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.
Passive income is the key to early retirement. This year, Joe is investing in commercial real estate with CrowdStreet. They have many projects across the USA so check them out!
Joe also highly recommends Personal Capital for DIY investors. They have many useful tools that will help you reach financial independence.
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I definitely think bonds get a bad wrap, while they are not as lucrative as they once were with current interest rates, I like to think of them as the boxing head gear in a fight, the stock market could be throwing punches at you but bonds are there to at least soften the blow, it might still hurt but certainly not as painful in a market downfall.
This was great, thank you. I’d like to know more about the relationship between the interest rate and bond values.
Or you can do what I just did, invested in my own mortgage bond fund, I paid off a mortgage at 5.5%.
Of course selling the ‘bond fund’ requires a re-finance or selling the property, but it is 5.5% return which is not too bad. it saves quite a bit of money every month, $1,145.
Thanks for the article.
A lot of people tend to think that bonds are only for “older” folks. It really depends on one’s risk tolerance. If an older person has a butt load of money and have a great tolerance for risk, they too can stay in stocks. If a person is just starting out in investing, and thinks that current market prices are over valued, they may want to put more of their money in bonds vice stock. Risk tolerance is key.
I had no idea the bond market was twice the size of the stock market. I thought it would have been the opposite. You learn something new every day.
Thanks for your comment on my Financial Samurai guest post, Joe!
Now, you need a follow-up article to explain that holding bonds is completely different from holding a bond fund. A relative thought she was investing conservatively, using a bond fund. Actually, she was benefitting from a falling interest rate environment. The fund’s “book of IOUs” paid a higher rate of interest than newly-issued debt, the price per share of the fund went up until the yield of the shares matched that of new debt. So, she saw value of shares flying up.
Going forward, if new debt is worth more than a fund’s book of IOUs, the share price will go down, so that yield per share will rise to other funds. With interest rates so low, it’s a lot more likely that future debt will be issue at higher rates, than at lower rates.
Great post – thanks for this resource.
Very helpful article. Thanks. Since I’m still in my early 30s I am heavily invested in stocks. I’ll probably look into bond in about 15 years or so.
When I retired the first time in late 2009 at age 51 my portfolio design included a high percentage of corp bond funds to generate income. As interest rates have declined since then that income has dropped but my bond fund values have climbed. The thing about bond values is they move the opposite direction of the interest rate paid. I have moved some of my bond allocation to stock holdings by buying on the dips but I still hold multiple corporate bond funds for the income. I recognize the risk of bond value decline once interest rates rise but they would ultimately generate higher income as bonds are replaced within the fund.
Thanks for sharing. I’ll probably move some of my bond allocation to stock during the next down market as well. So would the increase in income offset the decline in value? I need to study this in detail.
Thanks. This is great! It’s very helpful!
As a 28 year old, I am heavily invested in stocks, not much in bonds. But as I age, I definitely intend to learn more about the bond market and how it can serve me in reducing my risk nearer to my retirement years.