Now on this website, we like to focus our advice and ideas on equities. This is because quite frankly, as with our readers, we are all young, and have the ability to weather the volatility and added risk which the equity markets require as a sacrifice for higher returns. Now, a more traditional investment strategy involves the famous 60/40 split. This is 60% equities and 40% bonds. It is a portfolio meant to provide more consistent returns (minimizing volatility) while also ensuring that you get exposure to long-term benefits of compounding slightly higher returns.
To discuss the values of each different investment style, it really comes down to your own personal needs, your timeline and generally how comfortable with risk you are. But before we can even address that, I need to highlight what bonds in and of themselves are, because we haven’t really done that on the website so far.
So when you buy a share on the open market, you are buying a piece of the business - a portion of the voting class shares, and an entitlement to a certain proportion of the earnings and assets of the companies. Effectively, if the company does well, increases market share and earnings go up, then that portion is worth more. However, a bond is just a fancy instrument meaning “debt”. As a bondholder (as opposed to shareholder), you agree to lend the company (or government) a certain principal (known as the face value of the bond), which you will be paid back upon the maturity of the bond. A bond’s maturity is basically just how long the lending timeframe is (when the borrower actually has to pay you back). Over this period of time, you as the lender will be paid a certain interest rate (or coupon in technical terms). On say a $10,000 dollar bond with a 10 year maturity, carrying a 10% coupon, you would get paid $1,000 annually as a bondholder.
So why is this financial instrument so important? Well, it is the primary way large institutions finance their operations without having to give up an ownership stake. Debt in particular is useful for the creation of value-accretive projects which need a fixed repayment cost. These bonds allow corporations to easily plan out cash flows while completing what are meant to be value-added endeavors.
On the investor side, bonds, as debt, carry a much safer return schedule. They are guaranteed repayments and carry a much higher priority when it comes to things like payouts upon the bankruptcy of a corporation. Effectively, no matter how the business is performing at the time, your interest and principal payments have to get made, otherwise the company will by definition go into default and usually file for bankruptcy protection. Even in that scenario, your investment is much more protected than equity as you get first claim on things like proceeds from an asset sale. Additionally, there is a lot of variability when it comes to bonds, with some being secured on a company’s direct assets, and thus granting even greater priority to those bondholders in things like asset sales. All of this is critical as it means that your coupon rate is effectively guaranteed money from that company. By comparison, while an equity investment can do very well as the company does well, if it has a couple of bad quarters (by no means going out of business, but just not meeting expectations), that investment will not perform very well.
So how do you take advantage of this reality? Well, the best way to actually take action is to participate in the bond market yourself. I personally haven’t ever purchased bonds (besides I-bonds when they were yielding like 10%) for my portfolio, but I'm now getting sorely tempted by the over 5% 6-month Treasury yields. This is effectively a risk-free 5% return to keep my cash safe while I wait for the market and economy to process the effects of all the rate hikes and the continuous downward revisions to earnings.
That is especially the case with the flexibility that bond sales can give you. Just like with equities there is a very liquid secondary market for bonds (which just like stocks becomes more liquid the more well-covered the underlying borrower is). For T-Bills you can usually unload your bonds relatively easily. The variation in the price of a bond relates to the current coupon of competing bonds and the face value. If the rates are higher now than what they were when you bought your bond, then your contract will probably trade for a discount to principal value and vice-versa.
So, I hope that this has given you a better sense of how bonds work, why they are important and maybe how you can use them in your portfolios! Talk to you soon guys!
Mateo Gjinali
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