One of the many things I have really enjoyed over the past few years is getting to work with some of our client’s children (NextGen clients). We have recognized that individuals age 20-30 could greatly benefit from having access to an advisor who provides guidance and answers questions that are common to this age group. Often, decisions that are made in the first few years following college have a major impact on an individual’s financial life for many years to come.
Due to the importance of getting your financial life off on the proverbial right foot, I have decided to write a mini series of blog posts aimed at some of the financial basics. These principles also serve as a great refresher for the more seasoned investor.
One of the basic principles that is foundational to beginning your investment knowledge is to be able to understand the basics of a bond. At its core, a bond is merely a loan that a company, city, or government takes from its investors versus borrowing from a bank.
When an entity issues a bond, it is really borrowing money from investors for a specified time period at a set interest rate. Once the investor has agreed to purchase the bond (think of this as loaning the entity money), the entity now has an obligation to pay the investor according to the terms. Generally this involves a form of periodic interest payments to the investor along with a specified date that the loan will be repaid in full.
Often bonds are viewed as a more stable investment vehicle because of the consistent interest payments that are received. One common misconception is that bonds are risk free. Like many investments, bonds carry different amounts of risk based on different factors. There are four main types of risk that bonds have: issuer, interest rate, reinvestment, and inflation.
Issuer risk is the chance that the bond issuer becomes insolvent. Some companies have a greater risk of defaulting on their bonds than others based on their financial position. Because of this, companies that are perceived as more risky often must pay a higher interest rate to the bond holders to compensate them for the risk they are taking. If that entity does become insolvent, the bond holder typically is not able to recover the total value of the bond, and in many situations may only receive 30-40 cents on the dollar.
Another risk to keep in mind is interest rate risk. Bond prices often fluctuate depending on the current interest rate environment. As current rates go up, the value of lower interest paying bonds goes down. This can logically be seen by thinking through a situation. Assume you have purchased a $1,000 US Government bond that is paying 5%. Each year, you would receive $50 in interest from the US government. Now let’s assume that current interest rates rise to where a new $1,000 bond from the US government is now paying 9% interest. The price of your initial bond purchase would fall. Would you be willing to pay $1,000 for a bond paying $50, when you could get a bond paying $90 for the same price? If you elect to hold the bond to maturity, price fluctuations in the interim do not affect the amount you will receive when the issuer pays off the bond in full.
Because interest rates can often fluctuate, there is also a risk that when your bond finally matures, you may not be able to find a bond that is paying as high of an interest rate as you had before. This is referred to as reinvestment risk.
Another main risk that a bond holder has is inflation risk. Currently interest rates are at historically low levels. Short term government bonds are actually paying less in interest than the rate of inflation. If an individual has owned short term government bonds over the last few years, chances are their money will buy less today than it would have 2-3 years ago. In many instances, they have locked in a loss by accepting a rate of return below inflation.
Due to current low interest rates, we believe that money not needed for cash flow beyond six years (depending on your risk level) should not be held in bonds. Instead, we believe that longer term money should be held in different investments that will have the potential to outperform bonds.
Thomas Gross, CFP®