How Do Bonds Work?

Today we’re going to be spend some time talking about the bond market. Jack is going to join me and we’re going to do a little bit or role play. Where you’re going to play the role of a client and I’ll do what I normally do on a day to day basis. And I think it’s important to explore this area of the market and the fixed income segment. Because a lot of times when we’re looking at equity volatility, we tend to go to the bonds. And unfortunately, I don’t think a lot of people have a good understanding how the fixed income market works. And they sort of have the wrong expectations going into these places in the market. Well for sure and if you think about it, I mean how many times do they get to be told hey, are you in a 60/40 portfolio, right? Those are your options. You know, let’s go to the bond market. Let’s go to the stock market, fixed income, equity and that’s what they’ve been you know preached about, especially in 401Ks and more. And they have no idea that there’s other options even outside of those bond and stock markets. But specifically speaking, I think it will be fun. I’ll just ask some questions. Absolutely. Be the client here. So what is bond? What’s fixed income? What does that mean? Yes, the biggest thing I would say is there’s different types of bonds. So just like stocks, there’s large cap, mid cap, small cap bonds. There’s government bonds. There’s fixed income bonds. There’s I-bonds. There’s a bunch of different types of bonds. They all function a little bit differently. Corporate bonds and they have different risks to them. So when we’re looking at bonds first, we have to be careful which ones we’re looking at because they’re all going to carry a little bit different level or risk. They’re all going to work a little bit differently as far as how they pay coupon payments as well as tax as well. You know so we have to think about municipal bonds. Do those fit into the portfolio? So when we say fixed income, that’s a very big trillion dollar asset class. And there’s a lot of different directions we can go with that. So if somebody comes in and says….oh I’m the client, sorry. I have bonds in my portfolio. You know is there anyway for us to figure out if they’re good bonds, bad bonds? Is there such a thing? Yeah, absolutely. So every bond has a rating to it. You know so you can be a AAA all the way down to a D bond. So which would be more of our junk bonds. So a lot of times when we do investment analytics, we run these Morning Star reports. So if we look at a Mutual Fund as an example. That might have a stock, bond mix to it. But what Morning Start will allow us to kind of see is inside that bond piece, what type of bonds do we actually have? What’s the credit rating? What’s the risk of that bond portfolio? I think that’s the biggest thing that people miss is bonds aren’t a risk-free investment. They do carry risk with them. So we want to be careful with that when we’re thinking about retirement planning. So we have a system that helps us measure risk. So one would be like cash, 99 would be Bitcoin. A lot of times bond portfolios fall into this kind of 25/30. So think of that like a speed limit. You know 25/30 for driving downtown Traverse City. That’s okay, you can probably stop. You’re not going to run over a tourist. You might want to, but we probably shouldn’t. But if you’re doing 25-30 in Meijer parking lot, that’s a different level of risk to it. So not risk-free investment. We do need to be careful where we own them and how we’re using them. Now what about in the interest rate environment that we’re in and just went through. How do interest rates affect bonds? Yep, so interest rates and bonds have this inverse correlation. So when interest rates go up, bond prices go down. And the reason for that is if I’m wanting interest as an example. So I’m going to go out and I want to buy a 10 year Treasury bond that’s paying 4%. There’s going to be a lot of demand for that depending on what happens with interest rates. So that’s going to affect the net asset value of that bond price. So interest rates play a big role in how bonds are priced and how they’re going to change on a day to day basis. So if we’re in an interest rate rising environment, our bond prices aren’t going to do very well. And if we’re in retirement, pulling income from that, we might be pulling income from places that are actually going down in value. So what about the duration? How does duration of a bond, then plan to, you know how the position of that bond might want to look like? Yeah absolutely. So duration is how we measure risk in a bond portfolio. So we have a duration of 10 as an example. If there’s a 1% increase in interest rates, there will be a 10% drop in that bond price. So that’s a pretty big volatility scale. I thought bonds were safe? No, that’s the biggest thing is bonds are not safe. So bonds have interest rate risk. They have credit risk. We want to be careful with that. We want to measure how that plays into your investment portfolio. To give you context aggregate bond index has a duration of six. So if interest rates go up 1%, your aggregate bond index will go down about 6%. So that’s the biggest challenge I think when we’re looking at portfolios is bonds aren’t risk-free. We need to know how that fits into our overall investment portfolio. And when we think about that, how that overlays with our financial plan. If we’re going into retirement, we need to be thinking about how we’re going to pull income from our portfolio and where’s the best place to structure these bonds and the best type of bonds to have. If you don’t know where to get started with that analysis, please reach out to us. We have a lot of systems to measure your risk tolerance, build up that financial plan and then look behind the scenes, the actual details in that portfolio to see where you’re maybe over exposed with risk.