Awesome Easy Money – Passive Income Deep Dive – Bonds

Bonds

As you read a lot of investment and personal finance advice on what to invest in – the sentiment is heavily skewed to stocks or equities. The reality is that almost everyone should have some bond exposure and bonds are one of the best income generators. This post is going to walk through all things bonds – what they are, different types of bonds, how you should use them etc…..

I love bonds and hope you do too after reading this post!

What is a bond?

A bond is created when one corporation, person, government, or entity borrows money. The person borrowing this money typically considers this a loan – with a fixed repayment schedule, interest rate, etc. When a loan is paid back monthly – who does that cash flow go to? It goes to the person who lent the money. When that loan (or multiple loans packaged together) is made into a security is is considered a bond or a collateralized loan obligation (CLO) or an Exchange Trade Fund (ETF). CLOs are typically not publicly traded so I won’t speak toward them much here.

As an investor when you buy a bond you are the debt holder and get fixed repayments. This is why bonds are often referred to as fixed income securities.

Characteristics of a Bond

Most bonds typically have the following components:

Face value or the amount of money the bond will be worth when it gets to maturity and the basis for calculating interest.

Coupon rate the interest payment a year. A 4% coupon on a $1,000 face value bond generates $40 a year.

Coupon dates are the dates on which the bond debtor make interest payments which is usually annual or semi annual.

Maturity date is the date the bond will mature and the bond debtor will pay the face value of the bond back.

Issue price is the price at the bond debtor sells the bond which could be higher or lower than the face based on the time value of money. See my post here on valuation: Xxxxxxx

Credit risk relates to the risk of repayment. A Credit Rating is issued to each bond which rates how likely the debtor is to pay the debt back at stated rates. This may change over time as the health of a government or company improves. A lower credit rating typically means a lower price for the bond up front. Junk bonds have a lower credit rating as they are considered risky. Investment grade bonds have higher credit ratings as they have less repayment risk. Credit rating for publicly traded bonds are typically issued by S&P and Dunn and Brad Street and have their own rating scale but analysts at all the big banks typically weigh in as well. Tesla bonds are the ones I have seen in the news the most often recently besides government bonds.

Interest rate risk is the second risk the investor is taking by buying a bond (the first being credit risk). If you lend money at 5% today but 3 months from now you could have lent money at 6% – if you hold the loan/bond to maturity you didn’t really lose anything but in theory you “lost money” as your bond is now worth less. You bond is worth less because if you and investor B (who has a loan at 6%) want to sell your bond at the same time – Investor B’s loan is worth more and yours is worth less if they were equal terms for everything but the interest rate. More on this below.

Duration is a financial concept that boils down interest rate risk to a factor. In my eyes, it is an easy reference factor to reflect how sensitive the bond is to interest rates based on time value of money. While there are multiple textbook definitions I believe this one is the most straight forward: if a bond has a duration of 2, the value of the bond will go up 2% for every 1% change in interest rates and visa versa if interest rates go the opposite direction. The longer the duration of the bond (length of time), the more sensitive a bond is to interest rates which makes sense as we discussed in the valuation post here:

Type of Bonds

There are three main categories of bonds.

1. Corporate bond issued by companies.
2. Municipal bonds issues by cities and states
3. US government debt is considered a Treasury Bond if it is over 10 years. They are considered Treasury notes if they are under 10!years.

Varieties of Bonds

1. Zero coupon bonds do not pay out regular coupon payments. The yield on the investment is made from buying the bond at a discount and their market price eventually converges to face value upon maturity.
2. Convertible bonds have the ability to convert their debt into equity.
3. Callable Bonds – the issue has the right to call back the debt if interest rates go to low (these are rare)
4. Normal bonds like me mentioned above

How You Make Money on Bonds

You make money on bonds via two mechanisms:

1. Interest from coupons

1. Implied interest from the price you pay for a bond and how much cash you get at the end of the holding period.

How To Invest in Bonds

You can invest in bonds in the following ways:

1. Buy single bonds via your broker or directly from the federal government
2. Buy mutual fund bond funds
3. Buy Bond ETFs

Given most of us don’t have time to value individual bonds or keep up with how our debtor’s credit risk is doing – bond etf and mutual funds are your best option as they spread the risk and act/feel like stocks given your ability to trade them freely.

How I Use Bonds / Bond Investment Options

I use Bonds in two ways:

1. Part of my 401k balance

1. My primary driver of my after to tax portfolio. Bonds are over 60% of my Passive Income Portfolio that I described here: Passive Income Portfolio Starting at $25

I consistently am invested in the following ETFs that are transaction fee free at fidelity:

1. Ticker LQD – the largest bond ETF – investment grade bonds. Routinely yields 3%+ of monthly income
2. Ticker SLQD – the son of LQD with a shorter duration (less interest rate risk). Routinely yields 3%+ of monthly income
3. Ticker HYG – high yield bond ETF – lower quality credit ratings. Routinely yields 5%+ of monthly income.
4. Ticker SHYG – the son of HYG with shorter duration (less interest rate risk). Routinely yields 5%+ of monthly income.
5. Ticker EMB – Emerging Markets Bonds. This is the riskiest of all my bonds (a lot of short term volatility – especially right now) but if you go back over the past 10 years the ETF is relatively stable. Routinely yields 5%+ of monthly income.
6. Ticker MBB – Mortgage Backed Securities – I just like the fact that when someone else pays their mortgage their interest comes to me on this one. Quite stable and routinely yields 3% of monthly income.

You’ll notice above:

• I do not invest in mutual fund bond funds. I don’t see a need to pay fees for someone to buy bond funds when an ETF that has strict governance rules and very low fees exists.
• I do not invest in general international bond funds. I’ll admit I have an international bond fund in my portfolio but I don’t seem to be getting any added value to having this in my portfolio…. sounds like a future blog post!
• I don’t have any government bonds – the yield on all government bonds is frankly lower. I am here to make money – no thank you.

Addressing Bond Critics

You’ll read a lot in the financial sphere that interest rates are rising and you shouldn’t invest in bonds. That is not true!

The below is an excerpt from Fidelity that is one of the best I have read. I made some small commentary above as you will see.

Here are 4 features of US investment-grade bonds that may help you maintain perspective during rising interest rates.

1. Even in a rising-rate environment, bonds may still perform when you need them

Even in a period when bond returns may struggle in general, they can still play an important diversifying role in a portfolio, because they may rally at times when stocks fall—say, in the event of a crisis, economic slowdown, or other unforeseen market shock.

Investment-grade bonds have provided positive performance in years when stocks fell

For illustration only. Past performance is no guarantee of future results. Performance based on the S&P 500® (stocks), Bloomberg Barclays U.S. Treasury Bond Index (Treasury bonds), and Bloomberg Barclays U.S. Corporate Investment-Grade Index (corporate bonds). Data shows calendar years December 31, 1999–December 31, 2017.

1. Over the long term, rising rates can help bond portfolio performance

In a portfolio of bonds, old bonds are maturing or being sold and new bonds are being added. When rates rise, it will generally cause the price of the bonds in the portfolio to fall, but the income from new bonds will be higher, and that added income has the potential to more than offset price losses over time—if you stay invested. **** this is why an ETF vs individual bonds are better – no roll over to manage!

That’s why the amount of time you plan to invest is important when it comes to bonds. Bonds and bond funds with shorter durations reach the point where additional income offsets price losses faster, so they may be more appropriate if you could need the money sooner. On the other hand, longer-duration investments may be more appropriate for diversification in a portfolio designed to meet long-term investment goals.

Over time, higher rates may improve bond fund performance

Source: FMR. Assumes a starting yield curve based on actual rate on February 26, 2018. The 10-year Treasury rate was 2.86%. Interest rates at all points on the yield curve converge to roughly 5.89% over the course of 5 years on the rising rate path, and to 16.2% on the falling rate. The rate changes occur in equal parts each year for 5 years. The illustrative investment is made in 5-year zero-coupon bonds with yield levels initially set by the Treasury curve. In addition, we assume that the investment is rolled annually—a 4-year bond is sold and a 5-year bond is purchased. Cumulative market value illustrates a hypothetical total return for an initial investment of $10,000. This is an illustration and does not represent the actual performance of any specific fund. Actual performance will vary.

1. Even when bonds experience losses, the price swings aren’t generally like stocks

Investment-grade bonds have historically tended to suffer smaller losses than stocks, and they very rarely post losses over longer time periods. Performance varies greatly for bonds of different credit qualities, but even during the worst bear market for bonds, the 40-year period of rising rates from 1941 to 1981, the worst 1-year loss for the Bloomberg Barclays US Aggregate Bond Index was just 5%. Over a 5-year period, the bond index never posted a loss. These performance numbers don’t account for inflation—which can be an important consideration when evaluating investment performance, but they do illustrate the different magnitudes of price swings between stocks and bonds.

Of course, if you hold individual bonds to maturity, you may be able to ride out price fluctuations, knowing that as long as the bond issuer doesn’t default, you will get your principal back at maturity and interest payments along the way.

The worst-case scenario for investment-grade bonds hasn’t been that bad

Past performance is no guarantee of future results. Data from December 1, 1926, to December 31, 2016. Based on rolling monthly holding periods. Asset class total returns are represented by indexes from Fidelity, Morningstar, Standard & Poor’s, and Bloomberg Barclays. Fidelity Investments’ proprietary analysis of historical asset class performance is not indicative of future results. Results do not reflect the impact of taxes, inflation, transaction costs, or other factors. It is not possible to invest directly in an index. Source: Fidelity Asset Allocation Research Team (AART).

1. Hiding can cost you

If you are worried about rising interest rates, you may be tempted to move out of bonds into cash. If so, you might avoid the risk that rising rates could hurt the value of your bonds, but what about inflation? Over time, a broadly diversified index of US investment-grade bonds has produced positive returns (after accounting for inflation) far more frequently than cash (see the chart below).

Moving money to the sidelines won’t help manage the risk of declining purchasing power.

Investment-grade bonds and large-cap stocks have outpaced inflation more often than cash

Past performance is no guarantee of future results. Data from 1926 to 2016. Based on rolling monthly holding periods. Asset class total returns are represented by indexes from Fidelity Investments, Morningstar, Standard & Poor’s, and Bloomberg Barclays. Fidelity Investments proprietary analysis of historical asset class performance, which is not indicative of future performance. Source: Fidelity Investments (AART) as of 12/31/2016.

In Conclusion

Do you know many investments that routinely give you a 3%+or 5%+ return? The answer is now yes! The next time you see some internet ads claiming to be the next get rich scheme on 6% or 8% return I hope you consider what you could be doing in a much more liquid investment as I have described here: SEC regulated securities – the boring but right way to invest.