Asset ProtectionHigh Income EarnersInvestment

Bonds : a commonly misunderstood asset class

By October 29, 2020 December 28th, 2020 No Comments

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. »

https://www.investopedia.com/terms/b/bond.asp

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?

Remember : 

  • 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. 

To conclude 

  • 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. 

https://moneywiththeo.com/meeting/

Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. Bonds are subject to risk factors including: 1. Default Risk – the risk that the issuer of the bond might default on its obligation 2. Rating Downgrade – the risk that a rating agency lowers a debt issuer’s bond rating 3. Reinvestment Risk – the risk that a bond might mature when interest rates fall, forcing the investor to accept lower rates of interest (this includes the risk of early redemption when a company calls its bonds before maturity) 4. Interest Rate Risk – this is the risk that bond prices tend to fall as interest rates rise. 5. Liquidity Risk – the risk that a creditor may not be able to liquidate the bond before maturity.
The information contained in this presentation does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of the author, and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct.  Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected. The forgoing is not a recommendation to buy or sell any individual security or any combination of securities. Be sure to contact a qualified professional regarding your particular situation before making any investment or withdrawal decision.