Friday Finance: bonds (updated)

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This is an extract from The Poor Man’s Guide to Financial Freedom: A Realistic, 10-Step Manual for Building Liberating Wealth on a Low to Medium Income.

Defensive Assets 2 – Bonds

Executive summary

Jargon: bonds can also be called ‘fixed income’.  Investment-grade bonds are the normal ones.  Junk or high-yield bonds are the risky ones you should avoid.

Risk: low to medium for normal, investment-grade bonds.  It is possible for the value to decline, but it does not usually do so by very much compared to shares.

Return: low to medium, generally averaging around 3-5% in the long run.

The details

You’d think with a name like ‘bond’, evoking 007, these would be the coolest, riskiest and sexiest investment category.  I’m afraid not.  Bonds are a fairly safe asset and offer moderate returns.  If I were given the duty of renaming them, I’d call them ‘nigels.’

Bonds are basically loans to companies or governments, but they can then be sold on to third parties.  That’s what makes them a type of security.

For example, Widget Inc. needs some capital to invest in a brand-spanking new widget factory in Vietnam.  They sell 5-year bonds with an agreed interest rate of 3%.  By buying them, you are effectively lending Widget Inc. money.  Ebenezer buys $100 worth of these bonds, so he receives $3 in interest every year.  Don’t spend it all at once!  At the end of the five-year period, Ebenezer gets his original $100 back.  Done.

Ah, but bonds are a ‘security’, which means they can be sold to third parties.  Let’s change the example: Ebenezer starts to worry that Widget Inc. is in trouble and might collapse, meaning he won’t get his money back.  Or he needs some cash to buy a giant Christmas turkey.  Ebenezer sells his bonds to Warren before the five years is up, for a price they agree on.  Now the 3% interest will be going to Warren and at the end of the five years he will be getting the $100 dollars back if all goes well.

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 There are many complications here that I’ve decided to leave out for now.  The curious can look up ‘bonds’ in the glossary for more detail [exclusive book content].  The main thing to remember is that bonds tend to offer a higher return than cash but less than shares, which are coming up next.  Bonds are normally stable and are suitable if your time horizon is over two years or so.  That is, they are not suitable if you’re going to use the money earlier than that.  Bonds can do well even when the stock market crashes, which is why it is a defensive asset.

The return offered by bonds is high enough to make it part of many people’s long-term investments, but not enough to form the bulk of it.  Bonds usually act as a counterweight to growth assets like shares – they steady the ship when other investments are doing badly.  After discussing types of growth investments, we’ll come back to bonds and consider (a) how much of your portfolio they should constitute, and (b) how to invest in them.

A word of warning: there are some bonds called ‘junk bonds’ which are generally issued by teetering companies or governments likely to default, i.e. not pay the interest on their debts on time, or pay back the principal when the bond comes due.  Junk bonds are NOT defensive assets and, for the sort of person reading this book, should be avoided altogether.  When we get to diversification I’ll show you how to purchase the decent ones, which we call ‘investment grade’ bonds.

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If someone ever calls you on the phone and offers fantastic bonds that are about to go through the roof, these will be junk bonds and your answer will be no thank you.  They might also be selling penny stocks, which are very cheap shares belonging to companies that are probably about to go bankrupt.  There’s no meaningful difference: take Nancy Reagan’s advice and Just Say No.  Also, I highly recommend watching The Wolf of Wall Street.  It’s a great movie about exactly these matters.

Summary

Defensive assets help to preserve wealth but don’t build it.  Returns on cash and equivalents are generally low.  Returns on bonds tend to be moderate.  Investors usually hold only their everyday spending money and emergency fund in cash, with the rest of their defensive assets being held in the form of bonds.  Other defensive assets include precious metals and cryptocurrencies.

Next we’ll look at growth assets.  Later, in the section on diversification, we’ll examine what mix of defensive vs growth assets might be right for you.

[Edit: in the second edition, I’ll add two points to this section.

First, if you read up on bonds you’ll find many complaints about how returns are much lower than they used to be. This is true for US Treasuries and some others. However, bond index funds still seem to be achieving around 4% returns over recent years. Provided you’re well-diversified, you’re all good.

The second point is that I’ve revised my thinking on the purpose of bonds. In addition to adding stability for wusses who can’t handle full-on stock fluctuations, I’m coming up with a ‘nuclear emergency fund’ concept where you keep 1-5 years worth of living expenses in bonds in case of crazy circumstances like the ones we’ve been having recently.

It would go like this:

a) Those still in debt put aside a 3-month emergency fund in cash.

b) Those out of debt aside from mortgage put aside a 6-month to one year emergency fund in cash.

c) Those out of debt and well underway with their long-term, growth investments consider building an Apocalyptic Emergency FundTM. This would be an additional 1-5 years’ worth of living expenses saved in bonds for the especially risk-averse.

Retirees often follow this strategy but I reckon a younger bloke might benefit from such an approach, if he can afford it, in this era of endless lockdowns and hair-trigger cancellation.

I’m still pondering the strategy. Let me know what you think in the comments.]

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