Let’s start with the big question – what are bonds..?
What are Bonds?
Bonds, simply put are debt, issued by big corporations and governments to the general public through a Bond Exchange. Let’s do an example. The Government wants to build 10 new hospitals at a cost of $1 billion each, so they need $10 billion. While they do not currently have $10b in their budget to do this, they know that they will get an annual income from taxpayers to make the interest payments on that debt should they choose to issue it. So they go to the bond market and issue $10b worth of debt at say, 7% interest. These bonds are split up into smaller pieces of, let’s say, $1,000 each, so that smaller investors can purchase into those bonds as well, holding a share in those bonds.
At this point, pension funds and retail investors like you and me buy into those bonds, and in return the governments pays us an annual interest rate of 7% on our investment. Let’s say I invested $10,000, I will get an annual interest payment form the government of $700 deposited into my bond trading account. Simple, right!
What determines the interest rate?
The interest rate on bonds are largely set by the market, being the buyers like you and me and larger investment houses, and we, in a manner dictate what interest rate a bond issuer can charge by buying or not buying into those bonds. For instance, if the US government offered bonds at 1% interest, you and I might decide that our money is better invested elsewhere, so we don’t buy into those bonds, and then the bond auction fails. So next week the government can come back and offer 2% return on those bonds, and depending on the outcome of that bond auction, keep their offer there or raise it again.
And how do we decide if a bond is worth buying? The same way that banks use to determine if they will lend you and me money and at what interest rate – by taking a look at our credit records. So the US government might have a AAA credit record which means it’s a very safe investment, chances of a default is almost zero, so they can get away with offering investors a lower interest rate than say, South Africa, who currently has a BB- rating, basically junk status. So while the US might be able to offer a 3-year bond at 4%, South Africa has to pay investors a much higher 11% for the same bond in order to convince them that it’s worth the risk.
Do bond prices go up and down?
This is an interesting one, and the answer is yes! It is best to explain this with an example.
Let’s assume the year is 2023 and the current interest rate on a 10-year US bond is at 4%. That means if you invested $1,000 in this bond, you will get $40 per year paid to you by the government, every year, for 10 years, after which they will pay you back your $1,000. Simple.
It is three years later, 2026, and bond markets have cooled down a bit. The government can now issue new 10-year bonds, but this time, they only have to offer 2% returns on those bonds to entice investors, half of that from 3-years ago. That means that in order to receive the same $40 per year, investors now have to invest $2,000 into the 10-year bond instead of only $1,000 as in 2023. So what does this mean for the price of the 2023 bond? Yep, its value has increased.
Now, it hasn’t quite doubled from $1,000 to $2,000 as, at expiry, the government will only give the bond holder back what you initially paid for it – $1,000, but since the bond has 7 years to expiry and offering 2% more than current 10-year bonds, its value has increased by $140 (7 years x $20 extra per year = $140) to $1,140. A little bit bland, I know, but still a return.
Do bonds ever fail?
Oh yes! And when they do, the whole world goes into a tailspin. Remember the 2007 housing market crash? All of that was financed by, you guessed it, bonds! Everyone lost money on that one, apart from Michael Burry and a handful of other smart investors, of course.
That being said, bonds are generally considered one of the safest investments one can make compared to stocks and property, as they are not that volatile and rarely ever fail. This is why, by regulation, they form a big part of the retirement savings structure.
How do I buy bonds?
There are a couple of ways.
1. You can open an account on a bond exchange and buy directly into a bond. This will also give you the ability to buy into specific bonds, as well as the option to easily sell those bonds should you ever decide to.
2. Normally, governments offer their bonds to retail investors via places like the post office and other retail outlets. This makes them a bit easier to buy into, but in most cases, makes them difficult to sell and are generally bought with the intention of holding on to them until expiry.
3. My personal preferred way would be to buy into bonds through a bond fund. The fund will consist of various bonds, meaning if one fails, all of your money is not lost. It also gives you a more stable return across the board. You can generally buy into these bond funds through your normal share trading account or by directly buying into them through your retirement (& other) investment accounts.
When is a good time to buy bonds?
Timing is always difficult and one will never get it perfect, but considering what has been explained above, you will want to buy bonds when the interest rates offered by them are near historic highs. This is normally also at a time when general interest rates are very high and the world is in a bit of financial turmoil, pretty much like now in 2023.
So when should I sell?
When interest rates are at their lowest! If you bought a bond when bonds offered 4% returns and bonds now only offer 2% returns, your bond is worth more than what you had paid for it. It won’t make you rich unless you have billions to play with, but it is for this reason bonds are considered a very stable long-term investment.
The take away?
Yes, bonds are pretty boring, but it is necessary to understand how they work should you decide to manage your own investments, as you will be required by law to include them at the very least into your retirement savings account.
Feel free to go to bed now, I won’t hold it against you.