The Danger of Bonds


Bonds are often seen as a safe investment.  In fact, individuals are often advised to put money into bonds for safety.  But there is a danger to investing in bonds, particularly if you spend the interest generated.  Read on to find out what the issues are and how to avoid them.

Before we get started, let me highly recommend that you pick up a copy of The Bogleheads’ Guide to Investing.  This is a great book for those wanting to learn to invest in mutual funds, including both bond and stock funds.  In particular, it explains why index funds are best, how to diversify your investments, and other information you need to know to do well with stock and bond investing.  (Note, if you buy a copy through the links in this article, it will cost you nothing extra, but The Small Investor will receive a small commission for the sale.  You get great financial advice while helping keep The Small Investor going.  What a great deal!)

What exactly is a bond, anyway?

Let’s say that you are running a company and you want to build a new store.  You could issue more stock, where you would be selling new shares in the company.  For example, you could issue another 100 shares for $1000 each, raising $100,000 that could be used to build the new store.   If there are 100 shares now and you sold an additional 100 shares, that would mean that each existing share of the company would control half as much of the company (0.5%), where before the new shares were issued, each share controlled 1% of the company.  This means you’d receive a smaller share of the profits and have less say in how the company was run than you had before the sale.  This is called dilution, like adding more water to a glass dyed blue with food coloring.  The more water you add, the lighter the blue color becomes.

Instead of selling more shares and diluting the value of each of the existing shares, the company instead could get a loan for the money needed to build the new store, just like a consumer might do for a house.   In this way, once the loan was repaid, the shareholders would both have the new store and the same amount of ownership in the company.  Rather than paying off the loan in payments, where the loan value decreases with time like you would with a house, however, the company just makes interest payments for a specified period of time, then pays off the whole loan at once.  Also, rather than getting all of the loan money from one entity, the company breaks the loan into a lot of little pieces, typically $1000 increments, and sells them off in the credit markets to a lot of different buyers.  This loan for the company is called a bond offering and each little piece of the loan is called a bond.  You can buy as many of these pieces of the loan as you would like, paying $1,000 per piece.

When a company issues a bond, meaning when they sell off the pieces of the loan, they specify how much interest will be paid each year as a dollar amount.  For example, Amazon might issue a bond that pays $50 per year.  Since each piece of the loan (bond) cost $1,000, this means that Amazon would be paying $50 per year per bond, or a simple interest rate of 5%.  If you bought ten of these bonds, costing you $10,000, you would get back $500 per year.

After a period of time, usually a period of twenty to thirty years, Amazon would give you one more interest payment, plus a check for $1000 per bond to pay you back, then stop paying interest payments.  The day that this happens is called the maturity date and is specified when the bond is issued.  In fact, it is part of the name of the bond.  For example, if our Amazon bond that pays 5% per year were set to mature in 2040, it would be called an Amazon 5’s of 2040, where the interest rate is listed first and then the maturity date.  Simple, right?  So what are the risks?

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Interest rate risk

The first risk with bonds is what is known as interest rate risk.  Remember that the bond originally sells for $1000 and pays some fixed amount of money, say $50 per year?  Once the bond is issued, the first person who bought it is able to sell it to someone else, but the price they receive is whatever the other person is willing to pay.  This means that they may sell it for $1100, but they also might sell it for only $900.

While the price of the bond may vary, the amount that it pays in interest each year stays the same.  Our Amazon 5’s of 2040 would keep paying $50 per year right up until 2040 when the bond matures.  At that point, Amazon would give whoever owns the bond at that point $1000 regardless of how much they paid for it.  If you were to buy the bond at $500, you would be receiving an effective interest rate of 10% per year since you’d be getting $50 per year, and $50/$500 = 10%.  If you held it until it matured and Amazon gave you $1000 for it, you’d also make a profit on the change in the price of the bond ($1000 from Amazon versus the $500 that you paid for it).  This is called a capital gain.  If you were the one who bought the bond in the first place for $1000 and ended up selling it for only $500, you’d take a loss of $500, offset somewhat by whatever interest payments you collected.  If you held the bond for less than 10 years, you’d lose money on the deal since you would not get as much in interest as you lost in the price of the bond.

There are two basic things that make a bond go up or down in value.  The first is the perceived risk of owning the bond.  The more likely people think that it is that the company will default on the loan, the less they are willing to pay you for the bond.  This makes sense if you think about it.  If you were fairly certain that a company would keep paying you for the next twenty years, you might be happy with 5% in interest per year.  If you thought that there was a 50-50 chance that they would go bankrupt within ten years, you might not buy the bond unless you could get at least 15% interest.  That way, you’d only need to hold the bond for about seven years for the interest you receive to repay you for the bond, leaving any extra time that the company continued to stay in business and pay you interest after that point as a bonus.  You’d also probably make money if the company made it to maturity and repaid the loan.  This means that it can be very profitable to buy bonds in companies that see their credit scores cut after they issue the bonds, but of course, this is also riskier than buying bonds in companies with good credit scores.

The second factor is interest rates of other investments.  If interest rates went up such that you could put your money in a bank CD and make 5% per year, why would you buy a bond paying 5% where you could lose money?  You would wait for the price to drop so that you could make 10% or more so that you could get some extra reward for the risk you were taking.  This means that if interest rates go up, the price of your bond would go down.  Always remember this:

The price of bonds goes down when interest rates go up.  The price of bonds goes up when interest rates go down.

Note that both of these types of risk are easy to manage.  All you need to do is hold the bond until it matures and you’ll receive $1000 per bond regardless of what the bond price does over its lifetime.  If you buy bonds during times where interest rates are low, you could even make a little extra money from capital gains.

Inflation Risk

The other risk with bonds is inflation risk.  First of all, the price of bonds will go down if inflation picks up.  This is because people will require that they get a higher interest rate to make up for inflation before they buy a bond.  If inflation is 3% per year, a bond may be paying 5%.  If inflation rises to 7% per year, the bond price would drop until the new investor was receiving at least 10% per year.  This means that the bond price would need to fall by 50%.  There is not a lot you can do about this risk other than not buy bonds if you think that inflation is going to rise soon and to hold bonds to maturity if inflation does rise.

A bigger risk with inflation is for people living off of bond interest for a long period of time.  If you spend all of the interest that your bond portfolio puts out, you’ll see your spending power decline over time.  You see, the actual dollar amount that your bond portfolio will generate each year will stay about the same if you just keep holding to maturity and then reinvesting the principle in new bonds.  If you start with a $1,000,000 portfolio that generates $50,000 per year, in 20 years it will still be generating $50,000 per year.  When you start, $50,000 may be enough to comfortably cover all of your needs.  At 3% inflation, however, that $50,000 will only be able to buy about 60% of what it can today in twenty years, so it would be like taking a $20,000 per year pay cut.  This is particularly important for those hoping to retire very young, say at 40 years-old.  Over a fifty-year retirement, you could see your buying power cut from $50,000 down to $10,000 or lower.

The way to prevent this from happening is to not spend all of the money your bond portfolio is generating, instead using some of the money to buy more bonds.  For example, if your portfolio is generating $60,000 per year and you reinvested $10,000, you could build up another $200,000 in bonds in 20 years.  That could generate another $10,000 per year.

An even better idea is to also hold some of your money in common stocks.  This is because the price of your stock portfolio will increase with inflation.  In addition, as the companies in your stock portfolio grow, they’ll be worth more money even without inflation factored in, so it is like a double win for you.  This is why it is wise to keep a portion of your money in stocks instead of putting it all away into bonds.  This means that even if you have enough money to generate the income you need to pay for your lifestyle today from an income portfolio, you’ll need to save up even more to protect yourself from inflation before you can think of retiring and living off of the interest in your accounts.

(This is part of a series of articles to teach those who are new to investing how to invest.  To find other articles in this series, choose “Beginner Investing Class” under “Investing” in the menu at the top of the page.  If you have questions or you’d like a topic to be covered, please leave a comment.)

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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