What You Need to Know about Bonds in Evidence-Based Investing

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Image of Man Hand writing Bond Market with black marker on visual screenIn this post, we're going to talk about bonds in evidence-based investing.

This is part two of my three part series.

In my last post, I introduced you to the basics of evidence-based investing.

We said it was primarily a passive investing strategy whose foundation comes out of the efficient market hypothesis.

I introduced you to five factors that offer the potential for higher expected returns (premiums).

We also talked about the risk in holding these investments.

Bonds are the other major component of the evidence-based investment strategy.

I'll tell you whether there are factors that offer premiums for this asset class.

If so, what are the risks?

Read on to learn more.

The basics of bonds

Bonds fall into the category of fixed income.

Remeber, stocks represent ownership. Bonds represent loans.

Bonds are IOUs to the entities who issue them. Governments (federal, state, or local) and corporations can issue bonds.

All bonds pay a fixed or variable interest rate to the bondholder. They come due, or mature, at a specific date in the future.

At that time, investors get their principal and any remaining interest paid back in full.

The safety of the bonds comes from the creditworthiness of the issuing company.

Government bonds have the backing of the issuing government. Bonds issued by the Federal government are Treasury bonds. The full faith and credit of the Federal government back these bonds.

The shortest term bonds (maturing in < one-year) are Treasury bills.

Those with maturities of one to ten years are intermediate-term Treasury bonds. Those that come due in over ten years are long-term Treasury bonds.

Corporate bonds with similar maturities have the same short, intermediate, and long-term descriptions without the government guarantee.

Types of bond risk

The risks of investing in bonds are different from those in stock investing.

In stocks, you can lose your entire investment.

With bonds, the issuing entity agrees to pay back your initial investment at maturity.

If you invest in a company's bond and the company goes out of business, you could still lose your investment.

However, bondholders have a higher position in bankruptcy proceedings than stocks.

As such, you have a better chance of getting at least some of your money back.

Credit risk

In either case (stocks or bonds), you should always look at the financials and creditworthiness of the issuing company.

In other words, how likely is it that they will pay back your principal and interest.

The risk they default on those payments is the credit risk.

If you invest in US Treasury bills or bonds, the full faith and credit of the US Government are behind your investment.

In general, we assume these bonds are risk-free.

In the past, there was little doubt that was accepted as fact. In today's political environment, some doubt whether that guarantee is valid.

Rating downgrade

In 2011, rating agencies downgraded US Treasury bonds. That sent shock waves into the stock and bond markets
.

At the time, there was handwringing over a government shutdown, budgets, spending, etc. (sound familiar).

When the dust settled and agreements signed, they raised the rating back to the highest level.

Investors still consider bonds issued by the US government to be the safest bet in fixed income.

Corporate bonds are different. They have no government backing.

Be very careful when investing in corporate bonds. Only buy bonds from the highest quality companies.

As with stocks, one of the easiest ways to invest in bonds is through ETFs and mutual funds.

Each fund states the types of bonds they purchase.

I'll talk more about the types of bonds I recommend shortly.

Related:
What You Need to Know about Evidence-Based Investing
How to Survive a Market Crash

Interest rate risk 

Another risk in bond investments is interest rate risk.

Why?

The price of a bond has an inverse relationship to interest rates.

How's that for industry jargon! 😀

Here's what that means.

When interest rates go up, the price of bonds goes down. The opposite is also true. When interest rates fall, the value of bonds rises.

The longer the bond's maturity, the higher the rise or fall in its bond price.

What does this mean to you as an investor?

Bond fund vs. individual bonds

If you own individual bonds from a quality issuer and hold it to maturity, it means very little.

Assuming the issuing entity (government or corporate) stays financially healthy, you will get your money back.

If, on the other hand, you own a bond fund, it's different.

In this case, you don't hold the bonds directly. The fund owns them on your behalf. You own shares of the fund.

When bonds mature, they get their original investment back, not you.

To get your money back, you have to sell shares of the mutual fund or ETF. If you sell at a time when interest rates have gone up, the value of the bonds held by the funds will drop.

When you sell your fund, the price you get will be lower. In other words, you will lose money when you sell.

Don't be alarmed at this. The same thing happens with a stock fund.,

If the market is down when you want to sell, you will likely lose money. And, of course, if the market is up, you will make money.

And remember, with stocks, their value can go to zero (not likely, but possible).

That's not the case with bonds unless every bond in the mutual fund fails to pay at maturity.

That's a highly unlikely scenario.

Fixed income factors

Like with stocks, there are factors present in bond investments that evidence says offer higher expected returns (premiums).

There are two primary premiums.

Term premium 

The term premium means that longer-term bonds have higher expected returns than shorter maturities. As with stocks, the risk in longer-term bonds is higher than shorter-term bonds.

Interest rates are one of the most significant factors affecting the price of bonds.

Investors can predict how particular bonds or bond funds will respond in changing interest rates by looking at its duration.

Duration is another one of those industry jargons confusing to the average investor.

Here's what it means and how to use it to assess the risk of your bonds or funds.

First, you can find a bond fund's duration in its fact sheet or on the fund's website.

You will see it expressed in a number.

Duration example

Here's an example of how that looks for the Vanguard Total Return Bond Fund (VBMFX)

Image of stats on Vanguard total return bond fund from the website

You see two things here.

First, is the average maturity. Average maturity states the average time in which all of the bonds held by the fund mature (pay back the principal).

Notice the duration is 6.1 years. So, if interest rates go up by 1 percent, you can expect the value of the fund will drop by around 6 percent.

As we stated earlier, the reverse is true. If interest rates fall by 1 percent, you should expect the fund value to increase by around 6 percent.

You should not view duration as an absolute number.

It does, however, give you a reasonable expectation of what happens to your fund value with changing interest rates.

Longer-maturity bonds have higher durations than shorter maturity.

As such, their value will fall further and increase more when interest rates go up or down.

CIT Bank No-Penalty CD

Credit premium

A credit premium means that lower quality bonds have higher risk and higher expected returns than higher quality. In the bond category, lower quality means a higher risk of default; of not being able to pay back promised interest and principal.

High yield bonds, originally called junk bonds, are among the highest risk bonds in the US markets. That risk is primarily a credit risk.

Is the risk worth taking?

In my view, probably not.

Generally speaking, high yield bonds have a stock-like risk without offering stock-like returns. They are subject to the same economic risks as stocks.

In other words, if the economy or other factors bring down the stock market, high yield bonds will come down with them.

In an evidence-based strategy, we don't look for bonds to get higher expected returns. Stocks provide a much better solution for that.

Related:

The Most Confused Identity In Your Portfolio: High Yield Bonds

High-Yield Bonds: Historical Performance Data

Bonds in evidence-based investing

In an evidence-based investment strategy, bonds play an important role. Rather than providing a higher return, they act as portfolio insurance.

What does that mean?

If you look at the chart in part one of this series, you can see how much lower the returns of Treasury bills are.

However, they are risk-free (assuming you believe in the full faith and credit of the government).

How does that benefit you?

In essence, when the stock market crashes, investors sell stocks and move into the safest assets. That's often cash (Treasury bills) or other government securities.

An evidenced-based investment strategy uses high quality, short to intermediate-term bonds that offer safety in times of stock market turmoil.

If investors sell stocks and buy high-quality government bonds, the price of those bonds will go up.

That's the law of supply and demand.

The demand for safe investments increases while the demand for riskier investment decreases.

Remember the term premium. The longer maturity bonds will increase in price more than their shorter maturity counterparts (assuming the same degree of safety).

Final thoughts

I've really only scratched the surface on the two main components of evidence-based investing – stocks and bonds.

The goal was not to get into the weeds and a detailed analysis of the components.

I wanted to lay the foundation of the factors that decades of evidence say persist and offer higher expected returns.

In part three, I'll put the pieces together and show you how to build a low cost, evidence-based portfolio that fits with your ability and need to take on investment risk.

We will dive into the benefits of diversification and how to take advantage of the factors in building a better portfolio.

We will discuss the components of asset allocation and the importance of having a sound strategy to rebalance that allocation.

So, be sure to come back and get the final piece of the puzzle.

Now it's your turn.

Were you aware there were premiums available in your bond investments? Have you tried chasing returns in higher risk bond funds in this low-interest-rate environment? If so, how has that worked?

Tell me in the comments below.

See you in part three!

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Fred Leamnson
 

I started “Money with a Purpose” to help people “keep it real” when it comes to their money. Many advisors will tell you the only way to success is through planning. I completely agree. And there’s more. You must also align your plan with who you are and what you value. Doing this is THE key to making your money work for you. I started this blog to share with you what that looks like.

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