🎙 Bonds have been a great way to invest for income for quite some time. Even if Captain America isn’t getting on stage to sell them. But what are bonds and how to you invest in bonds in the first place? 🤔
This episode discusses topics like:
Hey there, friends! And welcome back to Girl on FIRE, the financial independence podcast for independent women.
My name is Priya, I’m a Chartered Accountant, an analyst and the creator of Paper Money Co.
I’m also a fierce financial feminist and the host of this podcast. I believe that a woman who is in control of her money, is in control of her life.
This week we’re talking about bonds! Bonds are another common option for passive income among investors.
So, we’re going to be talking about what they are, how they work, and how to invest in them.
Before we get started, I want to remind you to head to my website — papermoneyco.com — to sign up and receive your free copy of my Investing Starter Guide.
It’s totally free, you just need to enter in your email address and I’ll send it to you. And then I want you to start working through it.
It’ll give you a plan to follow, step-by-step instructions to get ready to start investing and building real wealth.
If you’re really serious about learning to master your money, then it’s the perfect guide for you, and I’d hate for you to miss out on it.
As always, Girl on FIRE is about learning, so whip out your favourite notebook or journal and get ready to take some notes.
If that’s not your thing, you can always find the transcript on my website — papermoneyco.com.
Okay, let’s dive in and talk about bonds! First, what are bonds?
What are bonds & how do they work?
Bonds are like loans. Think of them like an IOU. They’re securities that are issued by companies and governments as a way of raising money.
So, when you purchase a bond, you’re lending the issuer a sum of money in exchange for a regular interest payment over a fixed term.
When a bond has reached the end of its’ term, we say that its’ matured. So the term of a bond is generally expressed as its’ maturity, so for example, a maturity of 5 years.
And at the end of the term, the issuer will return your principle amount back to you.
Now, the interest payment you receive when you own a bond is based on a rate called the coupon rate.
So, if you have a $100 bond with a coupon rate of 10% per year, and a 5 year maturity you’ll be receiving an interest payment of $10 per year for 5 years.
At the end of the 5 year term when your bond matures, the initial $100 you invested is paid back to you as well.
Now, once bonds have been issued, you can also trade them without the involvement of the government or the company that issued them.
So, do you see how a bond works like a loan? You’re purchasing a bond which gives the issuer an infusion of cash. And then they’re paying you interest until the bond reaches maturity.
Different types of bonds
Now, bonds can come in different types. The most common being corporate bonds and government bonds.
And there can even be different types of government bonds, like municipal bonds and treasury bonds.
Corporate bonds vs government bonds
Now, corporate bonds are issued by individual companies as a way of raising money. So, just like companies issue shares to raise money from investors, they can do the same by issuing bonds.
The biggest difference is that issuing shares is equity for the company. And you become a part-owner of the company.
But issuing bonds is debt for the company. And you become a lender. So, instead of going to the bank where they may not get the best interest rate, companies may choose to issue bonds instead.
When it comes to government bonds, treasury bonds are the most common. It’s another way governments can raise money besides increasing taxes.
The easiest way to think of government bonds is this: think back to your history class. Back during WW2 when governments were issuing war bonds.
They were sold to investors with the message that you’re supporting your country fight and win the war. And that’s how the government funded the military at the time.
There was Captain America in his star-spangled get up pushing war bonds to investors to raise money for the war effort.
Now, you’re probably less likely to come across war bonds these days. And even less likely to see Captain America shaking his thing on stage.
But treasury bonds are still alive and well.
Junk bonds vs investment grade bonds
Now, another way to differentiate bonds is by their quality. So, not only do we have corporate and government bonds, but we also have junk bonds and investment grade bonds.
And this is a really important distinction, so I need you to remember it. All bonds receive a rating. Ratings agencies like Moody’s give bonds a rating.
Those ratings are a measure of the quality of the bond. So, bonds that have a triple-A rating, which is the highest rating possible, are considered to be investment grade bonds.
That means they’re a safe investment option in terms of risks. And we’ll talk about the risks involved with investing in bonds a bit later in this episode.
On the other extreme, we have junk bonds. Which are, well, junk. They lure investors in with empty promises of high yields, but they’re very risky.
These bonds are considered bad investments. The issuer is likely to miss interest payments or go bankrupt and you can lose your money, your silk shirt, your leather Kate Spade tote bag and the Corgi that rides around inside it.
Are bonds a good investment?
Bonds vs shares
Now, I want to take a second here to draw a few comparisons between bonds and shares, because they’re often both included in most types of portfolios.
We talked about shares and stock market investing in episodes 15 and 16, so if you need a quick refresher, go back and listen to those episodes before you continue.
So, when it comes to returns, bond returns are usually lower than the returns on shares. And that’s because there’s a lot less risk involved.
Bonds are a fixed income security, so if you’re invested in triple-A bonds, you’re pretty much guaranteed an income.
But that income is fixed. You won’t earn any less in a bear market but you also won’t earn any more in a bull market.
Shares on the other hand, carry more risk because they’re so much more volatile. And that means that the returns are generally higher, but also that returns are technically limitless.
Now, long term bonds can also be volatile, because the world is crazy and anything can happen.
But it’s still highly unlikely that a stable and well run government is going to collapse and those treasury bonds will become worthless.
Now, a bond is like a loan, right? So, let’s say you buy corporate bonds. That means you’re loaning money to a company.
Maybe they’re trying to raise money to expand into new markets. They have to pay you interest and eventually repay your loan whether or not their expansion is profitable.
Now, of course, they may always default on the loan but for now let’s assume they’re triple-A rated, so they’re investment grade bonds.
With shares, however, you can buy shares in a company to invest in it. And that company can use the money to grow the business. If the company doesn’t make any profit, they can choose not to pay you a dividend.
Bond prices & diversification
Now, as with any investment you choose, you should always be well diversified. We talked about diversification in episode 14 - it’s the idea of minimising your losses by not putting all your eggs in one basket.
So, investing in bonds is a good way of diversifying your portfolio because they’re fixed income and lower risk than shares.
You’ll notice that generally speaking, conservative portfolios have a much higher allocation of assets in bonds than they do in shares.
Prices of bonds and shares move in opposite directions, so when you’re mapping out your investing strategy, it’s worth considering holding them both for the sake of diversification.
When stock prices go down, there’s less capital gains to make and companies are less likely to issue dividends in a bad market — or their dividends will be lower.
And that makes the fixed income payments of bonds a lot more attractive than dividends that aren’t guaranteed and potential capital losses.
But when stock prices go up, stocks are more attractive to investors than fixed income payments because the potential income from dividends is higher and there isn’t really any limit to the capital gains you could earn.
Can be traded like shares
Moving on, bonds can also be traded on an exchange just like stocks. Which means that you don’t have to hold on to them until maturity, you can sell them to other investors.
As always, trades on an exchange are executed by a broker and that means you’ll have to pay brokerage fees and commissions depending on who your broker is.
We talked about choosing brokers and the associated costs in episodes 3 and 4, so be sure to check those out if you haven’t already.
Another important thing to note is that you can also buy bond ETFs. We talked about ETFs last week in episode 17. They’re like a prepackaged low-cost hamper of securities.
Fixed income security
Next, bonds are a fixed income security. That means that the income you earn from them, which is the interest paid to you by the issuer, is fixed.
It doesn’t change over the term of the bond. Now, this can be a good thing and a bad thing depending on what’s going on in the economy, which we’ll get into in a second.
But, fixed income securities are generally really popular for retirement portfolios. Because your income is fixed and as long as you’re investing in high quality bonds, it’s pretty much guaranteed income.
It’s a much safer investment for retirees or those close to retirement because returns don’t fluctuate the way that they do with shares.
If you’ve got an investment grade bond, then the market can do whatever it wants, you’ll sill get your interest payment.
Now, of course the downside of this is that there’s much less risk involved than when you’re investing in shares, so the returns will be lower.
Which is why being too heavily invested in bonds compared to other asset classes like shares can be dangerous. It could mean that your portfolio is too conservative and you’re making a very small return on your money and barely outrunning inflation.
Why shouldn’t you invest in bonds: the risks
Okay, so now that we know what bonds are, how they work and why they could be a good investment, let’s talk about the risks involved with investing in bonds.
But first, let’s take a mid-episode break because I need to ask my lovely Girls on FIRE for a favour. If you’ve listened this far into the episode, then you’re clearly enjoying it!
I’d love it if you’d just hit pause for 30 seconds, go over to Apple Podcasts and leave a rating and a review for Girl on FIRE, you can use the link right at the bottom of the show notes of this episode in case you aren’t sure how to get there on your own.
It’s a great way to support this show for free and it’s so much easier than me putting up posters asking you to buy PMC bonds, right?
Your feedback helps me improve the content that I share and it helps other women out in the internet wilderness find us and become Girls on FIRE as well.
And you’ll honestly make my day, as well. And if I’m not getting any cake or chocolate today, a 5-star rating would probably be the next best thing.
Okay, so back to the risks of investing in bonds. The three main risks you’ll face when investing in bonds are credit risk, interest rate risk and inflationary risk.
Let’s go through each of these.
First up is credit risk. This is the risk that the issuer won’t be able to repay the initial capital back to the investor once the bond matures.
So, this is just like the credit risk you have on your loans like your mortgage or credit cards.
It’s the risk that you won’t be able to pay back what you’ve borrowed. Now, the same applies with bonds.
This is one of the biggest risks associated with junk bonds. There’s a high risk that the issuer won’t be able to pay back your capital when the bond matures.
This is less likely to happen if you’re investing in triple-A bonds which are also called investment grade bonds.
Generally, speaking, governments especially governments of politically stable countries like Australia are considered to have really safe bonds.
The credit risk is a lot less prevalent for stable governments with good governance. But you should always check what the ratings are.
For example, Australia’s credit rating is currently triple-A, according to the S&P and Fitch ratings in 2020.
It’s important to note that different ratings agencies have their own methods and can rate the same bonds differently.
Interest rate risk
Next up, we have interest rate risk. This is the risk that the interest rate will go up and lower the price of bond holdings.
So, the coupon rate we talked about earlier determines how much interest the investor will earn while they hold the bond.
And that rate is determined by the interest rate or cash rate set by the reserve bank or the federal reserve.
Now, when you own a bond, the interest you receive is at a fixed rate. It won’t change when the cash rate goes up or down.
This is good news for bond investors when the cash rate goes down. Because it means that new bonds will offer a lower coupon rate, but your bond still offers the coupon rate that was set when it was issued.
But when interest rates go up, then newly issued bonds will offer investors a higher returns than existing bonds.
Existing bonds will then go down in value because they offer a return that’s below market. So, you’re not making as much money as you could be.
Not only that, but your capital is also tied up in these bonds that are offering below market returns. So, you may need to think about selling.
The last risk I want to talk about today is inflationary risk. Yes, our old foe inflation has returned.
You didn’t really think I was going to get through an episode about investing and not bring up inflation, did you?
So, interest earned from bonds is at a fixed rate and doesn’t change — not when the cash rate change but also not when inflation changes.
This means that if inflation increases, then the interest you’re earning on your bond is going to lose it’s purchasing power.
Because inflation has gone up but your returns can’t keep up. Now, this is more of a risk for longer term bonds, because anything can in the time between when the bond was issued and when it matures.
And the same applies with credit risk and interest rate risk as well. Anything can happen in the time between when a bond is issued and when it matures.
That’s why long term bonds are considered to be more volatile. They inherently carry more risk.
How to buy and invest in bonds
Okay, so if you’re ready to invest in bonds, how do you go about it? First, and most importantly, you need to consider your investing strategy.
We talked about determining your investing strategy in episode 14. You’ll need to consider your time horizon and your risk appetite when you’re deciding how you want to structure your portfolio.
And please always remember that this will change as you become a more experienced investor, as your needs and knowledge change and as you get older.
So, for me personally, at the moment, I’m a bit more aggressive with my investing because I’m only 29, I’ve got a long way to go for retirement.
I’m not really interested in income right now, I’m interested in growth. So, my portfolio is much more heavily allocated in shares.
I’m well diversified within that asset class - I have domestic shares and International shares. I talked about my stock market investing strategy in episode 17.
But I’m not putting a lot of importance on investing in bonds right now, because they don’t align with my current strategy.
However, my plan is to slowly reallocate more of my capital away from shares and into bonds as I get older and get closer to retirement.
Because, I’m going to need that fixed guaranteed income when I retire. And I’m going to want less risk and volatility the closer I get to retirement.
The last thing I want is to be a year away from retirement and have the market crash so hard that I lose everything and have to stay at work for another 5 years. I’m not into that.
But right now, I’m still relatively young, I’m still working. And I’m relying on my employment income to sustain my lifestyle not my investment income.
And that’s because my portfolio is focused on growth not income. And that’s going to change as I become a charming old lady.
60 - age rule
Now, when it comes to investing in bonds, one of the common rules of thumb out there for how to split your portfolio between stocks and bonds is this: take 60 and subtract your age.
That’s the percentage of your portfolio that should be invested in bonds, and the remainder should be invested in stocks.
This is a rule that by Burton Malkiel, I believe, but you know how I feel about rules of thumb.
I can easily say, well, 60 - my age which is 29 equals 31. That means 31% of my portfolio should be invested in bonds and 69% in stocks.
And then as I age, I adjust those percentages. Easy enough to do and to understand. But I don’t like it.
That 31% is completely arbitrary to me. It doesn’t take into account my plans for my future or my own risk tolerance and time horizon.
So, the moral of the story is this: yes, there are rules of thumb out there for anything and everything, always created by some financial expert.
But no one will prioritise your own best interest like you will. So get yourself educated, which is what you’re doing by tuning in to Girl on FIRE every week.
And then you can make an informed decision on what’s best for you and what aligns with your investing strategy.
There’s a reason I started this little series by going over how to determine your investing strategy. I didn’t just jump in and tell you what ETFs to buy.
Or what percentage you should be invested in bonds. Because I can’t. I don’t know your personal circumstances.
That’s something you need to take ownership of, whether you pay a trusted financial advisor to do it for you, or you learn how to do it yourself.
Next weeks’ episode
And that’s all I have for you Girls on FIRE today!
My challenge for you this week is to head to papermoneyco.com and get your copy of my Investing Starter Guide, if you haven’t done so already.
It’s totally free, you just need to enter in your email address and I’ll send it to you. And then I want you to start working through it.
It’ll give you a plan to follow, step-by-step to get ready to start investing and building real wealth.
On next weeks’ episode we’re going to be talking about your savings rate and why it’s the #1 factor in reaching FIRE or early retirement.
It’s going to be a super interesting episode so you’re definitely not going to want to miss it.