License to Kill – Bond(s) explained

Ok, the title is an obvious dad joke, but as it happens it still fits in with my naming convention for posts so happy days!  On to more serious stuff.

The most common proposed asset allocation for people pursuing FIRE seems to involve having absolutely as much invested in equities (or to a lesser extent property) as possible, and reducing every other asset class to as little as possible.  Which is certainly one way of doing things, and given the great performance of shares and property over the last 20 years or more there is an argument to be made for doing things this way.

It’s certainly not the only way of doing things though, and I will be trying to show why there is a case to be made for investing some money in other asset classes, in particular Fixed Income aka Bonds.  

So what are bonds?

Bonds are a type of debt that is issued by governments, semi-government organisations, and corporations, so basically you’re lending them money.  In Australia we also have what are called hybrid securities, but they’ve got some big enough differences that I’ll talk about them in a future post (probably).  

Bonds are also one of those fun areas where there is an exception to every rule, so although what I’ve written below is broadly accurate there is always going to be some type of bond or a specific issue that breaks one of the rules. 

So please don’t be an internet hero and “well ackshually” me about premium redemption/issue bonds, soft calls, hard calls, investor puts, floaters, PIK notes and all the rest of it because broadly speaking it isn’t going to make much difference for the purposes of explaining bonds.   Basically play nice readers!

https://xkcd.com/386/

Talk numbers to me…

Bonds are all about math.  As I’m sure regular readers of this blog can imagine this makes me very happy, and probably explains in part why I spent a large part of my career working in an area where understanding bonds was crucial, although to make things more interesting we added on a bunch of other stuff like equity options, credit derivatives, FX etc. 

The main numbers to think about are the price you paid for the bond, the coupon on the bond, the yield on the bond, the time to maturity, and the maturity value of the bond.  From those main numbers we also derive a bunch of other numbers I’ll talk about later.

Bonds are normally issued at a price of 100, with a fixed coupon (interest payment based on the maturity value of the bond) and a fixed maturity value at a known maturity date.  So that’s 4 of the numbers covered already, happy days! 

A lot of the time though you’re not going to be buying that bond when it is issued, you’ve buying it when it’s already trading in which case chances are pretty good you didn’t pay 100 for the bond.  Buying it along the way doesn’t affect the coupon or the redemption amount at maturity or when it matures. 

What it does affect though is the yield.  There are a bunch of different yield measures but I’m going to go with yield to maturity, ie what yield (return) will you get if you hold the bond to maturity.  

It’s not a perfect analogy, but one way to think about bonds is that they’re like a term deposit where the amount that you can buy it for moves around.  If you buy a bond for $10,000 that is going to mature in a year and it has a 2% coupon and redeems for $10,200 (redemption price plus coupon payment), then your yield (2%) is the same as your coupon (2%).   

But if interest rates have changed and so the price of the bond has changed and you buy that bond for $9,900 or $10,100, then your yield will be different from your coupon, either 3% or 1% respectively.  Hopefully that makes sense? BTW I’ve rounded the numbers here to try and keep it nice and simple.

Most bonds pay interest on a semi annual basis (I used an annual payment in the example above to make things easier) so to figure out how much interest you get when it gets paid it’ll be the coupon divided by two.

Hopefully all of that makes sense, if not let me know in the comments.

Issuers of Bonds

As I said above the main issuers of bonds are governments, semi government organisations, and corporations.

Debt issued by governments is generally the safest type, because so long as they control the printing press then they can always print more money to pay you back.  The Eurozone is a bit of an exception to this (understatement of the year) but in most of the other major sovereign bond markets like the US, Australian, the UK etc it’s true. 

Emerging markets are a bit different because they often issue debt in USD, which means that if things go pear shaped then they can’t just print more money to pay off bondholders. 

There can also be issues with getting your money back from sovereigns if they have too much debt, such as when they either don’t control the printing press (Greece) or the bond is issued in a different currency (Argentina) but for the most part if you lend money to a developed country in their own currency then you can pretty reliably count on getting your money back.

There are also bonds issued by semi government organisations like the World Bank, European Bank for Reconstruction and Development etc, these are slightly less safe for the most part but you’re still not taking on much risk of not getting your money back.

Debt issued by corporations is riskier, partly because businesses obviously can’t just print more money to pay you back, and because corporations can and do go bust.  Sure it doesn’t seem likely that Telstra or Woolworths or the big banks are going to blow up any time soon, but there are plenty of other bond issuers out there with much more fragile finances.

As you would expect the more risk you are taking on the more return you want in order to be compensation for doing so.  This is because unlike a term deposit the value of your capital isn’t protected.  If you put $10,000 into a term deposit for a year with an interest rate of 2%, then you know that in a year’s time you will get back that $10,000 plus $200 in interest. 

If for some reason the bank you invested that money through goes bust, the government will make you whole (up to the value of $250,000 per entity per approved deposit institution.

If you invest in a corporate bond and the company goes bust, well you’re probably not going to get all or maybe any of your money back.  The good news is that you’re more likely to get money back than equity holders, but if the debts of the company are a lot more than the assets then you’re going to be in trouble.

There’s a clear framework for what happens if a company goes bust and who gets paid first and in how much etc, the short version of this is that equity holders are absolutely last in line but depending on what type of bonds you own you may not be a meaningful better position either. 

And unlike a stock, when you own a bond you don’t own a piece of the issuer of the bond, you just own part of their devt.  So if the company does great and starts making a fortune, you as a bondholder don’t get paid any more than what the terms of the bond state.  Basically you can get a fair chunk of the downside and none of the upside beyond the terms of the bond.  On the plus side this doesn’t happen particularly often, most of the time you’ll get what you were promised

Bond ratings

Now obviously some companies are more secure and stable than others.  If you take a bond from the biggest company in the ASX200 which is CBA, then it’s more likely to fulfil the terms of the bond than whatever the 200th company is.  That’s not to say the 200th company won’t, just that there is more risk.  The actual degree of this risk is quantified in a couple of different ways.  

First of all there are ratings agencies out there who will assign a rating from anywhere to super safe (AAA) to D (in default) with a bunch of graduations in between.  Anything rated from AAA to BBB- is what is called Investment Grade (IG), everything below that is called High Yield (HY) or less politely Junk. 

https://www.investopedia.com/ask/answers/09/bond-rating.asp

Just because a bond is IG doesn’t guarantee it will pay off, likewise something which is HY isn’t guaranteed or even likely to fail.  For the most part though the different ratings given tend to play out that way in the real world, with far less defaults for bonds rated AAA vs bonds rated BB for example.

The big three ratings agencies are Standard & Poors (S&P), Moodys, and Fitch, and between them they’ll rate most of the bonds and/or issuers.  They tend to be fairly backward looking in my opinion, and they were hugely and obviously wrong on rating mortgage backed securities back in the GFC.  Still, they will generally give you a reasonable idea of the creditworthiness of the bond issuer.

Because bonds are also traded in the marketplace you can take the yield offered on a bond with a particular maturity, compare it to an equivalent government bond, and using some fun math (yeah baby!) back out a credit spread which that bond trades over treasuries (or swaps but I’m not going to get into that). The higher the spread, the higher the perceived risk of the bond, and vice versa of course.

Are bonds safe?

Well it kinda depends on what you mean by safe.  If you mean are the bonds likely to deliver what the issuer of the bonds promised, then generally yes.  As I said with government and semi government bonds you will almost certainly get all your coupons and the maturity value of the bonds delivered on time.  Yeah, there are some exceptions to this but you’re unlikely to run into trouble with Australia, the US, the UK, the more economically sensible members of the Eurozone etc.

Similarly with corporates the vaast majority of the time you will get your money back on investment grade bonds, and it’s pretty rare to not get your money back on high yield bonds as well. That’s not to say it doesn’t happen, but it doesn’t happen much.

If you mean am I going to get back what I put into the bond, well no they’re not necessarily safe, particularly if you sell before maturity.  Remember when I said bonds are kinda like term deposits that can trade?  Well when they trade those prices move around, and they can move around a lot!  

Why do bond prices move?

There are a bunch of reasons why bond prices move around, the main ones are changes in the interest rate environment, changes in economic conditions, and changes specific to the issuer of the bond. 

We’ll talk about interest rates first. Bond prices have an inverse relationship with bond yields, which is a fancy way of saying if interest rates (yields) go down then bond prices go up.  

https://www.bloomberg.com/quote/GACGB10:IND

How much do they go up?  Well that depends on the magnitude of the change in rates, and a bunch of factors involving the bond.  Basically the longer till maturity on the bond, and the lower the coupon on the bond, the more sensitive it will be to changes in interest rates.  This is measured using modified duration and convexity. 

Modified duration takes into account the timing of the cashflows of the bond (so coupons and maturity) and gives you a number which is typically a little less than that number of years to maturity, the higher the coupon the more it decreases the modified duration. If you multiply that modified duration by the change in interest rates in percentage terms, it will tell you how much the bond price will move by (in theory at least). 

So if you have a modified duration of say 7.117, then for every 1 percent move in interest rates the bond price will change by 7.117 points.  So if your bond price was previously 100 and rates moved down by 1%, then your bond should now be worth 107.117.  Happy days!  Conversely if rates moved up, well your bond is now worth 92.883.  Not so happy days.

I’ve used the ASX bond calculator to give a couple of examples using the current Aussie 10 year bond.  You can hopefully see below that by changing the yield on the bond from 1.5% to 1% the market price has gone from 116.87 to 121.83, roughly a 4.25% change in price for a 0.5% change in rates, so presumably the modified duration on the bond is about 8.5. 

To make things slightly more complex, that relationship isn’t fixed due to something called convexity.  Instead of being a linear relationship, it’s actually a changing one (a curve rather than a line).  Basically the more bonds prices move away from where they were issued the more that relationship will change.  

Then there are things like GDP numbers, employment numbers, consumer sentiment surveys, PMI surverys, and all sorts of other economic news which will potentially move bond yields around, generally pretty slightly but it really depends on how important that economic number is and how much of a change from expectations it is. 

On top of that for corporations changes in their own situations will have an effect on what their credit rating/spread is which will affect prices as well.  If a company goes from being loss making to suddenly making a profit, then that’s going to be good for their credit and the bond price is likely to go up.  Bad news like a profit warning will potentially mean a higher credit spread and lower price for the bond.

There is also general investor appetite for risk, so if investors are happy to take on more risk in their asset allocation (risk on) then they will likely sell off lower risk assets like bonds and buy higher risk assets like equities and to a lesser extent property.  If things change and they want to go risk off, then the reverse happens and money tends to come out of equities and into bonds.

What happens to bonds if the stock market crashes or we have another GFC?

A stock market crash is actually one of the more compelling reasons to invest in bonds.  This is because when stock markets crash investors tend to put their money into asset classes where they feel a lot safer ie, bonds.  The rationale is that getting your money back is now hugely important, and even more important is not losing all your money as you will in those horrible equities which you knew you should never have invested in but that horrible financial adviser talked you into. 

People.  Are.  Not.  Rational.  People panic.  People sell assets which are going down in value even though they know they should be holding on for the long term.  This applies not just to retail investors, but also to professionals who should know better. 

In the GFC I spent plenty of time talking to institutional investors with a long term time horizon (ie 5 or 10 years etc) who suddenly decided they had to get out because of bad one month performance.  People will bail out if the proverbial is hitting the fan.  I wrote a bit about my experiences with the GFC here, and believe me there are a lot of people who are not going to be as cool calm and collected as they think they will be.  

It’s very very very very (extra very for emphasis) important to note here that at this point in time investors will not be thinking that all bonds are much the same.  When they are looking for somewhere to put their money that they now have after panic selling out of equities, they will park it in the safest place they can find, ie government bonds (aka treasuries).  This will cause the price of those bonds to rise because of supply and demand. 

If they still want to take on some amount of risk then they might put some into investment grade bonds, again this will push the price up a bit.  They will almost certainly not put money into high yield bonds, because those are risky and in a crisis will behave pretty similarly to equities, ie they will fall in value.  If anything they will more than likely try to pull money out of HY bonds, pushing the price down.

This excellent post really shows this in the below graph which shows the average performance of different types of bonds for a 10% or greater fall in the stock market (all of this is for the US but the same principle applies to Australia).

It doesn’t work in every case, as shown below (same source), but in almost all cases of a big crash in equities, treasury and to a lesser extent IG bonds gave you a big positive return to help out.  HY, not so much and in some cases actually gave you a worse performance than equities themselves.

Please believe me when I say it is a huge help psychologically to have some of your investments going up when the others are going down, which to me at least is a great reason to have some money invested in bonds.

You’ve convinced me, how much should I have in bonds?

Ok so I’m probably being slightly optimistic here given the number of posts I see on reddit about how VDHG would be so much better if Vanguard got rid of that terrible 10% that’s invested in bonds  and put it all in equities instead. 

It would be nice to think though that some people are now realising that come the next crash they too might not behave entirely rationally, and it sure would be nice to own some assets that are going to zig when the stock market zags, so to speak.

On the off chance that I have actually convinced people, well it really comes down to your particular risk profile.  This is going to be hard to believe for some people, but in the US the default portfolio for most investors is 60% stocks and 40% bonds. 

Looking at Oz , the default balanced investment option for most super funds over here are supposed to have something like a 70:30 split between growth assets (shares and property) and defensive assets (bonds and cash) although the reality is a long long way from that if you actually look into how they invest (that’s a discussion for another time though). So that maybe provides a useful starting point.

I know that the average FIRE portfolio that gets talked about particularly from younger bloggers (who have likely never experienced a sustained down market) is pretty much 100% equities and property, maybe even leveraged up.   Which is fine if you can hold on through the downturns, but not everyone can do this because it is extremely difficult to do psychologically.  I wish them all the best of luck, but I am pretty sure that at least some of them will decide that it’s all too much and sell whenever we have the next crash.

There are exceptions to the rule though.  One of my favourite bloggers, and someone who I know thinks deeply about this sort of stuff, is the FI Explorer who has about 15% in bonds and 15% in defensive alternatives (gold and bitcoin) as per his latest portfolio update.  

Whilst I don’t like Bitcoin myself, or gold for that matter, he writes a good explanation about why he holds both here.  I still don’t like either asset myself, but I recognise that I am not infallible, I could well be wrong about this, and certainly historically they have worked well as hedges. 

In any case the more important point here is that there is basically a 30% allocation to what would be regarded as defensive type assets.  This is actually a bit over his actual target of 25% in defensive assets, but he probably sleeps just fine at night. 

I’m a little more aggressive in only having about 21% of my assets (excluding PPoR) in cash and bonds, but it’s not a huge difference.  Both of us have been invested through stock market crashes and hopefully have come to realise that we are not the hyper rational investors that economists believe we are, and therefore it’s best to have a bit invested in stuff that will go up or at least hold it’s value when everything else is crashing. 

How do I buy bonds?

You can buy bonds individually, but you tend to need to have a fair amount of money to do so and you can run into a lot of problems with liquidity, big bid/ask spreads etc, it’s hard to build up a diversified portfolio etc. 

I buy bonds the same way I buy stocks, ie via an ETF.  Most of the major ETF providers have some variety of index ETFs tracking Treasury only or Treasury plus Investment Grade bonds, or you can buy HY stuff if you want.  Personally I just use one ETF which has about 75% in treasuries and the rest in IG.  There are also some actively managed bond funds out there, either as ETFs or managed funds. 

For the reasons I outlined above about bonds being a psychological safe harbour I personally would (and do) only invest in bonds which are likely to go up in a crisis, but different strokes for different folks applies as always.

Any more questions?

I’ve only really scratched the surface here of talking about bonds, but at the same time I feel like it’s an overwhelming amount of information.  If you have more questions then as always I’m happy to answer them in the comments!

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