B is for Bonds

Welcome back to the Elite Investor Club’s A to Z of investing.

I hope you’ve taken steps to sort out your asset allocation. In this episode we’re going to cover one of the biggest asset classes of all and one of the most misunderstood – bonds!

Don’t be fooled by the official sounding language. A bond is quite simply a loan. It’s usually either a loan to a government or a loan to a company. Companies need money to expand their operations, develop and launch new products or acquire other companies. Governments need money because politicians are incapable of living within their means, spend money they don’t have to meet their promises to their cronies and hope that there are enough suckers in the bond markets to buy their loans at pathetically low rates of interest. So far, sadly, they’ve been proved right.

The global bond market is enormous and is dominated by America, where short term loans of less than a year are called Treasury bills or T bills. Those that mature in one to ten years are T Notes and the really long term ones that can go up to thirty years are called Treasury Bonds. In the UK these government bonds are known as gilts, presumably because the government is guilty about how little interest they pay.

What you’re buying as an investor is a guaranteed future stream of income, called the coupon, and the return of your capital or principle at the end of the term of the bond which can be anything from a few months to several decades. Unlike shares, you don’t own a piece of the company or the government, you just become a source of funds for them. Bonds can trade at more than their face value, a premium, or below it, at a discount.

Like any asset, bonds are worth whatever someone else is prepared to pay for them. They will take into account the interest rate or yield and their view of inflation or deflation in the years ahead in arriving at the price they think those specific bonds are worth in today’s money. This where it can get confusing. If you invested ten thousand pounds in a bond paying one per cent interest for the next ten years, that’s £100 a year for ten years. What if interest rates on the next batch of bonds were to pay two per cent interest? That means I can come along with my ten thousand pounds and buy two hundred pounds a year income. The most I’d be prepared to pay for your bond is five thousand pounds, because I now want a yield of two per cent on my capital.

So, when interest rates go up, bond prices come down. Conversely, when all sorts of institutions like pension funds are told by their regulators to switch from ‘risky’ stocks and shares to ‘safe’ bonds, we see so much money chasing safe bonds that the prices go sky high and the yields become zero or even negative! Even some of the basket case countries of Southern Europe are able to sell their bonds at interest rates that in no way reflect the risk of a potential default.

So we now have this situation where bond prices are at a forty year high based on record low interest rates. We all have to play a guessing game about when the Bank of England in the UK or, more importantly, the Federal Reserve in America, decides to raise interest rates. Because the likely result of an interest rate rise will be a crash in bond prices. Any such crash will be exacerbated by the lack of liquidity in the market, but that’s a concept we’ll look at another time.

In the world of loans to companies, corporate bonds, we’ve seen a similarly disturbing trend. Bond prices have risen significantly even for companies with poor credit ratings whose bonds are given the rather unflattering name, junk bonds. Very small companies have been successfully offering mini bonds, while at the micro company level you could even regard crowd-lending as a form of corporate bond. In all cases you have to balance the interest rate being offered with the likelihood of the company being around and able to repay your capital at the end of the bond period.
If you’re new to investing, the only way you should hold bonds is within broadly diversified funds within the kind of asset allocation we discussed in the previous episode. If you’re an experienced investor, now might be the time to research strategies for shorting some of the major bond markets, either through spread betting or through leveraged ETFs that give you the chance to place a Put option on the bond markets.

The bond market is too big to ignore, but at this moment in history I urge you to approach with care!