Why Should I Care About Bonds?
The further I get down this financial independence path, the more on autopilot I get. That is a good thing on a lot of fronts. Automating your investments and giving you time to focus on what’s important. But it can also mean getting a little close minded or losing enthusiasm.
I think it’s crucial to ABL (Always Be Learning). When we get a chance to learn about a new investment vehicle or method of investing, we give ourselves an opportunity to get better returns, get more efficient, and re-stoke that enthusiasm.
So what’s the exciting new topic today? Bonds.
Wait did he say bonds?
Bonds Can’t be Interesting…Can They?
They’re the boring things that old people get to keep their money safe right? Clutching your wallet and riding out those last couple decades is the image that often comes to mind, at least for me.
What even is a bond? Are they all like those savings bonds you may have gotten from a grandparent that meant you had to wait five years to actually celebrate your birthday?
Well why don’t we dig into this classic investment vehicle and see what it’s all about. We can debate if they should be a part of your portfolio, the percentage you should hold and when they matter… but I think it’s always good to understand them.
And spoiler alert…there’s a new interesting bond offering in town.
What is a bond?
I’m a big fan of the ELI5 concept found common with Reddit. ELI5 stands for Explain Like I’m Five. To me, the ELI5 for a bond is a way for you to loan some organization money with expectation of receiving some interest over a set period of time.
This could be the United States Government or it could just be a corporation.
How’s that different than a stock?
A stock is where you actually become a part owner of sorts. You own shares in a company and you get to keep it as long as you like. Those shares will change in price without any consistency.
A bond generally goes up at a fixed rate, which means it doesn’t change.
Say you buy a bond for $10 and it’s an eight year bond that pays 8%. Generally, these bonds pay out simple interest vs compounding interest.
Wait…There’s different types of interest?
You bet there are. Simple interest means you will be receiving the same amount of interest every year regardless of how long you hold the investment.
So that $10 bond you bought that’s paying 8% simple interest means that it’s paying 80 cents every year. So at the end of that eight years, that $10 bond is worth $16.40.
Here’s how that’d look:
Year 1: $10.80
Year 2: $11.60
Year 3: $12.40
Year 4: $13.20
Year 5: $14.00
Year 6: $14.80
Year 7: $15.60
Year 8: $16.40
So after eight years you received a total of 64% returns
Now back to comparing that to Stock
When we talk about returns for a stock, we generally refer to it in the compounding way. Basically, your interest earns interest. In the bond/simple example you got 80 cents every year. But with this stock/compounding example, it’s going to ramp up as long as the stock performs well.
For an apples to apples comparison, assume the stock goes up 8% every year.
Here’s how that’d look:
Year 1: $10.80
Year 2: $11.66
Year 3: $12.60
Year 4: $13.60
Year 5: $14.70
Year 6: $15.87
Year 7: $17.13
Year 8: $18.51
So after eight years you received a total of 85% returns
Also notice that in year eight you earned $1.38 in interest vs only $0.80 in year one. The longer you keep getting that compounding interest the more extreme the gap will become. In year 30, you’d be looking at $7.30 in interest in a single year.
So why would I ever want the bond?
After seeing how the stock seemed to blow away the bond, why would you ever want a bond? Well, one flaw with my example was that I assumed the stock would just grow at 8% steady every year.
If someone could guarantee me 8% at this point I’d probably just sign up for that eternally. In reality, the returns are going to really fluctuate.
You may just be starting out and have a small nest egg but see big percentage returns, only to be met with flat or negative returns once you’ve had a chance to actually put back a bunch of savings. While that may mean the stock market did its part and averaged out just fine, your returns don’t look so hot.
You had those awesome years “wasted” on a small amount of money.
Stocks have been on a mostly upward trajectory for the last ~8 years but someday, that will end.
Bonds can hedge against down stock years
What really makes something go up or down in value? Generally, buying and selling. No matter how great a company is, if everyone is selling those stocks, you’ll generally see that price go down. It’s supply and demand.
When everyone is selling stocks and then the stocks start to fall, people look to buy something. That “something” is often bonds. When everyone start running to bonds, there’s a lot more demand and thus those values go up.
So bonds give you a bit of a safety net when things on the stock side start to slide.
Where do you get exposure to bonds?
When talking to friends, I generally see folks get exposure to bonds in the form of lifecycle funds. A lifecycle fund is one which automatically changes its allocation based on how close you’re getting to a certain date.
So a 2060 fund right now would mostly be stocks but in 2055 it would have a sizable amount of bonds. This is because bonds are seen as safer and more stable. As you get closer to your retirement date (2060 in this example), many people believe that you transition to more of a wealth preservation mode vs a wealth building mode.
Are all bonds boring government bonds?
Ok, so the real reason I got interested in writing an article on bonds was the discovery of a new interesting FinTech company (SMBX). Full disclosure, I was sponsored to write this post on bonds but I wrote the article the way I wanted, so it’s an honest introduction.
SMBX gives you this avenue to purchase bonds in currently operating businesses. It also provides you with financial documents on the company so you can complete your due diligence on the company.
Companies have a certain window of time for people to invest in and new companies are periodically added. The interest rates you see are generally 7%-8% with a length of 5 yrs.
Keep in mind that there’s never a free lunch. You’re investing in businesses that can fail and could default on these bonds. Said simply, those 7%-8% returns aren’t guaranteed.
But, it does give you an avenue to make your journey into bond investing a lot more interesting. A speciality ice cream shop in San Fransisco might be a little more interesting research than an old school government bond.
I hope you enjoyed this write up on the historically un-sexy topic of bonds and maybe you’re introduced to a new company doing interesting things in the finance realm.
Comment below and let me know if there are any other companies doing interesting things in finance that you’d like to hear me review.
