Wall street makes its money on activity, you make your money in inactivity- Warren Buffett
Depending on how old you are and how aggressive your strategy is as an investor, you might want to consider holding some bonds in your asset. Bonds play a crucial role in your asset allocation.
What are bonds ?
In a simple term, when you buy bonds, you loan out your money to an organization/company or even to the government. Buying stocks makes you the owner of a fraction of the company, buying bonds makes you the banker that loan out the money which must be paid back with interest.
In my whole life, I have been borrowing money from banks to buy ‘stuff’ and it was totally alien for me years ago that we too could become ‘banks’ that loan out money to big companies like Singtel, Maybank, or even the US government!
If a company goes bankrupt and gets into financial difficulty, it is not obliged to pay the money back to its shareholders but it is required by law to pay back the holders of its bonds.
Is there any risk buying bonds?
Generally, there are three risks involved if you decided to buy bonds- default risk, interest risk, and the length of the term of a bond.
Let say you spend MYR100,000 to buy a bond from company HYX for 10 years at a coupon/interest of 6% per annum. Company HYX promises to pay you MYR6000 per year for 10 years. At the end of 10 years, you will get back your principal of MYR100,000, so in total, you pocket a total of MYR160,000 after 10 years.
Company HYX might default payment anytime within the 10-year period and this is default risk. Even though it is obliged by laws to pay you, the payment default still can happen if the company goes ‘kaput’ (bankrupt).
To help investors to decide how risky a company or government is, there are various rating agencies evaluate these companies/governments’ worthiness ( credit rating).
For example, S&P (Standard & Poor’s ) will give a rating from AAA to D according to the credit-worthiness of corporate or government bonds. AAA means the highest rating and the risk of default is very low.
This is usually given to government bonds from Germany, Australia, and Denmark. Any bond rating below BBB- is considered non-investment bonds ( junk bonds). Therefore, to attract investors to buy non-investment bonds ( which has a higher default risk), the only option will be offering a higher coupon rate.
Interest risk of a bond
Another risk involved in buying bonds is interest risk. Let say you buy the bond as mentioned above with a coupon rate of 6% per annum. If the interest rate has risen to 10% per year, you will be having a hard time selling your bonds to the ‘secondary market’ since your bonds only pay 6% interest per year instead of 10%.
So as a rule of thumb, when interest goes up, your bonds’ values come down and vice versa. In either case, if you hold a bond to the end of its term you will, barring default, get exactly what you have paid for it.
Length of term of a bond
The third risk of holding a bond is the length of the term. It is quite logical to think that the shorter the term, the less risky is the bond. The longer the term of a bond, the more likely interest rates will change drastically before it matures. This implies greater risk and the bond issuer has to offer you a higher coupon/interest rate to lure you into buying the bond.
Who wants their money stuck in a treasury bond for 30 years and getting a lower interest rate than a 3-year bill ( shorter-term bond)?
Why do you need bonds?
I cycled my BMX to school from Primary 3 to 6. That helped my mum to save MYR10 every month, and I thought that was a lot of money.
I decided to cycle to school and we knew that there were two brake pads in each bicycle- one front and one rear.
The best part of cycling back to home from school was during the descent on a stretch of road that ran downhill at 20 degrees. It was the most exciting moment every time my BMX was descending at high speed from the highest point of the road.
My bicycle brake pads damaged easily and I needed to change the pads almost every quarter. One day I decided to keep my MYR0.20 ( cost of a new brake pad) since another brake pad was still working.
” What is the point of having two brake pads if one could do the job?” I thought I was smart enough to help my mum to save that 20 cents.
The disaster happened one day when I lost control during my usual easy-adrenaline-filled descent and had a crazy somersault fall from my BMX and sustained multiple contusion and abrasion.
I was lectured by mum for hours about the importance of double protections while taking risk in life.
Bonds ETF is your second brake pad
So what is the purpose of holding bonds in your portfolio? To protect yourself from market risk, your first brake pad would be stock diversification.
As you know, I buy VUSD and VWRD ETFs that hold more than 3000 companies stocks in the world. This is the first brake pad when you invest in the stock market.
Your second brake pad will be adding bonds to your portfolio. If you hold VDTY ETF, it is a US treasury bond that has an AAA rating. It consists of 262 bonds. Another option will be holding IGLO ETF, it is a global government bond from countries like the USA ( 40%), Japan, Germany, UK, and Canada. There are over 700 bonds in IGLO ETF. Don’t buy an individual bond, you will never know whether a company or even a country ( remember Greece?) could go bankrupt in the future!
By mixing bonds ETF in your portfolio/asset, your portfolio will be less volatile. If you look at the Vanguard website, the historical return ( from 1926 to 2018) of a balanced portfolio ( 50% bonds/50% stocks) was 8.2% per annum with the best return of 32.3% ( in 1933) and the worst return of -22.5% ( in the year 1931).
If you think you have the stomach to digest high volatility and opted for an 80% stock and 20% bonds mixture, your average return would be 9.4% with the best return of 45.4% ( 1933) and the worst return of -34.9% ( 1931).
So do you see the point? You need bonds ETFs in your portfolio to make your ride smoother so that you can sleep better at night!
Conclusion
Investing is simple but not easy. Most of us think we can digest and withstand the volatility until the real crash happens and start to realize the fear and anxiety during a bear market.
Buying bonds is like having the second brake pad in your bicycle to protect you from the volatility of the stock market. Having just one brake pad ( diversification) might not be good enough if you do not have a strong heart at looking hard-earned money evaporates 30-40% overnight.
Since 1928, on average stocks have fallen at least 5 percent three times a year, at least 10 percent once a year, at least 20 percent once every 4 years, and at least 30 percent once every decade.
You have to prepare mentally for volatility in the market. Holding bonds in your portfolio is an important strategy in asset allocation.
I always sleep well at night no matter what direction the market is heading but unfortunately, I still get irritating calls almost every late evening from the hospital!
