Why am I talking about Bonds right now?
I usually have conversations with higher net worth individuals (+$1M estate) about their personal finances. They are usually expatriates and they have been living in the United States for the past couple of years.
Part of our discussion is how to take advantage of a fully diversified financial plan that is designed to help protect them & their family, that would help save & lower their taxes and potentially generate a positive cashflow for retirement.
When we discuss their investment planning strategy, I usually explain several investment vehicles such as Stock, Bonds, CDs, etc… that could be held inside tax-advantaged plan such as Roth IRAs, Traditional IRAs, 401(k)s, etc… What I realized was that they had a great understanding of how Stocks and other investment vehicles worked, except for Bonds. This is the reason why I wanted to enlighten our community on the commonly misunderstood asset class.
Most investors somewhat understand how Stocks work because of the fact that the media talks about it all the time. However, most Americans and Expatriates do not understand how Bonds work.
What is a Bond?
If you want the fancy definition : « A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. »
For a down to earth definition : Bonds are issued by Corporations, Governments, Municipalities, and other issuers when they need to finance their projects. In return, they are providing a fixed return to the lender (i.e. you, the investor) on a recurring basis: quarterly, semi annually, annually.
The main objective when buying a bond is capital protection, it is unfortunately not enough taught to investors.
Bonds fluctuate with interest rates: whenever interest rates go up, your bond price goes down and vice versa. For example, let’s say that Apple issues a Bond at par (i.e $1,000) and offers a 5% interest rate to the holder. You, the investor, would hold this Apple Bond and expect a $50 annual income from it. Once bought, your Bond price will fluctuate based on the interest rate fluctuations and the offer/demand of the bond. If interest rates go up, then the price of your Bond will trade at a discount, or decrease. (Why would somebody buy a 5% bond when they can get a 6% bond? This is why your Bond price will decrease — to respond to the offer and the demand).
Bonds beat Stocks when companies are struggling
In simple terms, stocks have the potential to go to zero if a company goes bankrupt. However, Bonds pay back your principal and coupons (or interest rate) because in the case of a default scenario, Bonds are backed up by the Government who would step in to pay you. As a financial planner, I mostly invest clients money in relatively high quality investments which lowers the level of uncertainty.
Issuers have the obligation to pay back their debt investors but have discretion over what to provide for their Stock holders.
The bottom line is, if you are a Bond holder, you will have priority over a Stock holder. And this is extremely important when you are in a recessionary period like we are facing.
Why do wealthy people own Bonds?
Wealthy people have already made it, they worked too hard their entire lives to now risk their money. Why should they take the risk to lose it all gambling with the Stock market? Do not get me wrong, I truly think the Stock market is a great way to achieve financial success, but historically it provides much more volatility and uncertainty to your portfolio.
Why do you hold Bonds in your investment strategy?
Sophisticated and usually wealthy investors understand why they should hold Bonds within their portfolio: Bonds allow you to help PRESERVE your capital (i.e. your so hard earned money) and generates a recurring income stream. Most people do not understand how the Bond market works because it is not as advertised by the media and not « sexy ».
Why you should hold Bonds when yields (interest rates) are so low?
As I am writing this article, the 10-Year Treasury Yield is sitting at 0.81%. So why should you hold a security that has such a low return?
- you hold bonds to protect your capital. Not to gamble.
- you need to diversify your investments with different asset classes.
- as interest rates go down, bond prices go up. This allows you to sell your bond at a premium and potentially generate a higher return. The Federal Reserve — the entity in charge of controlling inflation and interest rates — has considerably decreased interest rates
The advice when buying bonds
Focus on high quality bonds. When looking at the credit ratings, focus at least on what is called « Investment Grade » Bonds. Rating agencies are rating companies on their ability to pay back their issued bonds.
- Wealthy people hold Bonds
- When interest rates are going down, you benefit being a Bond investor
- Holding bonds inside your portfolio helps diversifying your investment risks
By educating my clients, I am able to make them understand how the US financial system works and how to use it in their advantage. If you would like to start a conversation with my team and I, feel free to click on the link below and submit your request.