Time for another nuts and bolts investing post, laying out some of the details of the Grizzly portfolio and how we go about saving and investing for our future life. We’ve already talked about stocks and the basics of index funds, and now it’s time to discuss the other basic building block of a very simple investment portfolio – bonds. We’ll go into some details on bond basics, why you should own them, sources of risk, and the best ways to invest. So sit back, grab some popcorn, and let’s talk bond investing basics.
Bonds can be Complicated
Saying that we’re going to talk about bonds is sort of like a Zoologist saying they’re going to talk about insects. Insects are one of the most diverse populations of animals on the planet – there are around 1M recorded species, more than any other type of animal. The total biomass of insects on planet earth also outweighs all other animals combined. Bonds are like insects. The bond market is FAR larger than the stock market. Within the US the total value of all bonds is around $40 trillion, compared to only $20 trillion in stocks. The variety of bonds is also FAR more complicated than stocks – there are bonds from every level of government, bonds tied to mortgages and housing, bonds with terms that sometimes look like stocks, etc.
Basically, bonds are a big harry complicated beast and explaining them effectively in a few hundred words is going to be impossible. I’ll try to cover the basics, but keep in mind that’s what they are – basics. However, as with many things in investing, those layers of complication can often be disregarded by the average investor. Similar to stocks, when investing in bonds the average investor (including the Grizzlies) is much better off investing in a low-cost index fund. But to make it even easier we’ll go over a few options that the Grizzlies use.
So What are Bonds
The best way for the average person to think about bonds is to compare them to something most people are familiar with: loans. Bonds are reverse loans. You are the lender and something else (a company, the government) is the borrower. With a typical loan (education, home, business, etc.) a bank gives you a large chunk of cash up front and you agree to pay that amount back over a set amount of time with given interest rate applied (e.g. a 30-year mortgage at a fixed 4% interest rate). Bonds are just fancy loans to companies, governments, and other large institutions. They get a chunk of money upfront and agree to pay a certain amount of interest and principal on a clearly defined timeline. When you buy an individual bond or invest in a bond fund you’re essentially just lending money to those companies and governments, similar to how a bank lends money to a college student or potential homebuyer. They can become MUCH more complicated if you get into the details. But at their heart, they’re just a loan that you the investor are funding.
Every bond is an investment in something. The two broadest categories of bonds are government bonds and corporate bonds. Almost every country and most smaller governments like states and cities fund a portion of their spending through bonds. The funds are then used for pretty much everything the government purchases and builds – the military, national parks, roads, bridges, FDA inspectors, etc. etc. Outside of small newly created corporations most major corporations also fund a portion of their investments through issuing bonds. If it’s a bond issued by a corporation you’re funding some investment in their business – a new factory, research and development on a new drug line, an upgrade to a fleet of trucks.
Bonds vs. Stocks
The simple explanation – bonds are less risky than stocks. The way bonds are structured is usually guaranteed payout. The company (or government) agrees to pay a fixed amount over a certain period of time. They’re legally bound to pay that amount. If they don’t pay, they are in default and the owners of the bonds can bring them to court. What happens after that is VERY complicated and a topic better handled by Mrs. Grizzly or another lawyer. But suffice it to say, bad things happen to a company or government that goes into default. Most try to avoid it. When in default bondholders are also one of the first in line to collect if a company is carved up into pieces and sold off. Stocks have no such guarantees. If a company goes bankrupt they’re usually left with nothing and have limited legal recourse. Additionally, dividends, unlike bond payments, are never guaranteed and can and often are changed when business plans fail.
But less risky doesn’t mean better; it just means different. In investing you are paid for taking on risk. Higher risk = higher returns. The inverse is also true. Lower risk = lower returns. This is pretty much as universally true a statement as you get in investing and finance. Bonds almost always have lower returns than stocks. There are a few situations in which this hasn’t been the case. E.g. if you started investing at the top of the internet bubble in 2001 bonds would have performed significantly better than stocks. But these situations are largely historic quirks.
Let’s look at some actual numbers. The table below shows the average returns from an investment in the SP500 and US treasury bonds (T-Bills are just a type of US treasury bond that gets paid off in less than a year). The data comes from our friends at the Federal Reserve’s FRED Database.
The average return from stocks over the last century cleared 11% per year. The average returns of our bonds are only 5%. However, the standard deviation of those returns was a whopping 20% for stocks but only 8% for bonds. Another way to look at this is to see how the returns cluster over time. Below is a histogram of the returns of the SP500 and 10-year treasury bonds of the last century.
A huge portion of the returns to bonds cluster around 5% while very few ever fall into the negative territory. However, you also never see extremely high positive returns. Almost every year is clustered nicely around a nice low return of around 5-10%. Stocks are VERY different. You see high swings both directions.
Bonds make up an important part of a nice simple investment portfolio precisely for the reason laid out above. They are less risky than stocks. If you are in a time in your life (such as post-retirement) when you cannot risk a 50% drop in the value of your portfolio in one year (as can happen with stocks) the best course of action is to invest a portion of your assets into a less risky asset that also provides a decent return – like bonds.
However, there is another slightly more complicated reason for diverting at least some of your portfolio to bonds. They are less risky than stocks in that their returns swing less widely from year to year, but they also help balance out the swings in the stock market because bonds will often move in the opposite direction from stocks. When stocks are down bonds are up. In fancy statistical parlance – they’re not highly correlated. The below graph helps show this. This is a plot of annual returns from bonds vs. annual returns from stocks.
It looks like a cloud of noise and that’s the point. If you own bonds their fortunes won’t necessarily move in the same direction as the fortunes of your stock portfolio. This is a good thing! Particularly when the stock market takes a nose dive off a cliff.
Sources of Risk
Just because bonds are less risky than stocks does not mean they are not without risk. If you invest in bonds you should be prepared to lose a bit of money now and then. The principal that you invest is not as safe as it would be in a savings or money market account. There are a few key risks that bonds are subject to.
We discussed this early but it’s worth returning to it. Not all issuers of bonds pay their debts. Default is a real risk when investing in bonds. But not all bonds are created equal. A company like GE is about as riskless as they come. While many coal mining companies over the last few years have seen waves of defaults. You’ll often hear default risks talked about in terms of a companies credit rating from the big rating agencies – Standard and Poors, Moody’s, and Fitch.
These three companies assign ratings to every major company indicating what they feel is the likelihood of default for a given company and given bond. While not perfect (there are MANY examples of them giving their highest rating to what would turn into junk during the last recession) they are usually fairly reliable. This is where terms like AAA rating come from. AAA means a very low probability of default. While the term ‘Junk Bonds’ refers to bonds rated less than BB by these agencies with accompanying higher default rates.
Conversely, the risk of the US government not paying on the bonds it issues is pretty much zero. Why? Because the US government can just print more of what it uses to pay it’s creditors – dollar bills. However, if they US government decides to start printing huge sums of money to pay its bills we have another problem. Which brings us to the second major risk associated with bonds – inflation.
Inflation is always a risk to any investor, but it can be particularly nasty for bond investors. If inflation is high, stock investors, at least over long time horizons are usually okay. If the value of a dollar decreases it means higher prices for EVERYTHING, including the products and services that most companies sell. Costs will go up in dollar terms, but so will revenue. As a result, you typically see stock prices move up along with high inflation. This is not the case with bonds. Bonds are always a fixed interest rate on a fixed amount of principal. That means that when inflation is high the value of a given bond can be eaten away very quickly.
Interest Rate Changes
The final big risk associated with bond investing is caused by changes in prevailing interest rates. This can get a bit complicated and is probably worth a post all on its own, but the basic premiss is that the price of bonds moves in the opposite direction of interest rates. If interest rates go up the price anyone is willing to pay for a bond you own will go down. If interest rates go down the price someone will be willing to pay for your bond goes up. Why is this?
Let’s use an example. You purchase a bond that will never default for $100 paying $2 per year forever – 2% interest. Suddenly the US government makes an announcement. They will now be selling an unlimited number of bonds for $100 apiece that pay $4 per year forever – 4% interest. If you try to sell your bond now how much would someone be willing to pay for it? The answer is less than $100. Significantly less – $50 to be precise. Since there is now an easy way for anyone to get 4% interest they’ll demand 4% interest from your bond as well. As a result, for your measly $2 a year they’ll only pay $50.
However, this is an extreme example and most bonds are nowhere near that sensitive to price swings. To get a sense of how sensitive a bond or bond fund is to interest rate changes investment professionals us a term called duration. Duration is usually expressed in years. For example, the Vanguard Total Bond Market fund has a duration of 5.9 years (scroll down to ‘characteristics’ and you’ll find it listed). What the duration of a bond means is that for every 1% change in interest rates you can expect that % change in the price of the bond or bond fund. E.g. if interest rates move up by 1% then the value of the Total Bond Market fund would drop by about 5.9%. In reality, it is more complicated and a number of other factors come into play, but duration is a good guide for most investors.
What to Buy
I hope you’re not surprised by my answer here if you’ve been other posts. As with stocks almost all investors should stick with low costs and simplicity. Which in the case of bonds means the Vanguard Total Bond Market fund highlighted above. If that’s not available to you (e.g. in a 401k with crappy options) then what you are looking for is something with the words bond index or total bond index and low fees. Bond funds can often carry some of the highest fees so be careful. For reference, the Admiral version of the total bond index fund has fees of .06% – this is reasonable. Much higher is not.
How Much Should You Invest in Bonds
This is a more complicated question and most stuff you read will tell you it depends on things like your age or your ‘risk tolerance’. The later is generally better advice than the former simply because your age is usually just taken as a proxy for the more complicated term of risk tolerance. Essentially, most people will tell you that if you’re older and closer to retirement you should be less willing to take on risk (i.e. lower risk tolerance). We’ll talk about asset allocation in much more depth in a later post, but the Grizzlies like to think about our risk tolerance much more than our age. Age is worthless to us as we are far from your typical American’s who envision a retirement at some ripe old age of 65. We generally feel we can absorb a fairly large amount of variation and we have about 10% of our portfolio invested in the Vanguard Total Bond Market index.