What are bonds?

What are bonds and why should I own them

What is a bond?

A bond is a financial instrument that represents a form of fixed interest loan, typically made to a corporate or government entity.

These organisations borrow money by issuing bonds, on which they then pay fixed interest for a defined period of time. By investing in these bonds, you can receive that interest.

The interest paid on a bond is called its coupon. The time that the bond has left to run on that bond is called the duration. At the end of the duration, the principal, or original amount borrowed must be repaid.

What is a bond fund?

Bond funds are a collection of bonds grouped together by some defining characteristics, such as duration, yield, currency or issuing entity. The minimum purchase of an individual bond might be tens of thousands of dollars. By grouping these bond investments together, a bond fund makes it possible for retail investors to buy a collection of bonds for a much lower entry price.

A bond fund will have a dividend that it pays out to you, the owner, which is the sum of all the coupons it receives (minus any costs). It also has an average duration, which is the average length of time the bonds contained in it still have to run. 

Distribution Yield

The distribution yield on a bond fund is the dividend payout divided by the current price of the fund. Distribution yield is a useful way of comparing different bond funds.

A different metric used for comparing bond investments is known as the yield-to-maturity (YTM). Investopedia has a fuller definition of all things bond-related here.

Why should I own bonds?

Bonds are likely to return less than stocks over the long run. So why would you choose to own them? Well, having a portion of your investments in minimal risk bonds will reduce the volatility of your overall portfolio.

You don’t have to own bonds (J.L.Collins actually advocates against it during your wealth-building phase), but they are likely to help you sleep at night. And even by Mr. Collins’ own admission, up to 25% bonds is likely to not affect portfolio performance too much and is definitely going to smooth out your ride.

Compare these three sample portfolios (from Jan 1987 – Dec 2019):

3 sample stock bond portfolios
stocks vs bonds returns in a graph
stocks vs bonds in figures

Clearly the portfolio with 100% stocks has the highest growth over the long term, as you can see from the CAGR (compound annual growth rate) column, but also it had the highest drops from its peaks, or ‘Max Drawdown’. A maximum drop of ‘only’ 25% is easier to stomach than over 50%

Are bonds better than stocks?

Bonds and shares are completely different types of financial instrument. Bonds represent fixed interest loans. Stocks represent ownership of dynamic businesses.

Bonds typically vary in price less than shares, as you know exactly what you’re getting back from a bond. Unlike shares, with bonds, the payout is fixed.

There is always the chance that a bond could be ‘defaulted on’, or not paid out. This might happen if the company goes bust. But as long as whoever issues the bond remains solvent, you will get paid out the coupon for the duration of the bond, then get paid back your original loan amount (the principal) at the end.

In practice, most people rarely see the payout of principal since they buy bond funds rather than individual bonds. Fund managers do the actual buying and selling of bonds in the background. You never have to deal with bonds expiring or buying new ones. Just choose a fund that suits your criteria and let it do the work.

Should I own a global bond fund?

Since we’ve established that the best funds of shares to use for expats are global index trackers, does the same apply to bonds? Should I buy a global bond fund? The short answer is ‘maybe’. The reason for this is a bit less obvious than for shares, for a couple of reasons.

To explain, let’s look at the risks associated with bonds:

What are the risks associated with investing in bonds?

  • 1.     Default risk
  • 2.     Interest rate risk
  • 3.     Currency risk

Default Risk

Default risk is the risk that whoever owes you money, doesn’t pay you back in full. Perhaps not at all.

The higher the quality of the bond, the less likely it is of default. Corporate or municipal bonds have ratings that are a bit like the grades you got on your homework at school. ‘AAA’ and ‘AA’ are officially rated as having a high credit quality and ‘A’ and ‘BBB’ (medium credit quality) are all considered investment grade, though of different quality. Bonds that are rated ‘BB’ or below (‘B’, ‘CCC’ etc.) are commonly referred to as ‘junk bonds’, on which the likelihood of default is significant.

For the purposes of our situation here, I only want to consider ‘AAA’ and ‘AA’ bonds. The very highest in credit quality. I want these to be our ‘safe-haven’ or ‘minimal-risk’ asset with almost no default risk. For simplicity’s sake, I stick to government-issued bonds. Government-issued bonds technically don’t have their own credit rating, but the issuing state itself is given a rating.

You can see what credit rating your home country has on the Wikipedia page here.

Interest Rate Risk

Interest rate risk refers to the way in which the price of a bond varies according to prevailing interest rates. As central banks vary interest rates, consumer banks follow suit. This makes it more, or less attractive to own bonds, whose payout is set at a fixed interest rate.

For example, if a bond was yielding 3% and the interest rate available on a simple cash savings account went up to 5%, no-one would want to own the bond. Even though it would still be paying out a fixed 3%, the price of that bond on the open market would drop significantly.

How duration affects volatility

Bonds also have a ‘duration’. That is a repayment date, on which the ‘principle’ or initial total amount borrowed must be repaid. The length of time until that date is the duration.

Some bonds have an ultra-short duration, of only a month or two, and others up to 100 years duration. As interest rates tend to change quite slowly, the price of bonds accordingly usually varies slowly too. But in times of economic uncertainty, when central bank interest rate decisions come thick and fast, and they may vary interest rates more than normal, the price of bonds can move more rapidly.

The duration of a bond amplifies its price sensitivity to interest rate moves. This is because of the number of unknowns between today, and the repayment date of the bond. Short duration bonds will be much more stable, as it’s very unlikely that interest rates will change significantly in the next few months. Even if they did, the overall difference between holding short duration bonds and cash is small. If the duration is very long, a tiny change in interest rates can cause the price of the bonds to vary hugely, as there are so many more variables to consider during those times.

The two key takeaways are as interest rates go up, the price of a bond goes down, and the longer the duration, the more the price moves. The same works in reverse of course.

Currency Risk

Bonds are issued in a single currency. If investing in a currency other than their own, and investor exposes themselves to currency risk.

Currrency risk is the risk that the value of the purchased currency increases, or decreases against the investors’ own.

If an investor purchases a bond in a currency other than the one that they intend to use in the future, they expose themselves to currency risk. Of course, if the purchased currency increases in value, the investor is better off. But if it decreases then the value of their investments has effectively fallen. That is currency risk.

How do I manage bond risks?

Let’s deal with these risks in reverse order.

How to manage currency risk

Currency risk can be avoided by simply buying bonds that are in your ‘home’ currency. If you deem that your country’s government is creditworthy enough to always pay you back, then just buy your home bonds. If however, you don’t think that, then go ahead and diversify away to another country. Probably to one of the usual globally respected currencies with independent central banks (USD/GBP/CHF etc). But be aware that you are taking on some of this risk. 

On the flip side of the argument, buy buying bonds from a basket of currencies does give you diversification away from the risk of high inflation (which usually leads to higher interest rates, and hence falling bond prices) in your home country. If you consider that to be a risk worth protecting against then go ahead and buy a global government bond fund (A good point to start would be the ETFs IGLA (USD) / IGLH (GBP) / IGLE(EUR)). Otherwise, stick with your home currency.

For the record, I’m British, and I use a GBP government bond fund. I don’t feel the need to diversify away just yet. Perhaps as my investments grow I may add others, but for now, one currency is enough. 

Neither approach is right or wrong, they both have pros and cons. If you have a large enough portfolio of investments, perhaps having splitting your bond investments between your home country and a global fund would be sensible. This balances the risk factors.

How to manage interest rate risk

Interest rate risk is unavoidable, and always a trade-off. If you have short duration bonds you make the risk negligibly small, but you also won’t earn much of a return. If you go for maximum return, with a long duration bond, you expose yourself to maximum risk.

The wisest way to approach this balance is to aim for bonds whose duration matches your investment timeline. As expats we are in a bit of a tricky situation as we are often investing for the long haul – typically looking to fund our retirements, or future purchases that may appear far off, but we also may have significant costs or liabilities in the not-so-distant future. Perhaps moving home in a few years time, and buying a house when you get there.

I am not trying to time the market (that’s for fools), but I can’t help but notice the nature of the era that we are living in. We have unprecedentedly low interest rates. It may continue like this for many years, or, it may revert to its historical mean. In which case bond prices are going to fall significantly before they stabilise again.

In this case, owning long-duration bonds will only amplify any losses. So you need to weigh up the benefit of higher payouts from longer duration bonds, with the associated higher prices and potential for loss of capital if prices fall.

Choosing bonds to manage interest rate risk

The simplest way to approach this is just to go somewhere in the middle. My investment timescale is in the order of 30-50 years, but I don’t want to hold bonds of that duration. The interest rate risk is too high for me to stomach. So I choose somewhere around the 10 year duration for my bonds. This gives me a small return, with only a medium amount of risk. If I was approaching retirement I might reduce this duration further to stabilise prices. 

How to manage default risk

As for default risk, I simply stick with UK government-issued bonds. Also known as gilts. They match my home country’s currency and my future spending. I consider them to be sufficiently creditworthy not to have to diversify abroad and deal with currency risk. By doing this I am potentially facing more interest rate risk, but it’s a risk-reward tradeoff I’m happy to make.

The bond ETFs I use

For your reference, I have used the ETFs VGOV, IGLT and GILS in different portfolios all quite happily. They are all medium duration UK gilt ETFs. IGLS is also a useful short duration GBP bond fund if you want to minimize volatility.

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