The Story Of The Turtle And Rabbit Race
Have you ever know the story of a turtle and a rabbit race when you were a child?
Maybe most of you. If not, you can read the story here.
Young investors tend to avoid bonds because the yield is low compared to the stock market, so your investment will grow slow, and to be honest, bonds are boring. Sound like a turtle?
However, the good thing about bond is most of them are safe, offering a guaranteed return over an extended period. I’m talking about governments bond, triple AAA bonds or corporate’s bonds from sound companies.
The junk bond or South American government’s bond will be discussed in a different article soon. These type of bonds are risky, more than market stocks.
Where is the rabbit in this story?
Well, the rabbit is the market stock. Share price can swing widely and create opportunities for a significant gain but also for massive losses (you can lose everything), and you might never reach the finish line (your retirement).
What I’ve learned from this story for the financial world is that is better a steady, boring investment that grows over time with a guaranteed result to reach our goals.
What Are Bonds?
Did you ever borrow money from a bank? Sure you did. In the form of mortgage or credit card, we all borrow money at some point in our life.
Companies, governments, and municipalities do the same, and they issue bonds. A bond is a debt security with the promise to pay you back your money plus interest at a date in the future.
What is in for you is that you can lend your money and get interests for it, and it is pretty safe with bonds.
Usually, bonds pay a higher percentage than your bank saving account, and the risk is pretty much the same. This is just the basics, but as your portfolio grows, you will use the bond to offset exposure to more volatile stock holdings.
In my case, I own Vanguard Short-Term Government Bond ETF for 25% of my portfolio and Long Term US Treasury Bonds for 25%.
The reason I hold 50% of my portfolio in bond isn’t for the interest (it’s a miserable 2% per year), but helps with my trading strategy to achieve a higher return on my portfolio during a time of financial distress.
Let me explain. The other 50% of my portfolio is divided equally in global stock and gold ETF. During a period of economic distress for the market, the global stock index takes a plunge. Usually, the gold holding go up (not always), and the bond keeps steady. Then, I take half value from the bonds and move into global stock ETFs because the price went lower.
The market always turns around to carry on his uprising, and I profit greatly from this. After few months, when the bull market is over, I move back the money that I used to buy global stock ETF to the bond holding.
For me, Bonds are an edging against market risk while I get some percentage of interest. I know it might sound complicated at first, but it isn’t once you get used to the system.
Why To Buy Bonds?
Let’s have a look at another useful way to use bond and why you should buy some for your portfolio;
~ Bonds are predictable; Your income stream will be steady with a high allocation of bonds.
~ Bonds preserve capital; At maturity, bondholders get back the principle plus interest (ATTENTION; sometimes the bond issuer might default).
~ Bond offset stock holding; As mention in my case above, bonds help to weather a downturn in stocks.
All sound good till this point, but there is some risk in owning bonds.
When I was at college, I lend to a friend of mine 50 EURO. He was my friend, and I felt compelled to help him. I told him to give me back my money after summer (3 months) and should return 55 EURO. I love easy money.
Unfortunately, I never saw my money. So, whenever you borrow someone money, there is always a risk to lose your money.
Risks Of Investing In Bonds
Investing always carries risks, and bonds aren’t an exception. However, bonds are considered low risk compare to other investments such stocks, futures, and options.
The reasons are:
~ Bonds carry the promise of the issuer to return the principle at maturity. Stocks don’t. Meaning in the case an issuer default, bond owners get paid before shareholders and other third-parties.
~ Historically, bond market has been less vulnerable than the stock market.
~ Most bond typically make periodical payments known as Coupons, and they are a promise by the bond issuer from the beginning. Instead, for the shareholder, there isn’t any guarantee to receive dividends.
The biggest risk as a bond owner never gets back the principle; credit risk.
The most known cases are from South America, like the Argentinian crises in 2001/2002 which led Argentina to default on their foreign bonds.
Back in those days, I used to have South American Obligations, and I remember I was getting a 20% per year. It was unbelievable.
There is an easy way to know how risky the bond are; the higher the yield, the riskier the bond. Getting 20% on money borrow is just insane, and you should stay away from it.
The safest bond in the world are the one backed by US Treasury, but I don’t believe much in the ability of the US government to keep piling up debts.
Interest rate risk. The value of your bonds will change when the bank primary interest rate increase or decreases. Long-term bonds increase the value if the interest rate drop and vice versa. Short term bond are less affected by interest rate risk.
Inflation risk. If you are holding 10 years treasury bond and inflation skyrocket, the next issue of bond will carry a higher yield than your bonds, so you are going to lose value on the bond if you sell it. However, if you keep it for ten years, you will receive your face value plus the interest.
Call risk. A bond issuer might retire the bond before expiration due to lower interest rate so that you will find yourself in a less favorable bond environment.
Riskiest Class Of Bonds
Not all bonds are created equally. To determine better a bond risk, you should see who is issuing the bond. The only risk in bonds is the issuer. So focus on the issuer when picking bonds and you will be fine.
The riskiest bonds are issued from third world countries with poor policies and governments. I would avoid completely to buy bond’s issue by any country because most are bankrupt (Europe – Japan and the USA) and third world countries are corrupted.
I prefer corporate bonds issued by reliable corporations such Apple, Microsoft, Toyota, GE and so on. Just look in your country and think about the most reliable company quoted on the stock exchange. Buy their bonds and you should be safe.
Bonds issue from the strong corporations are in demand, so expect a low yield.
What’s Next With My Bond Portfolio
I’m doing some research how bonds will be affected by FED interest rate increase and make some sense about negative bonds, why investors should pay for the privilege to hold bonds?
I learned that there are investors who have to own government’s bond regardless of the financial returns. These institutions are:
These institutions are:
~ Central banks; hold bonds as part of their foreign exchange reserve
~ Pension funds; which own bond to match their liabilities
~ Insurance companies; need to hold bonds as part of their reserve
~ Banks; they need to meet liquidity requirements
~ Foreign investors; they buy bonds to edge on foreign exchange rates
~ General investors; who expect a prolonged period of deflation
Now I understand why negative yield bonds are in demand, just because someone have to hold them or assume the worst future scenario for the economy of the world.
In my case, I’m not interested in hold negative yield bonds. I don’t see the use.
The big message I get here is that Europe is risking to step in a deflation spiral like Japan did 20 years ago. In this case, Europe future would be doom and own bonds even with a negative yield, would be worth it.
The fact central banks are printing money like “crazy” is reflected in the bond market. The Central bank must buy a lot of Treasury to be able to print more money.
In this case, we risk breaking the financial system, with the start of one currency to collapse.
The FED is increasing interest rates, should I be worried about my 20 years treasury bond?
The answer is YES. I bought the Long Term US Treasury Bonds in February and today is up 1.7%, that doesn’t make any sense.
The FED is increasing rates with the possibility to reach 1% within a year, and long-term bonds should lose in value. But why my bond holding is making a killing?
I think investors believe that the FED not only will stop to raise interest rates but will get into negative interest territory. In this case, make sense to own long term bond.
In the past 20 years, the FED executed three tightening cycles; 1994 – 1999 – 2004. The three cycles of rising short-term interest rates met different responses from long-term bond rates.
You notice immediately that the last cycle was unusual, the 10 years treasury rate didn’t move much from its base.
Let’s have a look at the first cycle began in 1994. The Fed aggressively raise the rates, taking the market by surprise. The ten years Treasury bond lost 8% of its value, and the long-term interest rose sharply.
The second cycle started in 1999 during the dot.com boom. The market, this time, was prepared and ready for a FED tightening, in fact the ten-year treasuries ran slightly ahead of Fed Funds as the markets successfully ‘priced in’ the Fed’s likely course of action.
The last FED tightening cycle was a funny one.
Despite the Fed raising rates from just 1.0% to 5.25%, longer term interest rates barely budged. Foreign central banks were buying US treasury debt to control the value of their currencies against the US dollar, this had an impact on the 10 years treasury yield. This development inflated the US housing bubble.
What About The 2016 Tightening Cycle?
The FED hope in a 1999 scenario in which the market expect gradual rising rates.
Key questions asked by investors have included, “Are bonds a good investment when the Fed raises interest rates?
My answer is that bonds are always a sound investment and essential part of a balanced portfolio, however at the time of a tightening cycle, some bond perform better than others.
Unfortunately, I think foreign investors, government, and banks will buy US Treasury debt and keep the rates low for too long creating another bubble.
The fact that the UST (US Treasury debts) liquidity is drying up, which affect the functionality of the market. According to JP Morgan in 2014 it was possible to trade $280mn of USTs without moving the price. That has now fallen to $80mn.
This could create a wide swing of price for Treasury Bonds and markets could be messy.
You can learn more about the “messy” bond market in 1994 to get an idea of what could happen during this tightening cycle if things don’t go as planned. Yeap, you could be wiped out. In 1994 investors left on the table US$ 1 Trillion in losses.
[highlight color=”#6ed624″ rounded=”no” class=”” id=””]Today’s bond market is much bigger, about ten times the size of 1994. Losses could be staggering.[/highlight]
It’s happened, and we all know that history repeats himself just in a different form.
I’m not sure if this could be the year of a “black swan” bond market, but in a normal FED tightening cycle, a good strategy would be to buy short-term bonds; the proceeds from maturing bonds are reinvested in bonds with higher yields.
So, stay away from long term bonds such 10-30 years Treasury bonds because they are the one will get hit hard if the market turns sour.
Not only the bond market got bigger, but more sophisticated than ever thanks to the financial wizard of Wall Street.
There is more to the market shenanigan. Not only do these markets react to one another, but they react faster than ever before.
“A move in the long bond that used to take six weeks now happens in six days”
At the moment, the best way of action is to take a side position while the FED increase the interest rate. If by the end of 2016, Armageddon didn’t strike, then is safe to move some investment in the long-term bond market.
Next, I’m going to do a deep research on the best bond’s investment out to hold in my portfolio.
Best Bonds Out There For Your Portfolio
Three type of bonds define by maturity are;
~ Short-term bonds
~ Medium-term bonds
~ Long-term bonds
I’m interested only in short and long-term bonds for my rebalancing strategy.
To minimize risks and keep cost low, I buy ETFs, which hold hundreds and sometimes thousands of bonds. In average, the cost per year of these funds are only US$ 0.10 in fee.
This ETF is a bit different than other bond’s ETFs. The reason it doesn’t have a coupon so doesn’t pay out any dividends.
I will not go into the technical aspect, but outline the benefit and disadvantage holding the Vanguard Extended Duration Treasury ETF.
~ “Safe” by owning US Treasury Security
~ High volatility (ideal for a rebalancing portfolio)
~ Low cost at 0.10%
~ No Dividends
There are investors have benefit buying this product with a rebalancing strategy considering the volatility, but with more interest hikes by the FED, I conclude is pure madness to invest in this Bond’s ETF at the moment.
For every 1% increase by the FED, this ETF lose 24.7% value.
This ETFS track the Barclays U.S. 1–5 Year Government/Credit Float Adjusted Index.
I use it in my portfolio for 25% of total value as balance component.
If you invested US$ 10.000 in 2007, today it’s worth US$ 13.250.
As holding a short term bond, the price of this ETF is stable and grow over time without been affected by economic crises and stock market shocks. The highest drop was around 3%.
Alternative you can go for Vanguard Short-Term Corporate Bond ETF which produces the same result, have a similar volatility, but you borrow money to the American corporation instead of the government.
The brother of the Vanguard Short-Term Bond ETF is tracking the performance of the Barclays U.S. Long Government/Credit Float Adjusted Index. US$ 10.000 invested in 2007 would be worth US$ 19.600 today.
The average duration of the fund is 15 years.
This ETF is subject to wider shocks than a short-term bond ETF but offer a much higher return. The largest drop registered in the last 8 years was 20% in 2015.
I keep 25% of my total portfolio.
Here we have a game changer, at least for my current holding. The return is similar to the above ETF but much less volatile and more diversify.
This ETF holds 1661 bonds, against the only 70 government long bonds.
To me, this ETF sounds safer in the case of some massive economic catastrophe.
Borrowing to 1661 separate corporation you might have a few points of percentage in default, but borrowing money to the government, one entity, is a much higher risk.
This product is well known by investors and for a good reason. Staggering results!
US$ 10.ooo invested in 2007 would be worth US$ 22.ooo today. That is massive for a bond, I mean a 10% average after tax per year.
This ETF invest in US Treasuries. Volatility can be rough, 30% drop during the 2008 crisis.
The downside is the fund hold only 31 bonds and all in US government.
Contain the best of two the worlds; corporate and government bonds. The fund holds a large 8006 bonds, have a low volatility and offer a safe return of around 5%.
The best part is the super low cost o.6% and excellent liquidity.
Bonds are an essential component of a portfolio as a single investment either as a mix with shares. The more bonds within a portfolio, the more defensive will be your strategy.
However, if you own the Vanguard Extended Duration Treasury ETF which has a high volatile but excellent returns, you have an aggressive strategy to grow your wealth.
Whatever your goals, is essential to own some bond via ETF or buy directly from your government.