What is a bond?
What is a bond? Are they good investments? how can I invest in bonds? Are bonds safe? Should bonds be part of your investment portfolio? How are bonds taxed? What is a bond credit rating and why should I care? We answer all these questions in this article.
What is a bond?
A bond is a certificate which acts as proof that you lent money to an entity. The borrowing entity can be a business, a government, or just your local town.
In essence it is simply the process of lending money to a company, the company then promises to pay you back at a certain time with interests.
Bonds are legally enforceable. This means that a business is obligated to pay you back if they have the cash. If a business is unable to pay back the money owed, the business will be in default of payment, and will be forced, by law, to file for bankruptcy.
This makes bond payment relatively stable as investors are assured that the payments will keep coming as long as the company is operating.
Are bonds safe?
Yes and no.
Bonds are safe in the sense that their prices are more stable than stocks. Bonds usually pay a fixed interest rate, which means it can easier to determine future returns from bonds. Bonds can provide better protection as a bond investor will only lose money if the company goes bankrupt (which rarely happens).
On the other hand, bonds provide a false sense of protection. Their rate of return is relatively low and inflation will likely eat up most of your returns.
Lastly, don’t forget that bankruptcies do happen from time to time and a bond investors can still lose their original investment if a company goes bankrupt.
What happens to bonds if a company goes bankrupt?
Bonds are not as safe as people think. When a company declares bankruptcy, the court generally orders its assets (e.g. buildings) to be sold. The proceeds of the sale of assets will then be used to pay back creditors (including bondholders). But here’s the catch: Bondholders are not first in line.
The first obligation of payment goes to the company’s customers, who paid for a service which they did not receive, and they are entitled to their money back. Then, if any cash is left after reimbursing customers, the remaining cash is used to pay off any loans.
If any cash is left after paying off the customers and the loans, then the remaining cash is used to pay off any bonds. In some cases, bondholders never receive their money back in full.
How much money can I make by investing in bonds?
In truth, very little.
With today’s low interest rate environment, and with central banks quantitative easing programs which are buying bonds everywhere (and pushing interest rates down at the same time), the return on bonds today is at historical lows.
The German 10 year government bond is currently yielding -0.5%. You read that right, that is negative interest rates. This means that investors will lose money each time when they invest in German government bonds.
The US 10 year government bond is yielding 0.7% annually. While that is still positive, do not forget inflation. With current inflation ranging between 1.3% and 1.5%, investors in US 10 year bonds are also losing money every year.
Even US corporate bonds are yielding low returns, currently around 2.5%. When you factor in inflation, investors are making are measly 1% annual return.
Our economy is still very much on life support and, as such, we shouldn’t expect interest rates to increase any time soon.
Historical returns of bonds
Bond returns today are terrible, but how did they fair in the past?
Historically U.S bonds have averaged annual returns of about 5.3%. Before you get too excited you should know that inflation also used to be much higher in the past.
Consider the example of European bonds: when adjusted for inflation, they provided a mere 1.2% yearly return over the last 100 years.
Bottom line: Bonds have performed poorly in the past and are performing even worse today. But hey! At least they’re safer than stocks.
Should I invest in bonds?
Probably not and here’s why: Bond returns are at historical lows and there are no indication that interest rates will increase in the foreseeable future.
What’s worse? Bonds returns are kept low artificially by governments and central banks in an effort to aid the economic recovery. This means that you are not even getting the fair return of bonds, which is already very low.
That said, bonds can still be useful in an investor’s portfolio.
When should I add bonds to my portfolio?
While this may depend on your investment horizon, age, and risk tolerance, there are a few universal concepts.
Bond prices and returns are more stable than stocks, and this can act as an anchor for your portfolio.
State of mind – Bonds are also a great source of comfort in hard times. Bonds don’t fall as hard as stocks do during financial crashes. We are all humans and sometimes emotions get the best of us, it can be difficult to find the courage to invest when financial markets are crashing, and we may even have the feeling of cutting our losses and taking our money out. Holding on to bonds will help you sleep better at night.
Arbitrage – Holding on to bonds will ensure that you are never fully wiped out by any stock market crash. Not only will you sleep soundly if the market crashes, but if an extraordinary stock market crash does happen, you might be one of the few investors left standing, and you will have the capacity (by selling some bonds) to invest in stocks at incredible bargain prices and make a fortune in the process.
Liquidity – Bonds are a great source of liquidity. You can buy and sell bonds in a few clicks, and while bond prices do fall in hard times, it is unlikely that you will lose a significant sum of money with bonds. Today bonds still provide better returns than savings account or money market funds, so holding on to some extra liquidity in the form of bonds isn’t a bad idea.
How can I invest in bonds?
Investing in individual bonds is a little harder than stocks as bonds are not traded on a stock exchange. You can still invest in individual bonds via your broker but the selection is often less than ideal.
One of the best (and simplest) ways to invest in bonds is through ETFs. Bond ETFs are simply a basket of bonds from a certain industry or country. For example the Vanguard Total World Bond ETF is composed of over 16,000 bonds from across the world.
This ETF, and many other world bond ETF, are well diversified across many sectors and countries. As of September 2020, the Vanguard Total World Bond ETF is composed of 45% American & Canadian bonds, 35% European bonds, 10% Japanese bonds, and 10% from the rest of the world.
You can usually invest in bond ETF through your broker, as you would with any other stock.
What makes bond ETFs so great?
Bond ETFs are low maintenance. Bond ETFs automatically buy new bonds when one bond reaches maturity and systematically rebalance themselves to keep an accurate representation of the world’s bond market.
You can also choose between accumulating or distributing ETFs.
Accumulating ETFs will automatically reinvest the interests received, meaning that your bond ETF should keep increasing in value over time.
Distributing ETF will pay-out the interest as they come, ensuring that you receive a steady source of income every month.
Lastly, unlike individual bonds, bond ETFs are available on stock exchanges, which means that you can easily buy or sell them through the broker of your choice. This makes it the ideal spot to stash away some extra liquidity for a few months (or years). If you need the money, you can simply sell the bonds in a click.
Summary
While you won’t make much money off bonds, you are also unlikely to lose a lot of money on bonds. Most of the cash you invest in bonds will be available the day you decide to sell, making it a great place to stash away your hard earned cash in anticipation of a large purchase, a mini retirement, or a large emergency fund.
For more on bond allocation, check out our article here
FAQ
You may have heard about AAA, BBB, or junk rating. These refer to the credit ratings of an entity, i.e. the likelihood that an entity will pay back their bonds in full.
Of course, companies with stellar credit rating (AAA) are viewed as safe investments and the interest rates (also referred to as a coupon) on their bonds tend to be much lower.
Companies with worse credit rating may pay much higher interests on their bonds, but they also have higher probability of defaulting.
In short, there is no free lunch: the safer the investment, the worse the returns.
Companies need cash to operate. They can get cash in 4 ways:
- Through the revenue they generate (sell their products or services);
- By selling the company’s assets (e.g. equipment, real estate, patent, or copyrights);
- By taking on debt (either from the bank (loans) or from the market (bonds);
- By raising new equity (issuing new shares).
In general, it is easier (and cheaper) for businesses to take out a loan from the bank, however in certain circumstances (e.g. too much debt) banks may not be willing to lend to a comany anymore.on debt than to issue new stocks.
In this scenario, companies may opt to issue bonds instead. To do so they simply hiring an investment bank who will take care of issuing bonds and finding investors.
This depends on your country of residence but in general you could expect a capital gain tax of about 30%. This means that if you made 100€ in interest payment (or buying or selling a bond ETF), you will have to pay about 30€ in taxes at the end of the year.
Alternatively, some countries allow you to register capital gains as income and pay income tax instead. This could be advantageous depending on your income. For example if you retired early and have no income, you could use that as a an opportunity to sell bonds now and be taxed on income instead. In most countries there is a minimum threshold. For example in the UK the first 12, 500£ is tax-free while France is at 10,000€ and Germany is about 9,000€.
Of course, you are only taxed on the gains realised. This means that you invested in a bond ETF that reinvest the interest payments, you will only have to pay tax when you sell your bond ETF.
Lastly taxes on bonds will depend on the net return of your entire portfolio. This means that you can offset losses from one trade (e.g. stock losses) with gains from another trade (e.g. interest payment on bonds).