5 things you need to know about Bonds – and why they are like Parma Ham

investment bonds

22 Dec 5 things you need to know about Bonds – and why they are like Parma Ham

My brother returned from a European trip last week and his haul of goodies included Parma Ham from Parma, Italy. (where else, duh). Over the course of the week, we had three groups of friends come over to partake in the goodies and to feast on ham and melon.

 Among our friends, some relished and looked forward to it. For those eating parma ham for the first time, it was a novel experience. The salty slimy ham against the sweet and crunchy melon makes for an interesting proposition. While some loved it the moment they tried it, for many it took a while before they could fully appreciate and acquire the taste for it. Yet there were others who had a look, took a sniff and rejected it outright. They declared that they will have nothing more to do with it.

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Just like parma ham, my exposure to bonds come early, but my true appreciation for them came very much later. Many years ago when I first stated working, I sat through a session with my financial planner. It was one of those ubiquitous sessions whereby she would talk about the importance of having a diversified and balanced portfolio, and how a simple strategy of tweaking the asset composition in a portfolio would allow us to achieve the desired level of returns. She went on to regale me about how equities are the more risky investment class, and how by tempering equities with bond funds, we are able to reduce the risk levels and achieve a more consistent performance over time.

At that time, I was punting the Singapore stock market and my idea of risk management was to contra blue chips occasionally instead of only pennies. I had no ideas what bonds were except that they are slow, boring and more suited for geriatrics to invest in. And I had absolutely no intentions of finding out more.

Now older and slightly more exposed (I hesitate to use the term ‘wiser’), I figured that bonds are indeed indispensable and essential to anyone seeking balance. Assuming you are a bond newbie like I was, here are five things you need to know about bonds.

Bonds are debt.

Companies can raise capital in a number of ways. They could go to the market to sell more shares and use the new capital to fund expansion. Imagine I am a farmer raising pigs for parma ham, and I need capital to expand and to buy a thousand more hogs. I could approach interested parties Mario and Luigi and say to them if you were to invest some money, I would make you a shareholder and together we would own a much larger company that would conquer the market for ham and share out the profits.

On the other hand, I could also approach both of them and say that I am selling bonds that pay a 5% coupon rate. Essentially what I am doing is borrowing money from them and paying out five percent per annum in interest. I will repay the principal amount at a predetermined maturity date. It is a debt that I am taking on, very much like going to the banks for a loan.

Unlike companies, governments are not able to sell shares in their country hence they take to the bond market to raise money. In fact, and no surprises here, the US government is the biggest issuer of bonds in the world, while the Chinese government is the biggest foreign purchaser of US debt.

Once again, when someone purchases a bond, he is in fact lending money to the issuer.

Bonds are tradeable

Assuming Mario and Luigi both purchased $10000 worth of the bonds I’ve issued. One day, Mario decides he needs his money back to buy a new car. What he could do is to sell this bond to Luigi, or anyone who is willing to purchase the bond, for that matter. Effectively now, I no longer owe Mario a debt but this obligation is transferred to the purchaser of the bond from Mario, and upon maturity I would have to repay the principal amount to the new lender.

In the local context, retails bonds are traded over SGX and most brokers should be able to facilitate your buying and selling. Alvin has written an excellent article on how to purchase Singapore Government Securities here. However, for both instruments, liquidity and volume can be found wanting.

Bonds are traded much more in the US markets, and the easiest way to be exposed to bonds would be to purchase it through an exchange traded fund. These funds, through their basket of holdings attempt to replicate the performance of actual bonds. A fund that we like and have been following for a while is the ishares Barclay 20+ years treasury bond fund (ticker TLT). The fund tracks US treasury bonds that have more than twenty years to expiry and is a good bond proxy for your portfolio. Once again, a brokerage account that allows you to trade the US market will suffice and allow you to trade TLT like any other counter.

Bonds have yield

Stocks pay dividends and bonds pay coupon. Unlike stocks where the dividend depends on the company’s performance over the past year and is decided by the board, bond coupon rates are a percentage of face value and are fixed. What changes is the yield. Imagine Mario having a tough time selling his bond or finding someone to take over his loan at his purchase price of $10000. The only interested buyer is willing to pay $8000 for it and Mario caves in. Consequently he receives a coupon rate of $500 ($10000 x 5%) yearly and that for him, equates to a 6.25% return on his purchase price.

Bond price is a function of credit worthiness. An organisation that is deemed safe and able to repay its obligations would be able to finance it’s debt at a lower cost than one that is doubtful or even on the verge of a default. Hence, the Greek government, in the face of the country’s woes, would have to promise lenders a substantial amount before they are willing to part with their money. At the height of the crisis, Greek government 10Y bonds were trading at 41.8% yield!

Price is also a function of interest rates. If I had purchased bonds at 5% coupon, my returns would be 5% per annum fixed. Assuming interest rates have sky rocketed to 10% since then and the public can now easily achieve that amount through a fixed deposit investment. The only way for me to interest others to purchase my holdings would be to match the yield. ie. lower the price. Hence, bond prices decrease when interest rates increase.

Bond prices move

A popular misconception is that bonds prices move as much and as fast as one’s nails can grow – not very much at all. To dispel that, here is the chart of TLT over the past five years. The returns are hardly to be sniffed at.

Bonds balance out your portfolio.

Followers of Bigfatpurse would know that we are firm advocators of the Permanent Portfolio. One of the basic tenets of PP is that money flows around in a closed loop around the financial markets, and the asset class that sees the most inflow of capital will see the greatest price increase.

Over the past five years, TLT has returned 34% as opposed to the S&P500’s negative four percent. And interestingly, during the financial crisis in 08/09, bond prices spiked and increased by more than 25% as the equity market crashed. If you had a portion of your portfolio in bonds, you would have weathered out the storm and still be out ahead.

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My investing universe used to only consist of stocks listed on the Singapore exchange and I only knew how to take long positions in them. Bonds to me were just like parma ham – foreign and funny tasting. If only I had known earlier what I was missing out.

I have always believed in exposure. Exposure to Parma Ham has made me appreciate the unique quirkiness of this delicacy. Exposure to food from different cultures makes me understand better about others whom I share this planet with. Exposure to role models affected my career choice. And exposure to different investment instruments allowed me to adopt a more holistic view of how financial markets work. Exposure stretches the mind, never allowing it to return to its original dimensions again. Here at bigfatpurse, we hope to expose more people to good financial sense. If you have found our articles useful, do share us with your family and friends and expose them to more great investing insights!

 



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3 Comments
  • Tinychopsticks
    Posted at 23:20h, 22 December Reply

    Hi
    I am a newbie with bonds so I read your article with interest.
    You wrote “Bond price is a function of credit worthiness” . With the US printing so much $ not backed by any production, how credit worthy is the US$, especially over a 20+ years period? Many are worried about the fiscal cliff in early 2013. While it may be delayed by a couple more years, it will catch up during the next 20+ years. What would happen to US$ bonds then? Would you know what has happened to bonds issued by Greek, Spain, Italian, Ireland governments?
    Thanks.

    • Alvin
      Posted at 01:10h, 23 December Reply

      The U.S. prints money to buy bonds. This means bond price goes up and yields go down. USD goes down as well. The bond price is essentially propped up by the devaluation of USD.

      Do you work and live in the U.S.? It is better to buy the bonds in your country of stay so that you are not expose to currency risk. At the same time, owning gold would help you fight the devaluation of the currency you hold. This is why we advocate the Permanent Portfolio to protect your hard-earned money while striving for growth.

      You can take a look at the bond yields from the countries you mentioned:
      http://www.tradingeconomics.com/country-list/government-bond-10y
      Remember bond yields move opposite to bond price. Take Greek bonds for example, yields have been below 10% since 1998 to 2010. During the crisis, the yield shot to 40% because people fear that the country may default. But the yields have came down 20+% in 2012.

      Buying bonds alone is dangerous. You need to have a portfolio of different asset classes.

    • Jon
      Posted at 10:43h, 26 December Reply

      Hi Tinychopsticks,

      I re-read your question again. Are you concerned about how credit worthy the US of A will be as a lender or are you worried about the strength of the US$ in time to come?

      To answer the first, we need to go to credit rating agencies, the big three being Moody’s, S&P, and Fitch. All three agencies had rated long term US government debt AAA, their highest possible rating until 5Aug11, when S&P decided to downgrade their rating one notch to AA+. It is similar to an analyst downgrading a stock, and for a bond, the price might go down, the payout remains the same, and consequently the yield goes up. Unfortunately that scenario didn’t play out that way. Market participants fled into safe assets (bonds still considered safer than stocks) and the stock market experienced a five percent drop the Monday after the downgrade with bond prices remaining relatively steady.

      To answer your question even more directly. The US government actually prints money to buy bonds. Effectively they will not go out of business because they can keep printing and printing. And as long as they print, they will be able to repay all obligations. How long will they continue printing is anyone’s guess.

      And we all know that while printing money is a good stop gap measure, something has to give. In this case it is the value of the USD. By printing, the US government is in fact devaluing the USD against other currencies. Unless they are able to turn the economy around, the USD can only get cheaper.

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