So you now have your investing strategy, you are intent on using it (kudos to you!), and you have decided that bonds should be a part of it.
Here is the checklist you can use to decide which bond or which bond fund to buy:
1. When is the bond going to mature? Considering your investing strategy, do you need a long-term bond, or a short term note or bill?
You will want to know when you get back your capital – will you need the money at a precise date? Then you need a bond that matures just before that date.
Or if it’s a short-term maturity (a note or a bill), how will you reinvest the money? Will you find a similar or better interest rate to reinvest your money?
Or, depending on your strategy, you might decide that you need a certain maturity, in order to be able to reinvest your money in a specific way when that bond reaches maturity.
2. Are you trying to accumulate or to preserve capital?
To accumulate capital you will need a bond that brings income above inflation. Inflation being around 2% right now, you will be looking at yields above 2% in order to achieve that. You might then want to turn to bonds that are not risk-off, but instead you will want to consider those with a greater return and commensurate risk: corporate bonds, bonds issued by governments that have higher costs of borrowing and high yielding debt.
Risk-off bonds, like UK, US, Japan and Germany bonds, on the other hand, will allow you to preserve capital.
3. Do you want to outperform inflation or are you happy to keep pace with it?
This question is similar to, but not the same as, the above. To keep pace with inflation, you could either buy a bond that offers a rate similar to your inflation expectations. That means the onus of calculating how much inflation is likely to be in coming months or years is on you. Or you could buy a TIPS bond, a Treasury Inflation Protected Security: its coupon moves in line with inflation.
To outperform inflation, you could buy a bond that has a high returning potential, or you could buy a bond fund that has an objective of outperforming inflation. This wouldn’t be too difficult in a low inflation context, but at the moment strong inflation is expected since governments have engaged in several forms of quantitative easing (like printing money).
When interest rates are so low (as they are at the moment) that it would be difficult to lower them any more, this incentive isn’t boosting demand and so, they simply flood supply by resorting to quantitative easing.
And of course keeping up with or outperforming inflation would mean that the rate of inflation that you are interested in is the one that affects you! A US TIPS bond will follow the US rate of inflation, but this might not be the rate you have to put up with!
4. Do you want to provide income towards current expenses, or are you happy to leave interest to accrue?
Then you have a choice between coupon bonds that pay out regular income in the form of interest payments, and zero coupon bonds. Like the name implies, zero coupon bonds don’t have a coupon.
That is, you still earn interest, but it is not distributed through a coupon. Much like a savings account that you “set and forget”, a zero coupon bond simply earns interest and you get one lump sum at maturity, which comprises of your initial capital deposit plus accrued interest.
Related to this concern is the nature of the coupon: is it fixed, or floating? A floating coupon moves in line with a variable, like a tracker mortgage. Examples of floating coupon bonds are TIPS bonds, or bonds that offer the interest rate of the ECB plus 2%: when the ECB interest rate changes, so does their coupon.
5. How is the bond taxed?
As an individual investor, if you buy an Irish government bond and you’re an Irish taxpayer, you don’t pay any tax on capital gain. If you bought an Irish corporate bond on the other hand, you would have to pay capital gains tax.
In any case, you will have to pay income tax on income brought by the bond, that is, coupon payments. Similarly, if you buy any type of international debt and make a profit, you are obliged to pay capital gains and income taxes, whichever apply.
6. Do you need your investment to be liquid?
Liquidity is a measure of how easy it is to sell a bond. If you want your money to be available fast, perhaps in a couple of months or years, you will choose a bond with high liquidity (on the other hand, think of this: if you need your money fast, are you sure you should be investing?).
Or if you deem it safe to put your money away for a while, you won’t need such deep liquidity.
If liquidity was an issue, you would choose a bond with a small bid/ask spread, just like 2020 German bonds.
When there is only a small difference between the offer and the ask price of a bond, it means this bond is in demand, so you will find a buyer.
7. Are you buying a bond or a bond fund?
When a bond matures, you need to think about reinvesting the money: it means you will have to go through the process of choosing a worthwhile investment all over again. With a bond fund on the other hand, you don’t need to worry about that since the fund manager will do that for you, by reinvesting bonds as they mature, assuming the bond fund lives into perpetuity.
So individual bonds mature, but a bond fund doesn’t: the money is always reinvested as the bonds making up the fund mature, or as bonds are rolled over before they get to maturity. A bond fund also allows you to diversify your investments: you might invest in “risky”, junk status corporate bonds through a high-yielding bond fund, but the fact that the bond fund is made up of many different bonds somewhat mitigates the risk of default: if one issuer defaults, that is only one among many in the fund.
On the other hand, bond funds don’t pay out coupon payments, but dividend payments and they have a management fee.
8. Which currency should you invest in, Euro or Dollar?
9. How is this bond backed?
By a government? By a company? How good is their ability to repay? What assets do they possess that back the bond? In the case of securitised obligations, something else backs your loan: a Public Private Partnership is an example of this. PPP projects created toll roads in Ireland: bondholders lent money to the project, and the income generated by the project is used to repay them.
If it was possible for retail investors to buy such bonds, we would call this a “Revenue Bond”. Personally, I believe this would be a good idea.
And of course you won’t have forgotten about the subprime products we all read about in 2007: these were “special purpose vehicles”, that is, the “asset” backing the debt was in fact more debt.
How does this work? In the case of a mortgage-backed security for example, a bank will lend money to house buyers. The bank, instead of just waiting for people to pay their mortgages in order to get its money back, will repackage that debt and sell it on. From being the creditor of people paying a mortgage, the bank has become the debtor of other investors.
Its cash reserves are intact, instead of being depleted by all the money it has lent out, and the bank will repay its own creditors as people repay their mortages. Only when people are not able to repay their mortgages, the dominos collapse…
Are you surprised that debt could be considered an asset?! Well, the word has a very definite meaning in economics: an “asset” is something that generates an income and is transferable. Debt generates an income, since the lender receives interest, and is transferable, since the lender can sell that debt to someone else.
10. Have a look at the opinion of rating agencies
The job of rating agencies is to identify the bond issuer’s ability to repay.
Are you on the list?
Sign up for my monthly newsletter and get more content like this, learn about business opportunities, and never miss my Savvy podcast.