Author Topic: Not understanding bonds  (Read 3593 times)

Murse

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Not understanding bonds
« on: November 15, 2014, 09:29:53 AM »
I have read jlcollins, looked up many videos on YouTube and I am still struggling to grasp the use of bonds. My current understanding is that you buy a bond, and they pay a very small interest rate for a given period of time, sweet deal. So are bonds useful while building your stash? How so? Also, my understanding in retirement is that if a huge crash comes, you can draw from them instead of your low evaluated stocks. Is this right and what am I missing? Thanks!

jake14569

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Re: Not understanding bonds
« Reply #1 on: November 15, 2014, 10:24:32 AM »
Hello FutureNurse,

When you buy a bond, you are lending a company money at a certain interest rate. Usually, a higher quality company results in a lower interest rate because there is less risk of non-payment. There are a ton of different features and terms that you should learn about before you invest in a bond, most of which can be learned from a site like investopedia.com, videos on youtube, etc. The great thing about bonds is that, assuming the company doesn't default, you can expect to receive a certain amount of cash on a regular basis (majority of bonds pay out semi-annually, but some pay more or less frequently) until the bond's maturity date when you'll receive the original face of the bond.

Personally (and some may disagree), I feel like now is not the best time to invest in bonds. Interest rates are low and almost certainly heading up. Since bond prices and interest rates have an inverse relationship, I expect that any bond I buy today is going to lose value. For example, if I buy a quality $1,000 bond with a 4% coupon and a 10 year maturity today, I can probably expect to receive 4% payments every year for 10 years and then get my $1,000 back at maturity. But, what if I want to sell the bond before its maturity and market interest rates are now 6%? My $1,000 bond will be worth quite a bit less. Since rates are most likely going up in the next decade from today's historical lows, if I did buy a bond I would need to do it with no plans to sell it and be ok that in a few years I could buy bonds at higher rates or even that my bank account will pay better interest than the bond which I would then be stuck with.

Another thing to keep in mind is that, unlike dividends, bond payments are almost always going to be at a set interest rate for the life the bond. If you carefully select great dividend paying companies to purchase stock in, they should regularly increase their dividend. There are many companies who kept raising their dividend all the way through the recession. Google Dave Fish's list of Dividend Champions for a list of companies who have raised their dividend every year for the last 25+ years. And not only do the bond payments not increase, but the face value of the bond you'll receive at maturity isn't going to increase either. With thoughtful dividend investing, historically speaking I am going to benefit from increasing dividends and stock price. So, if it isn't obvious at this point, I'm a proponent of dividend investing in today's market over bond investing.

If I were going to purchase bonds today, I'd most likely do so through bond funds (like mutual funds comprised of bonds instead of stocks) with relatively short durations. Now, if you have an obscene amount of money and want to protect it and today's interest rates on quality bonds are enough to fund your lifestyle, then sure go ahead and start laddering bond purchases. But I'm definitely not in that boat!

I hope this is  helpful!

Murse

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Re: Not understanding bonds
« Reply #2 on: November 15, 2014, 10:33:21 AM »
Thanks for the response but I am actually trying to figure out what the point of having an asset allocation of say 80/20, how does this protect you over just an asset allocation of 100% stocks? I am not understanding when they help you (specifically in the accumulation phase.)

jake14569

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Re: Not understanding bonds
« Reply #3 on: November 15, 2014, 11:07:51 AM »
Theoretically, an 80/20 allocation would reduce your volatility and downside risk in the event of a market crash since the bond market and stock market behave differently. If the stock market dropped by a lot as it did in 2008, people may flock to bonds for safety and values would increase there. Even though you would have lost a lot of the market value in your equity portfolio, your bond portfolio should increase in value or at least decrease less than the equities did. In my opinion, there isn't a benefit from this if you are in the accumulation phase as you are reducing your long term return by placing less money in equities. Some people think its still a good idea to do 80/20 or 60/40 simply to limit their downside and provide some cash flow from their bonds even through a downturn. Its really a personal decision based on your risk tolerance. If the idea of losing 30, 40 or even 50% of your portfolio in the short-term will keep you up at night, it may be a good idea to have some money in bonds.

Radagast

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Re: Not understanding bonds
« Reply #4 on: November 15, 2014, 01:21:47 PM »
I was wondering this too, so I made a graph. I used the Monte Carlo simulator at http://www.portfoliovisualizer.com/ to check the end value of various allocations of stocks and bonds after 10 years. (The Monte Carlo simulator uses data from 1972-2013, but randomizes it so that the order of actual history doesn't bias predictions of the future).

You can see that in most cases you are better off after ten years if you held 100% stocks, but in worst case scenarios you would be better with only 40% stocks and 60% bonds. So, bonds are a useful guard against low returns, but usually you would be better off without them. Up to you how much value you put on best, expected, and worst cases.

See attached graph.

Murse

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Re: Not understanding bonds
« Reply #5 on: November 15, 2014, 02:06:23 PM »
I was wondering this too, so I made a graph. I used the Monte Carlo simulator at http://www.portfoliovisualizer.com/ to check the end value of various allocations of stocks and bonds after 10 years. (The Monte Carlo simulator uses data from 1972-2013, but randomizes it so that the order of actual history doesn't bias predictions of the future).

You can see that in most cases you are better off after ten years if you held 100% stocks, but in worst case scenarios you would be better with only 40% stocks and 60% bonds. So, bonds are a useful guard against low returns, but usually you would be better off without them. Up to you how much value you put on best, expected, and worst cases.

See attached graph.
Very valuable, thank you!!

ltt

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Re: Not understanding bonds
« Reply #6 on: November 15, 2014, 02:47:18 PM »
Be very careful about what company's bond you are investing in.  My father put money into a bond at Lehman Brothers, which I inherited.  Well, we know which way that went. :(

wtjbatman

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Re: Not understanding bonds
« Reply #7 on: November 15, 2014, 09:12:20 PM »
Be very careful about what company's bond you are investing in.  My father put money into a bond at Lehman Brothers, which I inherited.  Well, we know which way that went. :(

That's why if you're going to invest in bonds, choose a total bond market index fund. What your father did is the same as someone putting all of their money in Enron stock.

clifp

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Re: Not understanding bonds
« Reply #8 on: November 15, 2014, 09:31:04 PM »
Bonds are pretty useless for retirement savings for anybody under 35. Now once you get with a few years of retirement and during retirement then there role of decrease volatility is quite valuable.
The other time when having bond is valuable is when you are saving for a specific purpose in medium term say three to five years. Classic examples include saving for house downpayment and for your kids education. You don't want to have bear market wipe out your kids tuition.  In those specific case you'll want to hold a fair amount of bonds (or CDs) preferably with similar duration.

However if you are talking about a retirement of greater than 20 years stocks have historically outperformed bonds often by a wide margin.  Given the historic low interest rates I suspect the next 20 years will be another one of those times.