bonds fit into your portfolio please contact a financial advisor. We would love to hear from you at 7th Street Financial. Until next time, I hope you enjoyed the read and learned a little something you can use in your own life.
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