Episode 15: Bond FAQs
Aug 1, 2021
Many of us have heard of bonds but on this episode, we are going to cover some of the basics around this investment vehicle and why (or why not) you may want to consider them in your portfolio today.
- What exactly is a bond?
- Why you should consider bonds in your portfolio.
- How bonds could be in trouble in today’s economy…and much more!
Isaac Wright: Well, hello there. I’m glad to have you back here at Wright Money Tips. I’m Isaac Wright and today we have our guest of the day, Kevin Buenvenida. Kevin is one of our associate advisors here at Financial Dynamics. But we’re going to have a conversation; I think a lot of you probably have heard the term around called bonds as a financial vehicle. But I have to say this, a lot of people are still very confused and some people outright don’t even know what a bond is when it comes to an investment or financial tool. So, we’re going to cover what I call the basic FAQ’s around bonds today, and whether or not some of this information, hopefully can parlay into your financial affairs. With that being said, Kevin, glad to have you on the program today.
Kevin Buenvenida: Thank you so much. Glad to be back.
Isaac Wright: I think this topic is going to be a good topic for you to be able to take the reins. I’m just going to tee up because a lot of this information we see day in and day out. Number one is this, can you explain to everybody today what generally is a bond? Sometimes people are just confused over what that is. I know that sounds very simplistic, but let’s start there.
Kevin Buenvenida: Absolutely. So, I will do my best to make this as entertaining and thrilling of a conversation as much as possible because bonds are also known as fixed income and in the world of investing, tend to be the less exciting part when we think about putting your money to work in the market.
Isaac Wright: Yes, they do.
Kevin Buenvenida: So, in comparison to stocks, which most of us are aware of as a way to participate in the success of a company by being a fractional owner of that company, bonds are a little bit of a different animal. As a bond holder, we actually own the debt of an issuer. An issuer in our conversation piece today could be the U.S. government, it could be an international government, it could be a large company, it could even be your local municipality. And with that debt bond in the simplest terms, represents or is a financial instrument of an agreement between you and that issuer where you as an investor and owner of their debt have loaned that issue or that money. And in that agreement, that issuer is going to return that amount of money back to you after a set amount of time. In addition to that, during that time that you’ve lent that money to the issuer, they’re going to make a regular payment to you in the form of interest, also known as the coupon on the bond.
Big picture wise, as we compare stocks versus bonds versus cash and an appropriate, let’s say asset allocation and investment strategy, as I mentioned, bonds are less thrilling compared to stocks because their price doesn’t fluctuate as much as let’s say, a stock on a day-to-day basis. For that, most investors, most individuals, maybe even professionals, endowments use bonds or fixed income as the conservative part of their investment approach because the prices don’t fluctuate as much. And maybe for a more conservative investor, an average retiree who is now living off of a fixed income, the income coming off of the bond, that regular payment that you’re getting from the issuer can help supplement other forms of retirement income that you’re collecting.
Isaac Wright: You know, I think that probably is a really good summary, actually, Kevin. You know, the main thing is this, I think people need to understand it’s a debt obligation. And so it’s no different than having your own personal liability where you have to pay back your own debts, if you will. This is taking on the obligation from a company or a government or a municipal. Great way to kind of have people think about that and the fact that you have income payments come off of this. Some of them are systematic, quarterly and some of them are paid at the end of the bond. There are variations of that, but I think most people need to know it’s a substantial, it’s a very high level of importance that you understand that because it can be a very important piece of a portfolio.
So, for all of you today, keep this in mind. We’ll talk a little bit about this here, but I think we’ll have time. People are concerned about where bonds are going with interest rates, but the simple fact is this, bonds are always going to play a role under most circumstances in a portfolio that’s well diversified. So, probably that’s good to kind of lead into. Bond values, as you say, they don’t fluctuate as much as stocks typically. But what generally makes bond prices rise or fall?
Kevin Buenvenida: Even though bonds were conservative and we know that the bond prices don’t fluctuate as much as stocks, there are still influences that will cause bond prices to go up or go down.
First one, and I think this is maybe a hot topic for the investment landscape and maybe even political landscape for today, interest rates will drive the prices of bonds up or down. Now there’s a unique relationship with interest rates, as well as the bonds that you might own. It’s an inverse relationship. Basically, as interest rates or the environment that we’re in interest rates go up, bond prices and vice versa. If the interest rate environment goes down, bonds that you currently own, those prices tend to go up.
A Second factor that normally starts to play into bond pricing is going to be the demand for growth versus safety and an economic or market cycle. If we think about that relationship in boom times when people are feeling really good about investing in the stock market, they may want a vehicle that provides more growth, potentially more income and they may tend to have less of an allocation in their portfolio in bonds. So, there might be less demand for bonds, lower demand means lower prices.
And then the third part here that as an investor of bonds, and we’ll talk about risk specific to bonds in general, would be what kind of bond do you own and what kind of issuer have you entered into an agreement with? Are they a financially stable issuer, a big company that has lots of cash on the balance sheet? Or maybe you’re taking a little bit more risk with that company, with that bond where there’s uncertainty as to whether or not you’re going to get your money back at the end of that term? Or you’re going to be able to collect the interest payment, the coupon? So, those three things right there on the day to day tend to cause the volatility, it will be less than stocks for bonds and fixed income.
Isaac Wright: Well I think the last part since you brought it up too, because right now, people know interest rates are basically zero and they’ve been that way for a while. And of course, interest rates on bonds can be all over the place as well. But, typically have been leaning towards a low interest rate because of just the environment we’re in. But to be clear, you can definitely go aggressive and own some speculative bonds that will pay a large coupon payment, but you your inherent risk of whether or not you’ll get your money back can go up dramatically as well. So, again, these are just kind of basic FAQ’s today that we want to share with all of you. If you don’t have, or let’s call it, have somebody has communicated with you about bonds or just even alternatives in the space of fixed income today, when it comes to bonds, feel free to reach out to us, we’re here to help.
When it comes to bonds again, I know this is not a flashy topic. But individual bonds versus a bond fund, share a little bit about why that’s an interesting thing to think about when you are in the world of bonds and how to own them.
Kevin Buenvenida: So, when we think about individual bonds, I’m going to circle back to the two key points of what a bond is. It’s a defined maturity, or after a certain amount of time, you get your original investment back. Second competitive to that, typically you get paid while you have your money lent out to that issue in the form of that interest payment or coupon.
With a bond fund, what you’re able to do is through an investment vehicle, let’s say a mutual fund or an exchange traded fund, get immediate diversification by employing a strategy manager or a fund company to buy lots of different bonds for you. That portfolio typically is going to own different pieces of the bond market within the different styles of that manager has been employed to do.
But what’s key in knowing the interesting part about bond funds relative to individual bonds is that most of time, that portfolio manager or that bond fund, they don’t own their bonds to maturity. Their responsibility and maybe their goal, is to make sure that the money that you put with that fund grows to a certain degree and you collect the right amount of income. But they’re always watching out for the individual issues that they have in their portfolio. And for various reasons, they might sell a bond that they own well before they hit that maturity timeframe.
Because of that, they actually introduce more volatility with a bond fund, then let’s say owning an individual bond where with the individual bonds, you know, at the end of X amount of time, you get your money back. Hopefully you’re also getting paid with a bond fund though, because you may not necessarily own the bond to maturity. You might see fluctuations on the day to day, what we call net asset value or the price of the mutual fund or the price of the exchange traded fund, without having that definite time period to rely on, to bank on.
So, bond funds, great way to diversify, great way to get exposure to bonds, especially if you don’t have the time, the will, the skill to be your own bond manager to go out and do the due diligence on individual companies, what bonds makes sense in this type of interest rates environment. But for that simplicity for the immediate diversification, one major trade-off is going to be seeing some fluctuations on the day to day, meaning you could see some last year.
Isaac Wright: Well, I hope all of this is being understood and followed along by all of you today because listen, at the end of the day finances, and when it comes to investments, there’s a lot of small hinges that swing larger doors. And if you have listened to me at any point in the last 15, 20 years, I say that a lot. Well, bonds definitely fall into that category.
Kevin, last thing to talk about real quick. Let’s kind of say in the world we’re in today, what are some risks that people are aware of and of course, you mentioned this earlier with interest rates, this is a big one. Anything you want to share related to bonds, or let’s call it, some options out there if people are considering having some, let’s call it more conservative ways to be able to invest some of their dollars?
Kevin Buenvenida: Absolutely. So, the other big risk opposite of, or maybe in tandem with an interest rate environment that we’re currently in would be your credit rating risk. So, as Isaac was mentioning, you might find opportunity to invest with a company that might pay you a little bit more, but they’re not necessarily as financially stable as some of the bigger companies you might find. Or in comparison, if you use the United States government as a benchmark, which right now is viewed as a risk-free investment in terms of their fixed income, some of those companies don’t have the best credit rating. And you’ve got two big agencies or two big companies, kind of helping you do the homework: Standard & Poor’s and Moody’s. They’re basically giving ratings on the different types of bonds out there.
So, credit risk basically means putting your money with a company that’s not as financially stable. Where the trade-off is you might get paid a little bit more on the interest rate, but the likelihood of you getting your money back might be a little bit lower than let’s say a more reputable or larger or more stable issuer.
Now the interest rate environment that we’re in does put us in a little bit of a conundrum here. We’ve got to find ways to keep our money safe, but at the same point, find ways to grow or earn a competitive rate of return. We know checking and savings, really not paying anything right now.
One area that we might want to consider in terms of “this is the safe money of our portfolios,” is to consider something like a fixed index annuity, something that offers principal protection in a great market, or even in a downside market, but a way for us to participate to the upside with the success of an equity-based index to earn a rate of return, maybe a little bit more competitive than what we’re saying with the bond market. Now, with that, take less of a hit, let’s say when interest rates do eventually rise, even that hopefully with the index that you’re currently in, that annuity solution is participating nicely to the upside.
Isaac Wright: That’s probably a good point, Kevin. I think it’s important for everybody to know, having a financial and an insurance firm that understands both sides of the fence. There’s pros and cons to every solution. But, we’ve seen a lot of financial industry professionals start understanding the power of using insurance contracts and annuities specifically. A lot of them can also pay if you don’t even go into some of the more complicated products, if you will, can definitely pay a higher return than simply what’s out there in the banking world with CDs and treasuries, which are also, again, all tied in what I call kind of that more conservative chassis, if you go high quality credit. But again, keep in mind, you can own bonds that are junk bonds too, that are extremely volatile. You pay a high rate of return, potentially whether or not you get your money back. Again, may or may not be on the table.
Kevin, I think overall today, this has been a good opportunity and is a little bit more of an educational approach today. I know we’re not having a bunch of banter, but I think people need to understand and all of you today, I think you need to understand the fact that if we’re going to stay in a low interest rate environment and on top of that, we’re having inflation, when it comes to your purchasing power, it’s going to be something that you’re going to have to pay attention to. Because your purchasing power of the money sitting at the bank, making less than 1% you are getting, really your money’s getting eaten into.
So, if you have any questions or any concerns, Kevin, our team here at Financial Dynamics, we’re here to help and feel free to reach out to us. And I hope today’s been a little bit more on the educational front when it comes to just the purposes of what bonds do and we look forward to talking to you soon.
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