Have you noticed that bonds are all the rage all of a sudden? Sure, when it comes to stocks, all the hoopla makes sense. They’re all over the place from one minute to the next! But bonds are the slow-moving cousin of stocks. So why all this interest?
Well, bonds are pretty fascinating once you start to understand them and today you’ll learn just how deep the bonds rabbit hole goes.
We’ll learn what bonds are, how to invest in bonds, types of bonds including savings bonds, why and when you might want to invest in bonds, and how well do bonds perform.
What is a bond?
Bonds are called “fixed income instruments” but that’s economics jargon. In real-people terms bonds are loans given to other people, but unlike a loan you would give a friend, bonds are nicely packaged up so that they can be traded around easily.
They have well spelled-out terms, like payback dates, payback value, terms in case the borrower goes bankrupt and interest payments.
Since they are nicely packaged and well spelled out, these bonds can be traded to bond experts or even traded around on the stock market by the click of a button.
Also unlike a loan you might give to a friend, these loans are usually given out by huge companies or governments who are willing to go through the effort of making them. Then since these entities are very large the loans are usually quite a bit safer than one you might give to a friend.
A bond is a chunk of debt issued by a company or government to individual investors. Bonds return the full principal and a fixed interest amount called a coupon to the investor at the end of the bond’s maturity, or as regular payouts called dividends.
How to invest in bonds?
When you invest in bonds, you “buy” a chunk of debt and an agreement to get a higher amount back. So the better question is “how to buy bonds?”
Savings bonds are bought from the US government (more on that below) and you buy them from treasurydirect.gov directly.
Bond ETFs or bond mutual funds, like BND, is a diversified collection of various bonds.
It’s a great way to invest in bonds because it has tiny transaction and tiny management fees. These can be bought wherever you buy stocks, like Questrade.ca, Forex.com, Vanguard, Wealthsimple.com, or even just your bank.
For any Canadians out there, I wholeheartedly recommend Questrade for trading because of their exceptionally low cost.
(I even have a separate article about how to get started in investing using Questwealth – their robo advisor service.)
Everyone else, stay tuned. I’m doing some rigorous research!
Bonds can also be bought directly from companies, but I wouldn’t recommend this as the best way to invest in bonds. It’s awkward and generally results in huge fees if you’re not a big player (to the tune of 3%.)
What do bonds do?
When it comes to your investing life, bonds have two big uses.
- They offer some stability for living expenses and for sanity.
- It provides some ‘rebalancing’ opportunities.
Bonds are loans whose value is not based on how well a company is performing, so they are valuable to own when companies are not doing well, such as during a recession. They are your anchor that can continue providing returns even when times are tough. That’s what the job of a bond is.
Even better when times are tough and your stocks aren’t worth much you can sell your bonds to buy more ‘cheap’ stocks! This is called rebalancing but in recession-esque situations, I would really recommend an updated strategy.
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How do bonds work?
In essence, you buy a bond for some amount, (say $1000) and the issuer agrees that when the bond matures (say in 5 years) you will get that amount back plus interest (so, say $1300.) That’s about it for how to invest in bonds.
Sometimes, the agreement is that you get monthly or quarterly payouts called dividends. Sometimes there’s just the one payout, called a coupon, at the end of the term.
Bonds are not an ownership investment based on the merits of a great business model for future growth. It is a credit investment based on the loanees’ future ability and intention to pay back the money you lend it. For that, you get a fixed amount of interest as a return on your investment. And that gives you a lot of security when the future growth of those companies on the stock market are dropping like they did this year.
It doesn’t sound like a huge difference to the average person but the effects are huge.
If a company does well, it doesn’t help your bond’s value. If a company does poorly it doesn’t hurt your bond’s value.
As a debt, the way the contracts and laws work is that they have to be paid out before anything else. So if a company or country is falling apart, they have to pay your debt back, before they can hand out any bonuses or stock dividends. Making them safe even in the worst of conditions.
Even better, almost always, when stocks go down, bonds go up since investors are looking for the security of bonds because they know companies will be hurting.
If that company still exists you are getting your money back with some interest icing on top!
How do savings bonds work
So, that’s the general idea of bonds. They come in a lot of varieties though (discussed at the end) and one that is particularly interesting is a savings bond.
How do savings bonds work? A Savings bond is a special investment the US government gives you access to, to help you save. You directly buy them from the US government treasury and they will give you interest and pay you back at the planned date.
The government uses that money to directly pay for any of its expenses. Then as payback, the US government backs the loan.
Currently, these are called EE bonds, and they offer a 0.10% annual interest rate with some limitations. (See the FAQ below.)
What is one benefit of purchasing savings bonds?
Since the US government backs the loan, it is considered the highest standard of safe money.
So really, by buying savings bonds you’re helping the country while keeping yourself safe for the long-term.
How to redeem savings bonds
If you’re wondering how to cash in savings bonds, it’s an efficient process through the US treasury website that only takes 2 days.
Bonds and inflation
At the very least when you own bonds you will be protected from inflation. The reason for this is simple and one of the most attractive features about bonds.
- Inflation is largely based on interest rates.
- Interest rates are largely set based on government bond rates.
- Therefore your bond money is protected from inflation almost by definition.
That may not be the most attractive sounding investment to a 20-year-old with big plans. But to an 80-year-old with plenty of money that is likely the sweetest sounding investment possible.
Historical Bond Performance
If you look at the past 100 years of US history, bonds actually aren’t that bad. They return about half of what stocks have. During a recession, the values of the bonds even go up even though the interest payback you are getting does not change.
At some points in our modern history bond interest rates have even been incredibly high.
However, Interest rates in general, thereby bond yields (the interest income you get on bonds) has been falling for nearly 700 years and the modern bond payback for holding them is going to be substantially lower now than what you might predict using historical statistics.
The 1980s (as well as the 1300s) had bond interest way up near 15% compared to the near 0.1% that you would be receiving right now for owning a bond.
Regardless of bond yields falling, the main reason investors should allocate their assets to bonds still remains valid. You are going to keep getting a safe and steady source of income. And you will be protected from the ups and downs of the stock market.
Even with the low modern returns, I’m sure people who haven’t been greedy and going all in on huge stock investments have been quite happy with their bonds ownership. That income helped them stay patient to just ride out those economic storms and it gave them cash to buy stocks and, my favorite, real estate at very low prices.
Why should everyone own bonds?
1 – Mental Aspects
A mix of stocks and bonds is usually recommended for your sanity to stop your investments from being so scary during a recession. As discussed above, bonds are safer and move a lot slower than stocks, so during a recession it gives you something to hold on to.
Even better, if you are retired and living on your investment money, owning bonds will allow you to sell something that doesn’t have a plummeting value during a recession. This will make your mid-recession life much less nerve-wracking. I own 18-months of bonds as a runway for any negative life events and I feel invincible!
2 – Improved returns
Interestingly owning bonds can help your long term returns even though the average return is lower than that of a stock.
I am a huge fan of owning a simple index fund portfolio of stocks and bonds. If you typically own a portion of your portfolio in bonds, you can liquidate that portion when recessions come about, it’s the allocation strategy I always plan for.
This allows an investor to always have funds at their disposal to buy discounted recession stocks without having to time the market, or wasting time attempting to.
3 – Recessions WILL happen
We have markets that rise and fall. No one knows when exactly they will move but everyone knows that they will drop and rise back up.
Sometimes it’s because of the economy. Many times it’s because investors are scared something might happen, somewhere in the world. You never know when it may happen. You never know when it will end and markets start rising again. The only thing you know for sure is that it WILL happen. Markets will go down and then after some they will go back up.
You always read in investment prospectuses from fancy investing firms that “past results are not a guarantee for future performance.” Do you know what that means? They were lucky the first time, they can’t guarantee the future because no one knows what will happen, and how investors will react. You need to be prepared for both the good times and the bad times.
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4 – Saving your time.
There is a certain efficiency to having a blend of both stocks and bonds. Yes, you would obviously make more money by skipping out on market crashes with perfect stock timing. But no one can do it.
You have to work hard and smart and secure your future as quickly as possible. That is where your efforts should be directed. Not by trading in and out of stocks and trying to time the market to try to avoid a recession.
The secret is that your time should not be spent trying to look out for recessions and determining what stocks will be least affected. If you just allocate some of your money to bonds you gain the benefits of possible discount stock purchases with none of the effort.
Why bonds are always in the financial news these days?
CNBC, Bloomberg, Fox Business News, they are all talking about both bonds because of two big reasons
1 – Bonds are actually having a good year.
When the pandemic first hit, stocks were battered. Sure bonds were down a little too, but they recovered faster. The S&P 500 stock index and phenomenal rally is actually up for the year. But bonds are still outperforming them. Who would have expected that we would have an up year in markets during a pandemic that resulted in an economic drop of 33%?!
2 – The Bond Market is bigger than the stock market
While most people shouldn’t own a huge amount of bonds. There are a few sets of people who love bonds and have TONS of money which actually makes the Bond market TWICE as big as the stock market. That’s an incredible figure!
1 – Retirees with plenty of money – There are a lot of people who worked into their 60s or 70s who have tonnes of money and no need to try to grow it. You might think these people are the minority of the world. But no they are not…not by a long shot. In fact, go figure, retirees have most of the money!
2 – Companies who need guaranteed money – Along the line of people with lots of money who need to make sure they have a safe inflation protected source of cash.
Mainly this means pension funds and insurance companies. They both have piles of money and they need to be able to pay it out during crazy times. Insurance alone is 3% of the US GDP ($630B/yr) and that money just piles into coffers whose only goal is to be able to payout during catastrophes.
Pension funds have even more money! US pension funds have $18.8 TRILLION DOLLARS invested!!! That’s an insane amount of money and they love bonds!
3 – Countries who need some USD
Here’s a fun fact. The world works in USD. So other countries need access to it in large sums. Japan and China own over $2 trillion dollars of US treasury bonds as investments but also to make sure they don’t have any trade issues.
Wonder why people make a big deal about boring bonds? Well, actually most people own GIGANTIC amounts of bonds. Way more than stocks could ever amount to!
Bottom Line about Bonds
Bonds are an important part of a balanced investment portfolio. Although they won’t provide as great a return as stocks or real estate in the long-term, they do provide virtually guaranteed returns and a rock to hold on to during turbulent times.
So unless you’re in your late in retirement and have no issues funding it, bonds shouldn’t be your whole investment strategy, but they make a great “peace of mind” slice of the pie.
Bonds: FAQ, resources, and definitions:
A government bond is a “debt security” issued by the government. In other words, by investing in bonds, you are loaning the government money for its spending. These can include federal, local, or municipal bonds.
Government bonds are generally considered secure and low-risk investments. They offer regular interest payouts (called dividends) and sometimes offer an interest payout at the end of the bond’s maturity.
Sometimes, government and municipal bonds are tax-free, meaning taxes will not be paid on interest earned, not that they give a lot of interest.
US savings bonds
Currently, US savings bonds are known as EE bonds and have a 0.10% interest rate, and are taxable. These are bought through treasurydirect.gov.
While the idea of buying directly from the government and cutting out the ETF-middleman to save the small fees sounds interesting, the numbers don’t really work out. You make less on these than you would on a bond ETF because the rates are pretty horrible.
Prior to 2005, the US treasury sold “E bonds.” They were typically sold as paper bonds through financial institutions, where you would buy a bond at half its face value. (I.e. you would buy a $100 bond for $50 with a pre-determined maturity date. See more)
US savings bonds value
The savings bonds’ value depends on when the bond was purchased and the purchase price.
Paper bonds (prior to 2005) were sold at half of the face value and electronic bonds are sold at face value.
The current US savings bonds interest rate is 0.10%/year, and the exact value of previously-purchased bonds can be calculated on the treasuredirect.gov calculator.
Series EE bonds
Low-risk bonds through the US government available on treasurydirect.com. These offer a 0.10% interest rate, and can be cashed any time with a maximum maturity of 30 years. (However, government bonds cannot be cashed-in within 1 year of issue, and if you cash them in within the first 5 years, you lose 3-months of interest.)
Treasury bonds are government-issued debt securities that are generally considered secure and low-risk.
US treasury bonds
US Treasury bonds (aka T-bonds) are debt securities issued by the US government with a maturity age between 10 and 30 years. They pay semiannual payouts until maturity, at which point the owner receives the face value (principal) repaid.
What do treasury bonds pay? A 30-year US treasury bond pays 1.25%/year. Meaning every $1,000 invested will pay $12.50 every year. At the end of the 30-year term you get your $1000 back.
Bonds (debt) issued by states or municipalities to finance operations. Very stable investments! Bond funds contain these. You can buy special muni bond funds but I wouldn’t bother.
Tax-free municipal bonds
In many cases, municipalities offer tax-free bonds, meaning you will not pay taxes on earned interest. Not that it will be a lot but it’s still nice 🙂
Bonds issued by the government to finance the military during times of war. They generally offer rates below market value, but appeal to citizens as a patriotic contribution.
Bonds that pay higher interest rates than comparable companies and governments because they have lower credit or represent a higher-risk. (They are sometimes synonymous with junk bonds). I recommend against them, we put bonds in our portfolio for stability during recessions. High likelyhood of default does not fulfil this goal.
Junk bonds (aka high-yield bonds) compensate investors higher as they are more likely to default than investment-grade bonds. I don’t like them, see above.