Today, we have an article from Roy, one of our regular readers, who is an expert in fixed income (bonds.) This is great because I really don’t know much about bonds. I know I’m lending money out and I’ll get some interest. I know I need to allocate 20% of my investment asset in bonds according to my risk tolerance. I read that’s it’s a good idea to avoid long-term bonds for now because the interest rate is bound to go up at some point and drive the bond funds price down. So currently, I have 20% of my investment portfolio in Vanguard’s Short Term Corporate Bond ETF, GNMA fund, and the Total Bond Market Index Fund. (VCSH, VFIJX, and VBTLX.) I spread it out a bit to diversify, but I don’t even know if that’s the right move. Anyway, here are some bond basics and it helped me understand my funds a bit better. I hope it’s useful for you too.
Stocks (Equities) vs Bonds (Fixed Income Securities)
What does it mean to own bond mutual funds in your retirement account?
For the sake of simplicity, we’ll only talk about corporate bonds and not government treasury, agency, municipal, or mortgage-backed bonds in this article.
Most of us that work in the private sector have company sponsored 401(k) plans instead of pension plans – meaning that from every paycheck, a certain percentage of our pay goes towards our retirement account to fund our living expenses when we retire. Those of us with retirement accounts are invested in the equity market (stock market) in one form or another, whether it’s individual stocks, mutual funds, or index funds. Moreover, there’s a good chance a percentage of our account is invested in fixed income securities (bonds), especially as we get older and our risk tolerance declines. Coupled with the fact that the bond market is almost twice the size of the stock market ($93 trillion vs $54 trillion, respectively in 2010), understanding the fixed income securities in our portfolio is integral in securing our financial futures.
Individual Stocks vs. Individual Bonds
Without getting too technical, we’ll go over an example with Apple (AAPL) in order to understand the differences between owning AAPL’s stock and AAPL’s bonds. Let’s pretend Alex wants to start investing and has $10,000. As of this writing, Apple stock is trading at roughly $99.00/share; Alex could buy 101 shares of AAPL for a cost of $9,999.00, become a tiny owner of AAPL, hope that AAPL sells boatloads of new iPhones and iPads, and profit from AAPL’s future success. Alex would be participating in the stock market.
On the flipside, Alex could participate in the bond market and lend his money to AAPL instead of becoming an owner. Think of buying bonds as buying a really big I.O.U from a company. In exchange for that I.O.U, you become a lender and get interest payments from the company on a semi-annual basis (and eventually, your principal). It’s important to remember that when you own a stock, the stock will never expire or mature; it represents an indefinite ownership as long as AAPL does not go bankrupt. However, bonds are different. Bonds have three key differentiating features – a face value, a coupon, and a maturity date:
- Face value – for most bonds, it’s denominated in $1000. Face value is the amount AAPL borrowed originally. It never changes. 1 bond = $1000; 10 bonds = $10000, 100 bonds = $100000, etc
- Coupon – interest rate at which AAPL will pay its bondholders
- Maturity date – date in the future when AAPL promises to pay back the face value
Alex could buy 10 Apple 2.4% 5/3/2023 bonds for a total cost of $9,554.67 as shown in Figure 1-1. After paying that $9,554.67, Alex will begin to receive $120 every six months ($10,000 x 2.4% = $240; $240/2 = $120 semi-annually) for the next 9 years, approximately; and then on May 3, 2023, receive the face value $10,000 (even though he paid a discount for the bonds: $9,554.67).
Figure 1-1, from Charles Schwab. (Click through to see full size)
Figure 1-1 is not a recommendation to buy or sell and is only for illustrative purposes.
In owning Apple’s stock versus bonds, Alex is subject to different types of risks.
Bond Mutual Funds
I’ll make a broad assumption that most of us have 401(k)’s with our employers and as such, we are not allowed to invest in individual bonds, but rather, have the option to buy into bond mutual funds. Similar to stock mutual funds where the mutual fund is a collection of stocks of different companies, bond mutual funds holds the same concept. Instead of owning 10 bonds of AAPL 2.4% 5/3/2023 and collecting semi-annual interest payments, the bond mutual fund is a collection of different bonds from different companies. Think of a bond mutual fund as a large book of I.O.Us from many companies; you become a lender to many companies in one investment.
Like having hundreds of different stock mutual funds, there are hundreds of bond mutual funds. I’ll give a brief overview on a sample fund, T. Rowe Price Corporate Income (PRPIX) in Figure 1-2. All this information is freely available to anyone with internet access on Morningstar.
Straight from the prospectus: “The fund will normally invest at least 80% of its net assets in corporate debt securities…At least 85% of the fund’s net assets must have received an investment-grade rating from at least one major credit rating agency…”
Figure 1-2, from Charles Schwab on T. Rowe Price Corporate Income (PRPIX). (Click through to see full size)
Figure 1-2 is not a recommendation to buy or sell and is only for illustrative purposes.
I hope that reading this short explanation on fixed income securities and the mutual funds that hold them, you’ll want to open up your 401(k) and review your holdings. Understanding what mutual funds you own is instrumental in successfully planning for retirement, no matter what age.