How do bonds work?

There have been a lot of various 'rule of thumb' investment strategies over the years to help figure out what your asset allocation should be, based primarily on your age. The underlying belief is that bonds are less risky investments and investors should increase their allocation to bonds as they get older. While this is an accurate generality, we don’t think people really understand what bonds are.

Bonds? Fixed income? Debt? Bonds are longer-term debt that corporations issue to fund long-term projects or purchases (generally, there are always exceptions). They can be thought of as an individual’s 30 year fixed mortgage, but in this case the individual is actually a company and the money is used to fund an expansion. We say longer-term because the normal day-to-day operations funding is provided by lines of credit (think of a credit card), but longer-term is anywhere from 5-30 years.

So, for instance, when an individual investor buys a McDonald’s bond, they are basically loaning McDonald’s money that they will be repaid at a certain date in the future, along with semiannual fixed interest payments (usually). In 2006, before the distortions of the ‘global financial crisis’ upended markets normal functioning, McD’s was able to issue a 10 year bond at 5%. That means that an investor who buys $1,000 of this bond is effectively giving McD’s $1,000 to invest in their business, and in return, McD's promises to pay the investor 5% per year ($50 per year) while also promising to give back the full $1,000 when the bond comes due in 10 years. If the investor didn’t look at their investment statements over the course of the 10 years, they would earn approximately a 5% return (why not exactly 5%? That depends on what interest rate the investor can earn on the $50/ year payments they receive… but I digress). If, however, the investor looked at their statements now, it would show a large gain in their bond holding – basically they bought this bond for $1,000 and it is now worth approximately $1,100 because the interest rate paid on the bond is higher than is currently available in the market. In essence, the bond interest rate stays the same while the market interest rate fluctuates over time. If market rates decrease, then the rate you are receiving in the McD’s bond is higher than the market interest rate and other investors will pay you a higher price for your bond.

What is a bond ETF?

Like all exchange traded funds, a bond ETF is an investment vehicle that owns a selection of bonds usually managed to a specific index. By owning a selection of bonds, the ETF is able to spread out a lot of the risk of investing in single bonds (risks, including default and interest rate), so anyone who buys a share of an ETF has a partial ownership in all the bonds that the ETF owns.

The interesting difference (to us at least), is that unlike an individual bond that will mature in a certain number of years – meaning that as long as you do not need to sell at any point in time, you will know your approximate return from the time you purchase the bond until it comes due – a bond ETF never matures. If you buy a bond that matures in 5 years, when 2 years pass, your bond will mature in 3 years. This basic functioning of bonds means that over time, the interest rate risk decreases and any premium or discount based on market interest rates diminishes.

ETF – What is it?

Exchange Traded Fund (ETF), go on...

In its simplest form, an exchange traded fund, or ETF, is a basket of stocks that has been created to mimic an index1 . When people say “the stock market was up 1% today,” they are saying that a certain stock market index was up 1%, and the ETF that tracks this index should be up about 1% as well. These passive ETFs are managed by companies like Vanguard who charge a small fee for keeping the ETF as close to the index as possible. Because of their size (Vanguard manages ~$2.4 trillion… that is trillion with a “T”… which gives them the cash to purchase WhatsApp 125 times), they are able to buy & sell the underlying securities much more efficiently than most investors.

Examples always help. Let’s say you own Vanguard’s Total Stock Market Index ETF (ticker symbol: VTI) – if you buy 1 share of the ETF, you have an indirect ownership stake in approximately 4,000 stocks. Even for large investment firms, it can be cheaper and easier to get exposure to these 4,000 stocks by buying the ETF than it would be for them to purchase all the stocks individually. Vanguard charges 0.05% to manage the index fund, which for a $25,000 investment results in an annual charge of $12.50 (or just over $1 per month).

But an ETF doesn’t necessarily have to hold stocks (and doesn’t necessarily have to be passive), there are now ETFs for just about everything, including: bonds, commodities, master limited partnerships or real estate investment trusts. The big takeaway is that an ETF is usually a cheap way to invest in a broad range of securities – potentially saving you tons of time, effort and money.

Other benefits of ETFs include:

  • Tradability: ETFs are traded like a stock, so you are able to buy or sell any time the markets are open
  • Transparency: ETFs publish their holdings daily so you always know what you own
  • Tax efficiency: because ETFs have very little active trading, you only have a tax bill when you ultimately sell your shares (and when you receive dividends), which can be different than some mutual funds
  • Costs: because of the passive nature of the investment, costs are extremely low

Drawbacks:

  • Because the investor is deciding when to buy and sell, investment performance is often negatively impacted when emotions run high
1 An index is a basket of similar securities. Indices can be quite broad (total US stock market, international corporate bonds) or quite narrow (Nashville area ETF, junior master limited partnerships) or anywhere in between. Professional investors usually create indices so that they can more accurately see how they performed compared to their investment strategy. As an example, if you are a mutual fund manager whose investment strategy is to invest in Nashville-centric companies, seeing how your performance compares to the overall market doesn’t make much sense – how do potential investors know if your performance was related to the small industry you invested in, or to your actual investments? By comparing your portfolio’s performance against just the Nashville index, we are able to strip out external forces and focus just on your ability to outperform against a passively managed investment in your small industry.

ETF vs Mutual Fund

Now that we now what an exchange traded fund is, let’s compare it to a mutual fund. First some quick background on mutual funds, which are investment funds that pool money from individuals and institutions to invest on their behalf. Mutual funds are often active investors, meaning that they try to outperform the stock market (or their specific benchmark). In their pursuit of higher returns, mutual funds usually employ teams of analysts to help uncover investment opportunities. There are so many professional investors in a similar pursuit, however, that finding profitable investment opportunities is quite difficult and consistent outperformance is very rare.

Onto the comparison:

  • Where mutual funds are usually active investors (buying and selling securities based on their outlook and analysis), ETFs are usually passive investment vehicles (they seek to track an index1)
  • ETFs are generally more tax efficient than mutual funds because they have very little active trading. A mutual fund buys and sells stock more frequently, which can create a higher tax bill even if you don’t sell your fund shares (if the mutual fund realizes a gain on a stock it sells, you are liable for the tax bill even if you didn’t take part in the gain). Because of the way ETFs are structured (basically like normal stocks), you only have a potential tax bill when you sell the ETF (or when you receive dividends)
  • ETFs can be traded anytime the stock market is open (9:30am to 4pm most weekdays) whereas mutual funds can only be bought and sold at the end of the trading day once their value is calculated
  • ETFs are generally less expensive to hold as they only track an index and do not have to employ teams of analysts (average ETF expense ratio 0.44% per year, according to the WSJ, compared to the typical mutual fee of 1.50% per year)
  • There are have been numerous studies that have shown the majority of active mutual funds underperform the market and those mutual funds that do outperform in one period are not likely outperform in the following period.

It is pretty clear where we come out: for most investors we believe ETFs are better than mutual funds. From a behavioral perspective, however, there are two interesting issues that we have overlooked thus far:

  • People invest in mutual funds because of the psychic benefit of knowing there is someone managing their money, and if the fund doesn’t perform well they are able to place blame on the fund manager as opposed to themselves.
  • Both investment vehicles are vulnerable to performance chasing that ends up hurting the individual investor. Studies have shown that casual investors are often too active and buy into a mutual fund or ETF after a run-up in value (and then sell after a period of underperformance, effectively buying high and selling low).
  • Rational solves both of these issues by managing your portfolio for you, which means you don’t have to do everything yourself. Secondly, our algorithms help take some of the human biases out of the management process. And lastly, our low cost means you are able to take advantage of one of the keys to long-term investing success – keeping costs low!
1 An index is a basket of similar securities. Indices can be quite broad (total US stock market, international corporate bonds) or quite narrow (Nashville area ETF, junior master limited partnerships) or anywhere in between. Professional investors usually create indices so that they can more accurately see how they performed compared to their investment strategy. As an example, if you are a mutual fund manager whose investment strategy is to invest in Nashville-centric companies, seeing how your performance compares to the overall market doesn’t make much sense – how do potential investors know if your performance was related to the small industry you invested in, or to your actual investments? By comparing your portfolio’s performance against just the Nashville index, we are able to strip out external forces and focus just on your ability to outperform against a passively managed investment in your small industry.

Inflation

Inflation has one of the biggest financial impacts on our lives and it is one of the least understood concepts in finance. Inflation is the underpinning of why something like a Hershey’s bar increases in price over the years (as my grandfather used to say, “back in my day a candy bar cost a nickel”). While we often shrug off those type of comments, they are actually completely accurate. Controlling for the changing size of a candy bar (since companies have recently kept the price the same but decreased the size… tricky tricky), on a cost per ounce basis a Hershey’s bar has increased from $0.05 to $1.00 over 50 years due to inflation – the force that, over time, decreases the purchasing power of a dollar (ie you are able to buy less in the future with the same $1).

To be more exact, according to the United States Department of Labor, to buy the same product that cost $1.00 in 1983 would cost $2.34 in 2013 (a 134% increase). So what happened over the past 30 years? The overall cost to buy a basket of goods increased due to inflation.

This matters to you immensely for 2 very important reasons:

  • As we have shown, over time, the purchasing power of a dollar – ie what a dollar is able to buy – diminishes as the overall price level increases. This has massive implications for how much you need to save for expenses in the future. Specifically, if you are planning for retirement or any large expense in 10+ years, the price you will ultimately pay will be drastically higher than it is right now, and you need to plan on saving more money over time.
  • The best way to put yourself on the right track is starting as early as possible to benefit from compounding (learn more about the power of compounding here!).

So far we’ve talked about inflation forcing you to save more for the same product or service – but inflation itself isn’t actually all bad. It is just something we all need to be aware of when we think about saving/ spending decisions. It also matters from a wage perspective: if you are making $50,000 a year for the past 5 years, this year’s income will only be able to buy approximately $46,000 worth of goods compared to 5 years ago (assuming 1.5% annual inflation). While a 1-2% annual raise might not seem to be that much, it will help you maintain your purchasing power.

So what causes inflation? While economists love to debate the exact sources of inflation, there are generally two accepted primary reasons for increasing price levels. The first is called Demand Push, which is a fancy name for consumers (you and me) demanding more of a product or service then is available, leading to an increase in price. This demand is generally caused by an increase in the amount of money available (the money supply) which makes it easier and cheaper to borrow money to buy things.

The second cause of inflation is referred to as Cost Push, where costs increase for companies and they raise the end-price to the consumer. This can be caused by workers requiring a higher wage, or a shortage of a commodity leading to a jump in its cost. When looked at in the aggregate, these increases in prices for individual companies means that, as a whole, prices for products or services has increased nationally.

It is broadly accepted in the economics world that low and steady inflation of between 2-3% is desirable as it allows for the economy to grow – there is enough money available for consumers to buy products and services but prices aren’t increasing at too high of a rate that would disrupt the normal flow of business. Too little inflation, or negative inflation (called deflation), encourages consumers to save their money because prices are coming down (which means that a good that costs $105 now will cost $100 in the future), leading to an overall drop in spending. And since one person’s spending is another person’s income, the overall income in the economy decreases.

The toll of high inflation can be seen in Argentina where the unofficial inflation rate was recorded at more than 27% in 2013 (the official rate of 10.9% is rife with issues and undercounting). This rapid increase in the price level discourages people from saving because $100 dollars saved at the end of 2012 would have been worth approximately $73 at the end of 2013. Since it is hard to find investments that reliably return 27% per year, people are discouraged from saving.

Speed Read:

Inflation is the general increase in price level over time that decreases the purchasing power of a currency. A low level of steady inflation in the 2-3% range helps ensure there is enough money available and in circulation that companies can invest in their businesses and consumers can buy products and services. If inflation levels are higher, then people who are savers or living on a fixed income (think grandparents) are injured because the money in their savings accounts is worth less from a purchasing power perspective every year. If inflation is negative (deflation), consumers and businesses are incentivized to save their money because the goods & services they want to buy will be cheaper in the future.

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