by You may have heard “You should own bonds” or “Bonds are safe”. Are they? What are they? Should you own them? Today we welcome you to the world of bonds. Our goal is by the end you can make a decision that’s best for you and your situation regarding bonds.
What is a Bond?
You might be asking “ok but what is a bond”? That’s a good question. Let’s define what a bond is first so we can all be on the same page.
A bond is debt issued by a company, municipality, or even a government. It is a promise to pay the borrower interest payments on that debt. At maturity the owner of the bond receives their principal payment. This is provided that the entity that issued the bond is still in business.
Let’s look at a recent example. Apple issued 10 year bonds with 1.25% coupon. As an owner of an Apple bond you would receive interest payments of 1.25% of your investment on an annual basis and at the 10 year period, provided Apple is still in business (likely), you would receive your principal back.
What does this look like?
In the chart we outline what you would receive from owning the bond. In the example we use $10,000 worth of bonds. This means you would have purchased $10K worth of Apple bonds.What’s a Bond Fund and Should You Own One?
| Year | Interest Received |
|---|---|
| 1 | $125 |
| 2 | $125 |
| 3 | $125 |
| 4 | $125 |
| 5 | $125 |
| 6 | $125 |
| 7 | $125 |
| 8 | $125 |
| 9 | $125 |
| 10 | $125 |
Over 10 years you would have received $1,250 worth of interest payments from Apple. At the end you receive your principal. Your $10K has turned into $11,250.
Is this a good deal for me?
Great question! For context if you had placed $10K in the S&P 500 for the last 10 years you would have considerably more money. Let’s look at the chart and see.
Right now you might be thinking “why would I want $11,250 when I could have $42K. That’s a great question and the answer comes down to the level of risk you are willing to take and volatility.
In the chart above you can see that the S&P had a negative return for 1 year. It was -4.4% in 2018.
Volatility and the risk that comes along with it is why many advisors recommend a mix of stocks and bonds.
Is it a good deal or what?
The answer is it depends on the level of risk you are willing to take and when you need your funds. If you can’t afford to have volatility in your funds having a portion of your money in bonds is a great idea.
While many of us have never experienced it there have been times in our history where bonds have outperformed stocks. John C Bogle points this out and details it in one of his books on investing.
Are Bonds Safe and Stocks Risky?
Bonds are often portrayed as a safe investment. They have risk. Bonds are debt. A company has borrowed money from…you. Before investing in bonds you need to know whether the companies or governments that are issuing the bonds are going to be around for the term of the loan.
Questions you should ask yourself before purchasing a mutual fund that contains bonds:
- What is the level of risk in these bonds?
- Who is the money being lent to?
- Is there a likelihood that they are in business 10,20,30 years from now (or whatever the term of the bond)?
- Does the level of risk match up with your comfort level?
Mutual funds that contain bonds outline the details of who they purchase. A fund that we have owned here at various times is a Vanguard fund that contains bonds from California authorities.
For example:
- California Department of Water Resources Water Revenue
- Bay Area Toll Authority Highway Revenue
- Anaheim Housing Authority Local or Guaranteed Housing Revenue
These are large entities that have sufficient revenue to pay back the bond. The bonds are also short term in this fund so it’s less of a risk.
Taking Action & Looking for a Bond Fund
Head over to your favorite mutual fund provider or brokerage that offers bond funds and start looking!
A few items we want you to look for when selecting a bond fund:
- Fees matter! Make sure you aware of what the annual expense is for the fund
- Taxes matter! If there is a fund that provides you tax free payments that may be beneficial to your financial situation
- What is the goal of the fund? Each fund is different and some are designed more to preserve your investment than to grow it. Make sure you know what the goal is so you can align it with your investment goals.
Share with us where you are at in your investment journey! We look forward to hearing from you.
