Bonds and how to use them wisely

Bonds might be unknown to many or boring to others. Nevertheless, they are very useful to balance risk in your investments.

What's a bond?

A bond is simply a loan that a country or a company gets from private investors. For example, the Philippines need money to finance road constructions, education, etc... Instead of taking a loan from banks, they'll loan it from people like you and me. Same goes with big companies. They'll look for a loan from people instead of banks.

These institutions will then emit paper documents called bonds in exchange of money from the investor. The investor can buy these bonds and the institution will pay back the money with interest and within a specific time frame.

Here are some definition of terms used when talking about bonds:

- Face value: it's the amount that investors loaned to the institution

- Maturity: that's the number of years for you to get back the face value

- Interest rate: that's the interest the institution promised to pay each year

- Coupon: bonds are simply printed on special paper. At the end of the bond, you'll find coupons you can cut. You can bring these coupons  to your bank when they mature (usually every year) and you'll receive the interest that the institution promised to pay.

For example, you can buy 1 million worth of bonds emitted by the Philippine Government with a 5 year maturity and 6% interest rate. Every year, you cut your coupon and go to your bank to get your interest of 60,000 pesos. At the end of the 5 year, you'll get back the million you loaned. In total, you'll get the million you invested + 300,000 pesos in interest (60,000 per year for 5 years).

What are the advantages of bonds?

1. It's safe. Bonds are emitted by a country or by a big company. Government bonds are safer because countries don't go bankrupt. Company bonds are less safe because there's a risk the company goes bankrupt but their interest rate is higher to compensate with the higher risk.

2. Interest rates are higher than banks.

Bonds vs. stocks



 

The table shows that stocks and bonds have respective advantages depending if your investment time frame is long or short.

Stocks return are bigger on the long run but they are risky on the short term.

Bonds are safer but returns are low on the long term.

How to use bonds wisely

Having bonds in your investment portfolio will help your investments grow when stocks are going down.

In this regard, people like me who invest in stocks to fund their retirement may be vulnerable. When the retirement age is near, any stock market crash will deplete the savings. For example, I plan to retire at 65 years old and I need 6 millions to fund my retirement. At age 64, I successfully saved 6 millions but a sudden market crash depleted my savings to 4 millions. Now I don't have enough money for my retirement and I need to wait 5 to 10 years for this money to grow back to 6 millions.

If instead, I started to sell my stocks in order to buy bonds as I get older, a market correction won't affect my savings.

It is the reason why I advise people to move their money from stocks to bonds as they get older.

A simple rule of thumb to know what's the percentage of your portfolio that should be in bonds: your age. If you are 40 years old, 40% of your portfolio should be in bonds.70 years old, 70% in bond, etc...

Where to buy bonds?

You can buy bonds from your local bank or other investment institution like insurance companies that provide a mutual fund made of bonds.

What returns can we expect?

Between 4 to 10% depending how much risk you are willing to take and what's the inflation level.

 

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