All About Bonds

Investing

This blog post is all about bonds. If you’d rather watch my YouTube video on the subject, here it is:

I was trying to decide how much of my investment portfolio should contain bonds. So I decided to do a bunch of research into bonds, and here’s what I found. Sorry this isn’t the video about my portfolio, like I promised last time, but I needed to do this research, so I thought I’d share it with you.

You know what a loan is, right? You lend a person money, and they pay you interest for a certain term of time if you’re lucky, and at the end of the loan, they give you back the principal. A bond is a legally binding form of such a loan between governments or corporations and you. You buy a bond, they pay you interest over the course of a number of years, and then at the end they give you your money back. The government or corporation wants to borrow some money, and they can do it from you!

There are two kinds of bonds – corporate bonds and government bonds. Government bonds can be federal, or municipal. Bonds from lower levels of government are riskier than federal bonds because those levels of government can default on their loans and can’t just print money to pay their debts. US Treasuries are bonds from the federal government. 

Not only can municipal governments default on their loans, but corporations can also get into trouble and not be able to pay you back. Buying a bond from a stable and profitable company is a much safer investment than buying from a fly-by-night startup. So bonds have different ratings.

There are companies out there that rate bonds. In the US there are three primary bond rating agencies: Standard & Poor’s Global Ratings, Moody’s, and Fitch Ratings. Each has their own rating system, but they’re similar. For example, Standard & Poor and Fitch both rate their bonds AAA, AA, A, BBB, BB, B, CCC, CC, C, and D. The best is an AAA rating. Safer bonds generally have lower interest rates than riskier bonds. You want investment grade bonds, which are the ones that are less risky – BBB and up. And you want to stay away from high yield or junk bonds – the ones with really poor ratings – BB and lower.

Primary issue bonds are ones you buy directly from the issuer through a broker or directly from the government. Secondary issue bonds are those that you buy from someone who already owns the bond.

Investment grade bonds are a lot safer than buying a stock. For this reason, people like putting bonds in their portfolio to both add diversity and safety.

It’s possible to buy bonds that have already been issued. But it’s unlikely that you’ll buy it at face value. Here’s why. Say a 10 year bond was issued with a 5% yield or interest rate. But the next day, interest rates go down to 1%. New bonds would have to be issued at the 1% rate. So now that 5% bond looks really good, doesn’t it? If you had to choose between the 1% bond and the 5% bond, you’d choose the 5% bond. So the person selling it to you can up the price a little, and as long as they don’t raise it TOO much, you’d still be willing to pay.

But buying bonds directly is safe – especially if you buy US Treasury bonds. You get regular interest payments and principal returned at maturity.

If you want to buy individual bonds you have to buy them from the government or over the counter from a bond broker. A bond broker is someone who deals with buying and selling bonds.

Benefits of bonds:

  1. Less risky than stocks.
  2. Diversification – not just stocks.
  3. Income from interest.

Bad about bonds:

  1. Lower returns than stocks.

But say you don’t want to buy individual bonds, and don’t want to wait years for them to mature, only to buy more bonds, etc. Also, you want more diversity in your bonds.

This is where a bond fund comes in. You can buy a basket full of bonds, either in a bond mutual fund or a bond ETF. I don’t like mutual funds, so we’ll just talk about ETF’s here, but the concepts are the same.

A bond ETF is a basket of a bunch bonds. This provides diversification. If one of the bonds goes into default, it’s just one of many many bonds in the fund, and will have minimal impact. And you can buy shares in that ETF on the stock market, which is very easy to do. Just contact your broker and ask them to do it, or do it through your broker’s website or using your brokerage account app on your phone. Bonds usually have denominations of $1000 or $5000 or more, but shares in an ETF usually cost much less than that, so it’s also easier to get started. You don’t need to buy individual bonds yourself – the ETF people do.

The owners of the bond ETF will constantly be cashing in bonds as they mature and will buy new bonds. They will also typically pay you a dividend, which comes from interest from bond payments or from selling of bonds themselves. While a bond ETF is not guaranteed to give you a dividend, it’s still very likely. Check the ETF’s payment history online to see what their payments are like. Another risk with bond funds is that they do not guarantee the return of principal. If you buy a US Treasury bond, the government will guarantee you your interest payments and return of principal when the bond comes due. A bond fund, however, may go up and down in price, and when you decide to sell, the price may be lower than at the time you bought it.

Bond etfs are more liquid than buying or selling bonds directly with dealers. Just go to your broker and buy and sell at will.

So, now you know about bonds.

What I’m personally trying to determine right now is how to rearrange my portfolio to follow a real strategy. Up until now, I’ve just tried purchasing funds that looked attractive. But I want to start following a strategy.

So that means I need to come up with a strategy, which partially means determining how much of my portfolio will be in bonds. I haven’t come up with an answer yet.

In case you want a place to start, here are the names of some bond funds that I know of. But it’s just a small list to get you started:

iShares Core U.S. Aggregate Bond ETF (AGG)

BMO Long Corporate Bond Index ETF (ZLC.TO)

Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX)

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