Today we’re going to talk BONDS in your portfolio. Bonds are an area of contention for OG and me, as you may know if you listen to many episodes of the podcast. I like bonds (in a regular market). OG thinks there is nearly zero room for bonds in your portfolio.
Our opinion really shouldn’t matter to you. You should know how they work so you can check them out yourself.
Now, your asset allocation model may have “bonds” listed as an asset class you need. How do you pick which is right for you? As always, we want to focus on the answer to this question:
“What return do I need to reach my goal?”
Some bonds will give you a very low return while others may help diversify your returns and stabilize your portfolio. To know which-is-which, let’s talk about how bonds work.
What Is A Bond?
Simply put, a bond is a loan to a company. You’re loaning them money. If you’re loaning a company your hard-earned cash, what are you worried about? I’d be worried about three things:
- What return will you give me?
- When am I going to get the money back?
- What’s the risk you might not repay?
Let’s tackle #1 and #3 together….and then we’ll come back to #2.
Returns and Risk
The return investors receive on a bond depends on two factors: current interest rates AND the company’s credit rating. Here’s a story problem.
Let’s say that company A has a bond offered at 8%, and company B needs to borrow some money. If they have the same credit rating, company B probably needs to offer 8% on their bonds, too. Why?
If company B offers bonds at 7% and company A is at 8%, which one are you going to loan money to? Absolutely! You want the highest interest rate possible, so you’re going to loan money to company A.
The point? Competition and prevailing interest rates determine the rate you’ll get on a loan. If interest rates are low (like they are currently), you’ll receive a low rate. If they’re high, you’ll receive a high rate.
How Do I Get a Higher Return?
There are two ways to get higher returns. The first is to loan money to riskier companies.
What happens when you have a rotten interest rate and apply for a credit card? Right. The credit card company gives you credit, but they jack up the interest rate. In this case, you play the part of the credit card company.
Let’s say you have money to loan. Company A is offering 8% on their money, and company B is offering 11%. What does that mean? It may mean a few things, but probably it means that company B has worse credit than company A.
How do we know?
Ratings agencies will tell you how safe companies are when you’re loaning money (if you’re using individual loans, you’re outside the scope of this class). Morningstar will tell you the credit quality of the bond fund you’re choosing.
Length of the Loan
It’s easy to understand bonds when you compare them (as we’ve been doing above) to credit cards and other loans you’ll take out during your lifetime.
One more analogy:
Let’s say you’re taking out a mortgage. You can choose a 15-year loan or a 30-year loan. Which term will have a lower interest rate? The 15-year loan.
Banks are more happy to give you a low interest rate when they can more easily factor in what the economy will be like during that period. That’s why an adjustable rate loan is nearly always lower. Adjustable rate loans might keep the interest rate steady for only 12 months to three years. The bank can easily forecast conditions during that time frame. But 30 years? No way.
The point is this: the longer you loan money to a company, the higher the interest rate you should expect.
Follow me so far? Great. Easier than you thought, isn’t it?
Here’s Where It Gets Slightly Complicated (But You Can Handle It)
You knew it couldn’t stay that easy…but this isn’t as hard as it’s going to seem at first. You may need to re-read this part a couple times, but it’s like riding a bike: this is an easy concept once you think about it.
Let’s say you can buy a bond paying 6% right now…but you also know that interest rates are about to rise.
Would you wait for higher rates or buy the 6% bond right now?
Of course, you’ll wait.
So, let’s flip the situation.
Let’s say you’re taking a family trip to Disney, and you need money right now and need to sell your 6% bond. If nobody wants the bond, what do you have to do with the price?
That’s right, you drop it.
That’s why bonds drop in value when interest rates rise. Nobody wants the lower rate loans. Conversely, if you’ve got a bond at 6% and interest rates are going to drop to 4%, what can you do?
You can take advantage of the fact that EVERYONE wants your bonds and jack up the price (you’re so, so smart!).
This is why we’re both negative about bonds right now. Interest rates will probably rise A TON in the next few years. That means if you hold bonds today, you’re asking for trouble.
Our recommendation? Don’t add bonds to your portfolio now, and wherever possible, move your bonds to short-term instruments in the future.
Identify what types of bonds you have on Morningstar….long term or short term. Highlight your long-term bonds.