Bond, James Bond
Up to this point, I hope that you have benefitted from this series. I have also benefitted from the series as I learned about infographics design for this series and reinforced my financial knowledge as well. Do let me know if you have any ideas for Finance 101 or any other series that I can do.
With that out of the way, let's look at the financial instrument that allows you to be a loan shark - Bonds. So, what is a bond?
Definition:
A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. - Investopedia
Bonds are debt instruments. When you buy a bond, you are lending money to the company or government institution issuing the bond for a fixed rate of return. -DBS
The keywords are:
1. Loan/debt
2. From company/government to investor
3. Fixed-rate of return
Essentially, you are lending a sum of money to a company or government, in which you will receive interests annually for the period and you will receive the sum of money that you lent at the end of the period. The entity that issued the bonds would use the money and invest in projects/infrastructures that they believe will have a better return compared to the interest they pay you. (i.e, I borrow $5,000 at 1% interest, to invest for a return of 8%. Profit for me 7%)
Furthermore, in the event where the entity is unable to pay its debt (default), bondholders have higher priority over stockholders over the liquidated asset of that company. When the company makes money, bondholders are also prioritised over stockholders in receiving the money.
"That's great! Why does everyone not rush to bonds?" Good question, that's because historically, bonds have an average return of 5% but stocks have an average return of 10%. Furthermore, low risk doesn't mean no risk. There are cases where companies or countries that have defaulted on their loans (Does the name Hyflux ring a bell?).
Hence, bonds as a financial instrument would be suited for a conservative investment approach. This is the reason why we are recommended to allocate more of our portfolio to bonds as we age. Furthermore, bonds are income-generating assets rather than growth assets. Hence, if your desire is to have passive income, you may look at bonds as a valid option.
BUT, if you would refer to my 4% Rule article, you would know that bonds are unable to last you that long into retirement based on historical data. Furthermore, Warran Buffett has not incorporated bonds into his portfolio at his age as well. So you might want to take that into consideration.
After this long period of voicing my opinion, let's look at the advantages and disadvantages of owning bonds.
Advantages:
1. Safe and consistent income - due to the interest rate (coupon) that you will receive
2. Higher on the priority list in the event of liquidation
3. Passive income
4. Diversify your portfolio as it is a different financial product from stocks
Disadvantages:
1. Lower returns as well
2. Default is still probable
3. Some bonds are not available to retail investors (Some bonds are too high in value, $250,000 for one bond)
These are the priority of bonds payout (A higher priority would mean that you would be paid first in the event of liquidation)
1. Senior secured bonds (secured means that that debt is backed with collateral)
2. Senior unsecured bonds
3. Junior Subordinated bonds
4. Guaranteed and insured bonds (The guaranty is from a third-party, but not 100% insured.)
5. Convertible bonds (Can be converted to common stock)
How to find the right bond?
1. Coupon Rate: It is the interest rate paid on the bond (3% of $1000 would be $30)
2. The seniority of the bond: If you have higher priority if the company is liquidated
3. Outlook of the company: If the company is over-leveraged on debt, income statement etc.
4. Inflation trend: If inflation is at 3% and your bond has an interest rate of 3%, your effective return is 0
5. Liquidity of the bond: If you require money in a short amount of time, are you able to redeem the bond for cash? You can look at the daily trading volume of that bond.
Thoughts and comments:
As bonds are currently not in my portfolio, I am not that familiar. However, if you wish to diversify your risk, you might want to consider using bond ETFs which has a lower chance of losing your money.
Sources:
https://www.investopedia.com/terms/b/bond.asp
https://www.dbs.com.sg/personal/investments/fixed-income/understanding-bonds
https://www.investopedia.com/articles/investing/121815/understand-security-types-corporate-bonds.asp
https://www.investopedia.com/articles/bonds/09/bear-on-bonds.asp
https://www.investopedia.com/articles/bonds/07/fixedincome.asp
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