[Unmetered] Bonds Go Way B-ey-ond that $50 Paper Your Grandpa Gave You
Ah, bonds. The notoriously dull cousin of stocks. The trophy-holder for the most uninspired birthday gift a kid can receive. Surely nothing in this sphere of boringness could be worthwhile to the average investor. Right?
Wrong. The bond market is heating up, and it’s time for normal investors to start paying attention. Why should you care? For starters, if we’re measuring by total US market size, bonds out-swing stocks annually by over 30% ($30 trillion annually for stocks, a staggering $40 trillion annually for bonds). When we compare daily trading, it’s not even close. Stocks trade around $200 billion per day. Bonds dramatically exceed this volume, with nearly $700 billion in bonds traded every day (data from industry group SIFMA).
Yes, this massive bond market includes around $14 trillion in common United States Treasury debt, but it also includes a much more interesting $9 trillion in mortgage-related bonds, nearly $9 trillion in corporate bonds, and more than $3.8 billion in municipal (state or local government) bonds.
But none of this means anything to us average investors… that is, unless we could leverage what we know to beef up our portfolios. Before we get there, though, let’s start with what a bond really is and how a normal person can get in on the action.
What is a bond?
A bond is simply a loan. In addition to more traditional loans from banks, entities like the U.S. Government or Target Corp. can loan money from each investor that buys a bond. Yes, there are often some fancy provisions baked into bonds, but at the core, there is always an entity (government, company, etc) borrowing money from investors (other companies, hedge funds, or even just you or me).
You probably already know that when you take out a loan, you have to pay back both interest and principal. Maybe you need money to buy a new car. You go to a bank, and they give you the money you need now… with the understanding that you’re on the hook to pay all of the borrowed money plus a certain percentage in interest.
If this makes sense so far, then congratulations! You already understand bonds! With a bond, the principal is the amount that the investor pays for the bond (think of this as the loan), and the interest is called the ‘coupon’, and is a convenient way to keep track of how much interest investors are entitled to annually.
Let’s run through an example: Let’s say Target needs some money to build new stores. They issue 20 year bonds for $1,000 each, and the coupon (or interest rate) is 10% payed annually. As the investor, if we buy one bond, we pay Target $1,000 today. Now each year Target must pay us a $100 coupon payment (10% of $1,000). After the 20 year period is up, Target pays us our last $100 coupon payment AND the full $1,000 back. Pretty sweet, right?
How should bonds fit into a normal investor’s portfolio?
We hate paying interest on our personal loans, of course. But banks! Well, they must love all this interest we’re coughing up. Think of bonds as a way that normal people can switch sides and reap the benefits of playing the bank role.
When a company like Target issues bonds, they’re generally considered to be pretty safe. In other words, investors can be pretty close to guaranteed they’ll get their coupon payments and full $1,000 back. When the United States government issues bonds, these are considered even safer. In fact, some short-term bonds (technically ‘bills’ if <1 year) sold by the U.S. Government are considered so safe that we call them risk-free.
You stock investors might be rightfully jealous by now. After all, how is it fair that stocks might fall 5% in a single day, but bonds are almost guaranteed or even ‘risk-free’? Here we’ve stumbled on the reason that bonds are often considered so boring: they’re remarkably reliable, meaning they don’t usually lose much, but they don’t usually gain much either.
This boring performance (AKA low correlation to other asset classes) is actually also one the best reasons that normal investors should include some bonds in their portfolio. With a 30% allocation to bonds, your portfolio might not look quite as steep during a high-gear bull market, but you’ll be thankful for your trusty bonds when the market takes a turn for the worse.
How can a normal investor buy bonds?
If you tuned in to my mini-exposé on how the stock market actually works (and I recommend you do), you’re familiar with the tune of this advice: Don’t be a hero, buy ETFs. I love how Investopedia put it. “Investors do not have to become bond geeks or learn how to be bond traders to buy bond ETFs”. Grab an aggregate bond ETF to access to the entire investment-grade bond market. You can even find tax-advantaged municipal bond ETFs, inflation-hedged bond ETFs, and practically any other basket to best fit your needs.
So no, bonds may never have the sexy allure of high-risk high-reward stocks, but if you’re looking to strengthen your portfolio’s risk-return profile (and that should be everyone), don’t look b-ey-ond (… sorry) that $50 note of wisdom from your grandparents.
Interested in More? Worthwhile Reading:
(Amazon affiliate links attached, but check your public library first)
I‘d also highly recommend checking out your public library audiobook selection first, then Amazon’s Audible Plus (awesome and unlimited listens, but $7.95/month and limited selection), or Amazon’s Audible Premium Plus (unlimited listens and monthly tokens, but $14.95/month). Or, students grab 6 months of Prime, then sign up for a Premium Plus trial and get an extra free token.
In this story, I included my own market and finance opinions and advice. While these are always historically supported and fact-based, please check with a trusted finance expert before acting on this subject matter.