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How do bonds work?

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  • How do bonds work?

    I give up. I have to ask even if I look stupid. How do bonds work?

    Bonds are underperforming stocks, but no one talks about buying bonds on discount or buying the dip like they do with stocks during a correction. Is there a benefit to getting into bonds more now that they are underperforming? Does that give you some benefit in the future if the market flips and bonds are outperfoming equities? Say you had $200K you were planning to allot to bonds. Are you better off buying the bonds now or investing that money elsewhere until bonds are performing more favorably and buying the bonds then?

  • #2
    In simplest terms, bonds are a loan from the investor to a company or government entity. In exchange for giving your $ for a period of time the issuer will pay you interest. At the end of the term you get your principal back. You can sell your bond before the term ends, but doing so subjects you to interest rate risk (no brief way to describe all the potential considerations).

    In the context of asset allocation, bonds are not meant to compete with stocks to see which one performs better. Rather, bonds are supposed to dampen the volatility of an overall portfolio, i.e. your highs may be lower but your lows will be higher. In general equities are higher risk than bonds because if a company issues both stock and bonds, bonds have a higher priority for payment. The bond is a promissory note with required payments while the stock is a slice of ownership. Profit comes only after obligations are met, such as paying the bond holders.

    You are planning to allocate $200K to bonds. Why?


    • #3
      I'll add to what GasFIRE correctly wrote.

      As long as you plan to hold a bond to maturity (when the issuer of the bond has repaid the entire amount), your only risk is of default, or not getting paid.

      If you want to sell the bonds before maturity you subject yourself to additional risk of the price of the bond going up or down. The price of a bond has an inverse relationship to interest rates.

      If interest rates go up, the price of a bond goes down.
      If interest rates go down, the price of a bond goes up.

      This is because bonds have a set face value and a stated interest rate. To achieve a higher or lower rate of return for the investor, the bond either sells for a discount or a premium relative to its face value.

      This means for a bond paying a 5% coupon rate with a face value of $100, an investor buying the bond for less than $100 gets not only the 5% interest but also the entire $100 face value at maturity. This difference between the $100 face value and their purchase price is part of the return.

      The sensitivity of a bond's price in relation to a change in interest rates is called its duration, not to be confused with its term, which is the time until it is supposed to be paid back.

      The FMV of a bond could drop while you're holding it but as long as the debtor keeps making payments you'll get repaid the interest plus the face value of the bond.


      • #4
        Good explanations above.

        I would add that a young doc often benefits from NOT buying too many bonds.

        Are you a younger doc?
        Young = income producing = high human capital.

        U are a “bond”.

        You have a guaranteed income for many years.

        The young doc could just put all the $ in a total stock market index fund and focus on:
        1. learning to be a great doc
        2. learning about $ (personal finance & taxes )

        For my first 10-15 years of attending work I had a 100% equity allocation.

        During this time I also paid off 300k of loans (consolidated to 6%) (no such thing as pslf back then).

        then instead of buying bonds earning <3% i decided to put some $ towards a mortgage that was at 4.2%

        Then we bought only a small allocation of bonds: 5%

        Then we changed homes and i paid off another mortgage at 3.375% rather than increasing bonds.

        Finally changed to 80:20 stocks:bonds then 70:30.

        70:30 has become 75:25 (bull market)

        Now building cash for a cash bucket to avoid sequence of returns risk (SORR) after early retirement in a few years (hopefully).

        Going forward I am thinking i will avoid buying longer term bonds and instead invest in:

        1. cash (bucket 1) ( SORR antidote)
        2. stock index funds
        3. Ultra short term bond fund + cash in IRA for rebalancing (dry powder for market drops)

        Currently 75:23:2 (stocks bonds cash)

        Overall retirement portfolio will likely be:

        75:18:7 [stocks: bonds : cash (ultrashort term bonds)]

        Thinking stocks will always dominate my portfolio.

        Inflation, low interest rates, high risk tolerance, large net worth + frugal lifestyle = high stocks for me.

        A young doc does not necessarily need a bond allocation.

        VTSAX and relax.

        Market drop = celebration for the young investors.

        JL Collins book "A Simple Path to wealth" is a great read and it explains why the young should own a 100% stock allocation better than I.

        I love Jack Bogle but his: "Age in Bonds" thinking is / was poor advice for a young doc in my opinion.

        I would ask not only: "What is a bond?"

        but also "Why should I buy it?"
        Last edited by Tangler; 12-14-2021, 02:46 PM.


        • #5
          The above explanation is really good.

          For me , why is the most important part.

          1. Stocks wont always out preform bonds, you just dont know when that is going to occur
          2. having a reliable income stream , I don't have a pension. It is not as important now, but maybe latter in life
          3. having money available to buy on dips or crashes - what I did 20 years ago , was 100% stocks and dollar cost average , every month buy more funds, regards of predictions, now it is more painful to watch the big fluctuations, when I know I could get a good deal
          4. having some sort of cash equivalent, short term bond fund to park some money
          5 understanding risk, I used to think , why would anyone buy a bond that paid 2% , when I could buy one that paid 5%, for me that was a knowbrainer, I would just pick the one that paid more. Until you realize, that the ones that pay more (junk) fall just as hard during bad times.
          6. realizing that this market is different, markets are always different but they usually revert back to fundamentals when the dust settles/


          • #6
            A different angle is considering the risk of an investment:
            • return of capital
            • Total returns: price appreciation +income
            Equity does not have a contract amount, bonds do. For the lower risk on bonds due to the contract, you give up some returns. Different risks.


            • #7
              Bond yield sucks now. Bond price is high. So you really are not buying at a discount similar to a market drop.


              • #8
                Originally posted by Lordosis View Post
                Bond yield sucks now. Bond price is high. So you really are not buying at a discount similar to a market drop.

                OP people don’t buy bonds on a “dip” as you asked in your post.

                People buy bonds for:
                1. diversification
                2. yield
                3. safety

                Not necessarily in that order.

                I am no bond expert but they don’t seem particularly attractive right now. Especially with the fed considering rate increases.


                • #9
                  Also, government bonds have historically done well during crises, so even though interest rates are low (when interest rates go up, bonds that are not held to duration will suffer, and bonds that are held to duration, you're still only getting the agreed upon interest rate, when the alternatives will be better), there is a consideration to having some bond allocation.


                  • #10
                    Originally posted by Tangler View Post

                    OP people don’t buy bonds on a “dip” as you asked in your post.

                    People buy bonds for:
                    1. diversification
                    2. yield
                    3. safety

                    Not necessarily in that order.

                    I am no bond expert but they don’t seem particularly attractive right now. Especially with the fed considering rate increases.
                    these days you aren't buying for the negative real yields! I <3 long treasuries for deflationary crash insurance. I buy intermediate TIPS for safety


                    • #11
                      Wouldn't touch long treasuries with a 10-foot pole. Especially now.


                      • #12
                        Originally posted by bovie View Post
                        Wouldn't touch long treasuries with a 10-foot pole. Especially now.
                        I've heard that for years...


                        • #13
                          Great explanations.
                          Currently bond yields are low and bond prices are high. That seems to reason when bonds outperform stocks that is when bond yields are high and bond prices are low. Are you any better off buying them now and waiting until the yields improve, or just waiting until yields improve and buying them then? Or are you basically just buying them all the time at whatever your set allocation is in hopes that a big downturn doesn't hit you too hard, and being presently surprised if yields improve?


                          • #14
                            Market timing is hard enough without also trying to predict inflation, interest rates and bond prices. Unless you have a clear crystal ball (mine is usually cloudy) guessing when to buy bonds is simply that, a guess. If you consistently invest over the course of your career, the timing of this purchase will not significantly affect the end result.


                            • #15
                              For the record I’m not looking to buy a big chunk of bonds. I’m actually trying to get rid of the ones I do have. I’m still young, high earning, and in a fairly stable spot in my career.

                              My question is more of: I plan to shift my current allocation to 80/20 equities/real estate with zero bonds until I’m closer to retirement. I’m holding like $250k in bonds in retirement accounts from my previous allocation plan. Is it better to liquidate those to meet my new allocation plan or just leave them where they are and put all new money in my new equities/real estate allocation?