Like 007: Successful Bond Selection

Bonds are one of the most essential investments available for those who hope to live off the money generated from their portfolio. The art of good income investment is about putting together a collection of assets such as stocks, bonds, mutual funds, and real estate that generate the highest possible annual income, at the lowest possible risk. The volatility in 2018 is a clear example of why portfolio diversification is a wise move. You really shouldn’t be keeping all your eggs in one basket.

If you're more risk-averse and can't bear the thought of losing money, bonds might be a more suitable investment for you than stocks. Of course, the safest investment you'll come across is none other than cash in the bank, but bonds typically pay better when it comes to interest.

Bonds are a great choice if you're near retirement or if you are already retired. At that point in your life, you may not have the time to ride out the stock market downturns, in which case bonds are a safer place for your money. Most people are advised to shift away from stocks and move into bonds as they get older, and this isn't terrible advice, provided you don't make the mistake of dumping your stocks entirely in retirement.

Benefits of Investing in Bonds

One advantage of putting bonds in your portfolio is that they're a relatively safe investment. Bond values don't tend to fluctuate as much as stock prices, so they're less likely to keep you up worrying at night.

Another benefit of bonds is that they offer a predictable income stream. Because bonds pay a fixed amount of interest twice a year, you can generally rely on that money to come in as expected. Municipal and Treasury bonds offer the additional benefit of paying tax-exempt interest to varying degrees.

Furthermore, some investors prefer municipal bonds because these bonds offer the chance to invest in communities. When you invest in a municipal bond, you might help to improve a local school system, build a hospital, or develop a public garden. There’s a social angle, combined with the potential for a completely tax-free interest income, which is why some investors forgo the higher interest rates of corporate bonds and invest in municipal bonds instead. If these terms are new to you, you can refer to my first power read, Introduction to Bonds, where I explain these various terms.

Drawbacks of Investing in Bonds

Though there are plenty of good reasons to invest in bonds, there are some disadvantages you should keep in mind. Much like other types of investments, bonds are also subject to risks such as call and prepayment risk, credit risk, re-investment risk, exchange rate risk, default risk, inflation risk, sovereign risk, and yield curve risk. The key risks with bonds however, are the interest risk and default risk.

Since bonds are a relatively long-term investment, you'll face what's called interest-rate risk once you buy them. For instance, what happens if you buy a 10-year bond paying 3% interest and a month later, that same issuer offers bonds at 4% interest? Suddenly, your bond drops in value, and if you hold it, you'll lose out on potential earnings by getting stuck with that lower rate.

Furthermore, while bonds are a relatively safe investment, there is a default risk involved. If an issuer defaults on its obligations, you risk losing out on interest payments, getting your principal repaid, or both. A company’s bondholders may lose much or all their money if the company goes bankrupt. There is no guarantee of how much money will remain to repay bondholders.

Another critical point to consider is that bonds aren't all that conducive to long-term investment growth. That's because the return on investment you'll get from bonds is substantially lower than what you'll get with stocks.

Between 1928 and 2010, stocks averaged an 11.3% return, while bonds averaged just 5.28%. Now, imagine you're able to save $300 a month for retirement over a 30-year period. If you load up on bonds and average a 5.28% return during that time, you'll end up with a $251,000 nest egg. However, if you go with stocks instead and score an average annual 11.3% return on investment, you'll grow your retirement account to $759,000. This growth is important because you'll have a hard time keeping up with inflation and maintaining your buying power when you're older.

A final drawback of buying bonds is that, due to the way they trade, there's less transparency in the bond market than in the stock market. As such, brokers can sometimes get away with charging higher prices, and you might have a harder time determining whether the price you're quoted for a given bond is fair.

However again, it’s vital to recognise that there is less risk when investing in bonds as compared to stocks and you’re still making your money work for you by investing in bonds.

Buying bonds can prove a little trickier than buying stocks, where it’s easy for investors to get started with just a little cash. With bonds, it can take quite a bit of cash to begin investing.

Bonds are sold over the counter, which means that they're not an exchange and the prices are not transparent to everyone. It is not like with equities, like the S&P, which could be 5000 euros anywhere in the world at the same time. Bond prices are a little more like when you exchange your money with a money changer. Each shop has a slightly different price because they want to get rid of or keep certain currencies, so they offer a specific rate accordingly.

Bonds work similarly, particularly if you're going for more exotic names, you might need to do some shopping at different avenues to get a better price. The price depends on whether the dealer has too little of the bonds, too many of the bonds or holds a particular view about the direction of these bonds.

To find a good price for bonds, it's best to shop around more. If you're going to buy into a bond fund, take a look at the different bond funds available. They might all be rated the same, be from big institutions, and have similar duration risks but one may have a better price than the other. You’d also want to consider counterparty risk which can be determined by looking at who created the fund, for instance Aberdeen or BlackRock, and the risk would then depend on when they started the bond or how much interest there is in the fund.

Who can you buy bonds from?

Firstly, you could buy bonds from a broker, just as you would buy stocks, though not all brokers offer this service. So, you’ll be buying from other investors looking to sell. Also, you may be able to receive a discount off the bond’s face value by purchasing a bond directly from the underwriting investment bank in an initial bond offering.

Another option would be through an Exchange-Traded Fund (ETF) or Bond Fund. An ETF typically buys bonds from many different companies, and some funds may be focused on short, medium, and long-term bonds, or provide exposure to specific industries or markets. A fund is an excellent option for individual investors because it offers immediate diversification and you don’t have to buy them in thousand-dollar increments.

Finally, you could buy bonds directly from governments. Many developed governments have set up a program in which investors can buy government bonds directly without having to pay a fee to a broker or other middleman.

Personally, I would use age as a rough gauge of whom you should go to. If you're in your 20s, I would suggest that you go for more risky investments with high yields like equities because you’ve got another 60 years to make it back. If you have a terrible year, you're going to have many more good years. Of course, if you are risk averse, then you can stick to safer investments.

There's a standard wall street rule, which is to take 4% of your earnings each year and invest it. Your investment will make you much more money than that initial 4%. You’ll be able to take out that amount equivalent to 4% continually, and it will replenish itself. So, if you want to leave money for your children, and want to have a certain amount of savings, then start the 4% rule. Work out how much 4% is, and how much do you need to live on. If you don't have kids, you can take out a bit more. You can take out a good 5%- 6% and that could last 30 years.

It’s important to note that it’s now an era of lower interest rates and longer lives with the help of medical innovation. These factors contribute to highlighting the importance of actively managing your investments.

Selecting a Suitable Issuer

In your 20s and 30s, you want to go for slightly more aggressive bondholders. I wouldn't be looking at government bonds, or Singapore saving bonds, as those are risk-averse, which means you're not going to lose much money, but you're also not going to make much. In essence, I would concentrate more on the riskier investments, which are corporate credits from bond funds.

If you have a significant investment capital that enables you to buy from individual names, I would recommend that you consider bonds from the emerging markets in Asia. If you can't buy individual names, then look at a Bond Fund or ETF from emerging markets in Asia because it’s the best place to invest in right now.

For instance, let’s compare a US bond by a prominent US energy player like GE versus a Chinese bond by a prominent Chinese energy player like Sinopec. Both of them have the same interest rate risk for five years and are rated BBB. The US company that has been around forever, whom everyone knows, may pay out 4% for five years. The Chinese company which is known everywhere in China (1.4 billion people) but not necessarily all around the world, may pay out 5%. Since people aren't that familiar with this Chinese company, it doesn’t get the same attention and prestige as the American company. This Chinese company gives a 100 basis points or a 1% difference between the two companies, even though the risks are the same. So, it would be financially smarter to invest in emerging markets.

Another reason why emerging markets are better investment choices is because of the way banks work. Since the US market is a bit more developed, US companies can get larger loans from banks, which has resulted in large corporate debts. Whereas for China and other emerging markets in Asia, the banks aren't that open to giving these companies large loans. As a result, they have a lot less debt and even if they do have debt, the duration to pay off that debt is much shorter.

Ultimately what you’ll realise is that with developed markets like the US and Europe, you get paid less, and there's actually more risk involved. With emerging markets, on the other hand, you get paid more and have less risk involved for similar rated countries. This is despite the fact that the duration and the risk ratings of these two companies are the same. It’s important to remember that not all emerging market countries are economically weaker: Singapore is defined as an emerging market, whilst Portugal is defined as a developed market. Of course, be sure to invest in EM premium and Asia premium as they offer one of the highest returns. Look into big companies in India, Indonesia, China and other emerging markets.