Share and bonds are big components of a traditional portfolio, but what are bonds and will they go into my campaign plan?
What are bonds?
Where shares are issued by a company as a part of the company, bonds are issued by a company as a debt to be paid by the company – or a government!
Technically, the UK government issues gilts, which are basically the same thing as a bond issued by a company (a corporate bond). Other countries also issue bonds but they generally call them “treasury bonds” or “government bonds”. They all work the same, but the risk is a little different.
How a bond works
The first step in answering our question “What’s a bond?” is to know how they work.
The bond issuer has to be pretty big and stable to be able to issue bonds that can be bought on the public stock exchanges. Governments and banks are pretty good candidates, but there are other big companies that can issue bonds.
Bonds have a “par” value and a “coupon”. The best way to think about it is:
par = cost of the bond
coupon = the interest rate to be paid on the par value
Usually the par will be something like “£100”. This is the price that the bond was issued at – not necessarily what you bought it for!
The “coupon” bit is a fixed amount. So, if the bond was a 5% bond, the coupon would be £5 – because £5 is 5% of the par value.
Back in the days before computers, bonds had a literal coupon that was removed from a certificate and taken to the company’s agent to go and swap for hard cash. Nowadays, the certificates are sensibly stored in a secure central location and the buyer only gets a digital record of ownership.
Bonds last for a set number of years, which is given by a maturity date. At the end of the period, the par value is paid back to the owner. Typically, longer term bonds have higher coupons. There is some talk of bonds that never get repaid, called perpetual bonds, although these are less common.
How can I buy bonds?
You’d think that you could just go any buy a bond. However, unless you have £100,000 in your pocket, you can’t buy a bond brand new. That’s for wholesale investors only.
As an individual, you can buy bonds indirectly, through buying into a fund (such as an ETF) that does buy £100,000+ of bonds. I’ll talk about funds and what they mean in another post, but the key thing to note is that you’re not paying par value for the bond: the price of the fund that buys the bond means that you’re going to pay whatever the market price for that fund is.
The coupon doesn’t change, though. That means that you’re getting a lower interest rate (called the effective yield or yield to maturity) based on the price you pay.
An example
You buy an exchange-traded fund that owns a selection of different bonds. For ease, they all have a par value of £100 and a coupon of £5.
You buy into the fund at a time when the average price divided amongst the bonds comes to £102.
Your yield is £5/£102 x 100% = 4.9%, even though the original yield was 5%.
Who decides the coupon value?
The issuer… and the market.
If interest rates are low, the company or government will probably issue bonds at a low coupon. Duh! Bonds are a debt owed by the company or government. Why would they want to pay a higher rate of interest if they don’t have to? They know that they can issue one that’s only slightly above cash savings interest and investors will still jump on them.
There’s also a link between government bonds, inflation and national debt, but that gets pretty technical. I wrote about how money is made in a separate post. The easiest way of saying it is that when the government needs to “borrow” money, it’s actually issuing more government bonds, so it’s a good idea for the interest rates to stay low to keep pressure down on the public purse. There’s a lot more to it, but I think this is good enough for this post!
Which leads us on nicely to the next part of the question…
Bonds! Huh! What are they good for?
Corporate bonds are great in that they have to be paid of before shareholders get their money back. This means that if the company is going bust, bond holders get paid back before shareholders.
There’s also the fact that governments issue a lot of bonds. Generally, governments can print money and are really good at paying their debts, although some countries have been known to restructure their debts and dishonour their government bonds, or been at risk of doing so. Think the Greek debt crisis in the Eurozone and you’ll be on the right track.
Traditionally, bond prices run counterpoint to share sentiment. It’s what makes them a traditional tool for diversification. This is because bonds see less growth than shares most of the time, but they’re safer. Simply, people used to run away from shares when rumours of the market crashing hit, and hide their money in bonds. This made demand go up for bonds, so people would pay more for them. Yields would obviously drop, but it allowed brave bond holders to sell their bonds for a capital gain.
They also rarely drop below par value. If they did, people would buy a thing that’s safer than shares for a higher yield. They just wouldn’t be on sale for that long.
It often pays to be brave…
That said, most pensions are invested in stocks and bonds. If you’re a pensioner, drawing down your (hopefully) fat stack, getting your money back is more important than watching it grow. You’ll be happy with a big helping of bonds in your pension that give a small amount of growth if you’re confident that a sudden dotcom boom, Lehman Brothers or COVID-19 drop won’t halve the value of your life savings.
Sounds good, but what’s the catch?
The catch is that low risk means low reward.
In the case of UK government bonds, for example, let’s look at a fairly typical UK Gilts fund. This one’s from Vanguard and can be bought on most share dealing platforms.
On the table, you will see an “Average coupon”, which at the time of writing is 2.5%. Better than cash, but not bad eh?
However, above this you’ll see a row for “Effective YTM” (this means Effective Yield To Maturity, i.e. the yield you’ll get if you buy into the fund today… except that the fund will charge a fee and your share dealing platform will charge a fee, too). At the time of writing, it’s 0.5%.
I mean, it’s still better than cash savings, but it’s not great.
Take away the 0.07% fee from Vanguard (the fund manager) and that’s 0.43%.
To make matters worse, inflation (the rate at which your money gets worse) is targeted to be 2% by the Bank of England’s Monetary Policy Committee. I’ll cover inflation separately, but think of it as starting at -2% for every interest rate you see.
So, UK government bonds will grow your money at -1.57%. Yes, that’s right, you’re actually getting poorer if you buy UK government bonds right now, just not poorer as quickly as someone who puts their savings in the bank and prays that interest rates go up.
Yeah, but that’s just the UK Government. Aren’t there any better returns from corporate bonds?
The picture for a US corporate bond fund is a little better, with an effective yield of 1.8%… but it’s still negative in real terms.
Now for pensions, that might not matter. You buy into a fund instead of a single bond, so when one bond hits its maturity date the money from the fund pot will get used to buy into a new bond. Over time, yields are hopefully going to increase, given that new bond yields are at all-time lows in the US (and therefore by most of the world).
What are bonds going to do in a FIRE portfolio?
Are bonds going into my FIRE campaign plan?
Absolutely not! Not while yields are so low.
I do have some corporate bonds in my pension, because I can’t access that for over 20 years anyway. However, if I want to be FI within 10 years, bonds can’t be a big feature. I don’t see any situation where bond yields leap up around the world in the next 5-10 years… well, none where FIRE is going to still be an option.
As bond prices traditionally move in the opposite direction to share prices, there’s a good argument that it might be worth having bonds for diversification: i.e. not putting all your eggs in the same basket. However, there are other assets that are priced semi-independently to shares, that have become a lot more accessible to retail investors (like me!) in the last decade. But that’s another story…
