Continuing the dive into all things personal finance it is time to talk about bonds. Bonds are issued by organizations, generally companies or governments to raise capitol. One way to think about it is crowd sourced funding at an institutional level. When buying a bond you are buying a debt instrument issued by an organization. Most bonds have a face value of ten thousand dollars and pay some amount of interest. The interest is the incentive to loan the organization the ten grand for the duration of the bond.
Bonds are the yin to stocks yang. When you buy a share of a stock you are buying a fraction of ownership in the company. When buying a bond you are loaning money to a company and they are supposed to pay that loan back with interest. The value of a bond tends to be less volatile than that of stock. They are a fixed income instrument after all. As such they tend to be less exciting than stocks but when it comes to investing I prefer to keep things chill. A bumpy ride is not a good time when it is my nest egg riding out the storm. A bond will most often pay out a steady stream of interest payments while staying fairly stable in valuation.
There are a few risks when investing in bonds. There is default risk, which is the risk that the issuing organization will go bankrupt failing to pay back the face value of the bond much less the interest owed. Fortunately there is some protection for bond holders in this scenario since as a creditor of the organization you get to be close to the front of the line when the organization is being liquidated. Some of the face value of the bond may be recovered while the organization goes through the bankruptcy process but, it is far from guaranteed.
An additional risk is interest rate risk. Interest rate risk is the possibility that you could buy a bond today with a five percent interest rate and at some point in the future interest rates will rise. Now new bonds are being issued with a six percent interest rate. Since new bonds can be acquired with a six percent rate your five percent bond isn’t as attractive as the new bonds. Should you wish to sell the bond on the secondary market the price of the bond will be discounted from the face value to account for the higher interest rates that are available.
How to avoid these risks? Buy bonds from organizations that are unlikely to default to mitigate the default risk and buy bonds from companies with short a duration to avoid the interest rate risk. But there’s a rub. Wouldn’t you know that there is no such thing as a free lunch. Organizations that are unlikely to default are in a strong financial position and a rating organization will rate their bond issue as AAA. With that AAA rating investors are assured that they will most probably get the face value of the bond back as the end of the duration. So the issuing company doesn’t have to pay that high of an interest rate. A company with a D credit rating is already carrying a lot of debt and may not have that much revenue with which to pay their existing creditors, much less the interest on the newly issued debt. An organization in such rough financial straits will have to offer a high interest rate to compensate investors for the risk they might not ever see the face value of the bond again.
How about interest rate risk? Would it be possible to just buy bonds with a short duration to avoid the interest rate risk? Well, once again there is a rub. Short term bonds tend to have lower interest rates than bonds issued for a longer duration. The general idea being you can make a fairly informed guess about what interest rates will most probably be in the immediate future. Guessing what interest rates will be at in ten years is more of a wild assed guess than just a guess. When short term bonds are paying higher interest than long term bonds it’s called an inverted yield curve and it makes fixed income traders all giddy as the natural order has been upset.
How then to go about buying bonds and getting over that 10k buy in for each bond? Wouldn’t buying a single bond concentrate risk in the one issue? Fair and accurate points both. This is where bond mutual funds come in or ETFs but lets discuss mutual funds for now. I am a huge fan of Vanguard and their total bond market index fund. This fund provides broad exposure to U.S. investment grade bonds with a medium term duration and does so with a low expense ratio. Vanguard generally offers the same fund under a couple of different names calling the different funds Institutional, Admiral, and Investor shares. The difference being the minimum required investment and the expense ratio. The more you have to invest the lower an expense ration you can get. VBTIX is generally available through companies retirement plans since the total of all participants in the retirement plan may be used to determine if the minimum investment has been reached. As of September 2016 here are the different flavors of Vanguard’s total bond market index:
|Name||Ticker||Minimum Investment||Expense Ratio|
I am fortunate in that the company I work for offers VBTIX in their 401k so I get to enjoy the low low expense ratio. In my IRA I have nowhere near enough to qualify for the minimum investment for VBTIX. Should I wish to hold bonds there I would use VBMFX until I grew my account large enough to satisfy the minimum for VBTLX to get the lower expense ratio. I like this fund for a few reasons. First off it is an index fund run by Vanguard so it has a low expense ratio compared to most other mutual fund companies that offer a medium term U.S. total bond index. Secondly it is an index of U.S. bonds. There are international bond funds but, those tend to have a higher expense ratio. And the U.S. based companies issuing bonds tend to do a fairly hefty portion of their business over seas so it comes with some international diversification. Finally even though it is a total bond market index a lot of its holding are medium term with some short and long held as well. This helps diversify the interest rate risk, it’s still there but rates would have to move hard to put a serious bite in it.