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Bonds and Bond Funds


Bonds are another investment tool for the Layman investor to take advantage of. You may of heard of them before, but may not know exactly what they are and how they work. In this blog post I hope to present to you in a simple and easy to follow fashion an overview of what bonds are and how to invest in them through bond funds.


Coupon Payments...

A bond is simply an IOU. It can also be called a debt instrument, as it's essentially a loan that companies, countries, states, and individuals use to raise money in the short, medium, and long term. Like any loan, lenders get to accrue interest or "coupon" payments on an annual or semi-annual basis. Every bond comes with a Coupon Payment attached. The Coupon payments are fixed dollar amount payments that are guaranteed by the entity issuing the bond (Country, Company, Municipality) to the lender (investors). The coupon payment will always stay constant, which is why bonds are known as "fixed income securities," however the yield on the bond may change. The Yield of the bond represents the effective interest rate on the bond, determined by the relationship between the coupon payment and the current price of the bond. Wait what?? Take a deep breathe and allow me to show you an example. An example always helps:


If a bond has a face value of $1000 and has a coupon payment rate of 5%, that means the bond will pay the lender a guaranteed $50/year. Even if the price of the bond jumps to $1500 or drops to $500, it doesn't matter. NOW, if the value jumps to $1500 and the coupon payment is always constant at $50, then the yield will now drop from 5% to 3.33% ($50/$1500). If the value of the bond drops to $500 and the coupon payment is always constant at $50 then the yield has jumped up to 10% (50/500).


Interest Rates...

Why then would the price of the bond fluctuate? INTEREST RATES. National interest rates can cause the price of a bond to go up or down. How? Well, let's think this through. Let's use the same example above. We have a bond with a face value of $1000 and a coupon payment of 5%. Let's say interest rates spike up to 7%, that means as a lender I could get a 7% return elsewhere instead of 5% I'm receiving from my coupon payments on the bond. As result, the demand for the $1000 bond that I own will drop. In fact, the price of the $1000 bond will drop to about $700 with a $50 coupon payment resulting now in a 7% coupon payment. As a result, there is an inverse relationship between interest rates and bond prices.


Capital Gains and Bonds...

Like stocks, bonds can also grant the investor capital gains. As we just established, when interest rates are high, bond prices are lower and therefore coupon payments are higher. Now you have the opportunity of buying cheaper bonds, but this also poses a higher risk for default. Higher interest rates usually mean that the central bank wants to keep the the economy of a country from overheating and this may cause the country to slip into a recession, which could then increase the probability of default on their debt obligations. However, if the economy slowly recovers overtime and stabilizes, interest rates may drop once again, which would then raise bond prices, which would then result in lenders receiving capital gains.


Bonds are a useful tool in reducing the volatility of an investor's portfolio. If your portfolio is only invested in stocks then you are exposed to stock market risk. Implementing bonds into your portfolio exposes you to the bond market and lowers your stock market risk.


Bond Funds...

Now, the question we must ask ourselves, is what types of bonds do we buy and how much? According to Benjamin Graham, author of The Intelligent Investor, the percentage of bond holdings in your portfolio should be equivalent to your age. The rest of your holdings should be in stocks. So, for example if you are 30 years old, 30% should be held in bonds and 70% should be in stocks. Now there are other theories out there with different opinions and we must make our own decisions. This is the art of investing.


In terms of what bonds to buy, indexing can help. Similar to buying regular Index funds to invest in stocks, we can buy Bond Index Funds, which can expose us to the bond market.

Bond Funds, like stock index funds, can offer the investor diversity in the bond market (U.S Government Backed Bonds and Investment Grade Corporate Bonds). Now, we have to be careful when picking a fund, because there are actively managed Bond Funds out there that have managers in place who will promise investors to beat the returns of the bond market. Like their mutual fund counterparts they often fall short and do not, over the long-term, beat bond market returns. They are also tax-inefficient and have higher expense ratios. Instead get a low cost Bond Index fund that simply tracks an index of Bonds. Almost all of the Bond Index Funds today track the Bloomberg Barclays U.S. Aggregate Bond Index. Vanguard Total Bond Market Index Fund Tracks this index (VBMFX).


Conclusion...

I hope that was a helpful overview of Bonds, their relationship to interest rates, and how to invest in them through bond funds. Of course, Bonds do get more complicated, but a simple overview is sufficient for the layman investor. As our skills start to build and improve we can shift into the more nuanced behavior of the bond market. Bonds are a great way for the layman investor to reduce stock market risk in their portfolio. Also it's a great way to earn passive income through fixed coupon payments. Feel free to drop a comment below, and follow me on IG @thelaymaninvestor. Happy Investing!


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