Bonds are supposed to be boring. In fact, best-selling author and former British intelligence officer Ian Fleming—the man behind British Secret Service Agent James Bond, code-named 007—thought “bond” was one of the most boring words in the English language.
In his 1962 interview with The New Yorker, Fleming said, “I wanted Bond to be an extremely dull, uninteresting man to whom things happened; I wanted him to be a blunt instrument ... when I was casting around for a name for my protagonist I thought by God, (James Bond) is the dullest name I ever heard.” He lifted the name from an American ornithologist named James Bond.
Ornithology, huh? Big yawn.
Now, I’m no bird watcher, but as a fee-only financial planner for physicians, I also manage more than $50 million dollars for about 40 families and a couple of pension plans, and I happen to believe that bonds are anything but boring.
I think bonds are fascinating, functional and fun, so I’m excited to share some questions clients have asked about them, along with my oh-so exciting answers:
- “What is a bond? I mean, how does it work?” A bond is nothing more than a loan. When you buy a bond, you’re basically making a loan to whoever issued the bond. So if you buy a US Treasury bond (the most common kind of bond here in the United States), then you’re making a loan to Uncle Sam. When you own the bond, you can collect interest from it, which is mostly how people make money in bonds.
- “Can I lose money in bonds?” Yes, you can. Most bonds are sensitive to changes in interest rates. When interest rates rise, bond prices drop, and vice versa.
- “If I can lose money in bonds, why would I want to own them?” Well, you can make money in bonds, too. When interest rates fall (as they have for several years now), bond prices rise. And regardless of the direction of interest rates, you can still gain interest by owning bonds or bond mutual funds.
- “What about the Bond Bubble?” Ah yes, the Bond Bubble. Pundits and soothsayers argue that bonds are doomed to lose money because interest rates are at historic lows and “interest rates have nowhere to go but up.” I wish the argument were this simple. It’s true that interest rates on US Treasury bonds are very low, and that these bonds are sensitive to interest rate changes. But it’s also true that you cannot predict the future, not even the future of interest rates. I mean, look at Japan: they've had super-low interest rates for decades now. Calling the future is a fool’s game."
- “So, should I dump all my US Treasuries?” If you ONLY own Treasuries, then maybe you should lighten up a tad. But before you go off and sell all your Treasuries, you have to remember that Treasuries are a special kind of bond because they are backed by the full faith and credit of the US government. This gives them a special status in the world, and they are seen by US investors and non-US investors alike as a “safe haven” during hard times. For instance, when all hell broke loose back in 2008, US Treasuries were just about the only kind of bond that actually gained value. This makes US Treasuries a good diversifier for an all-stock portfolio.
- “What kinds of bonds are there besides Treasuries?” Well, it’s a great big bond world out there. According to the Barclays Capital Global Aggregate Bond Index, there are about $32 trillion worth of debt outstanding from 12,000 issuers worldwide, making the global bond market twice as big as the global stock market. There are government bonds and corporate bonds; developed market bonds and emerging market bonds; high yield “junk” bonds and high quality “investment grade” bonds; short term, intermediate term and long term bonds; inflation-adjusted and “nominal” bonds, dollar-hedged and un-hedged foreign bond funds, and just to spice things up, there are floating rate bonds too. (If there is a Bond Bubble brewing, I find it hard to believe that it would impact every one of these at the same time.)
- “With so many choices, what kind of bonds should I own?” To thrill my compliance attorney and all the regulators who read my blog, I’ll say that you should consider your own personal financial situation, investment objectives and tolerance for risk before you invest in any bond or bond fund. But to address the question head on, I’ll tell you that diversification is a very, very good thing, and it might not be a bad idea to own a wide variety of bonds… a task made far easier these days by the proliferation of bond index funds from Vanguard and DFA.
Bonds may not be as gutsy as guns, as giddy as gadgets, or as glamorous as Bond's babes, but they’re an important part of a balanced investment strategy and they just might help your portfolio be stirred, not shaken, the next time it looks like the world is coming to an end.