Bond Investing 101--A Beginner's Guide to Bonds

hey everybody welcome back to the financial freedom show my name is rob berger in this video we're going to do a walk through on bond investing the idea is what are the basics you need to understand when adding bonds to your portfolio when i started investing i didn't really know a thing about bonds and so i just picked a couple of bond funds not really understanding that there is a huge difference between the different kind of bonds that you can invest in and the risks associated with the bonds and the potential rewards as well are very different from say a short-term bond versus a long-term bond or a bond involved issued by corporations with shaky financials for example called high-yield bonds so here's what we're going to do going to walk through basically how bond works that's what we're going to start with and talk about some of the terms a lot of it's just understanding the terms and concepts and once you understand that frankly that's about all you need in order to add bonds to an asset allocation whether it's 80 20 60 40 or whatever so that's what we're going to do we're going to look at some examples of some bond funds we're going to compare the difference between investing in an individual bond and what probably most of us do myself included and that is uh invest in bond etfs or mutual funds there are some differences uh of course going to look at some types of bonds and then kind of going to end uh the video with sort of three approaches you might consider for your bond portfolio uh and so that's what we're gonna do so let's get right to it and uh to understand the bond gonna go to the the digital white board and um the way a bond works of course at a high level a bond is nothing but a loan right when you when you invest in a bond you're lending money usually to a government or corporation we'll talk more about that but you're lending money and they are agreeing to pay you normally a fixed interest rate for the term of the bond so let's see how this might work we can imagine we'll do like a 10-year timeline and you invest a thousand dollars in a bond today let's say and we'll assume this is all the way over here is 10 years so we'll just assume this is a 10-year bond well what does that mean a 10-year bond well what it means is that each year and it's usually for the most part interest on a bond is paid twice a year and so you're going to get interest and we'll just assume the interest rate on this bond is two percent and they actually call that the coupon rate um and that harkens back to the day when bonds were actually in paper format you may have seen like on college campuses or in your neighborhood where someone wants to advertise something and they've got those little they have a piece of paper on the telephone pole and they have those little tabs at the bottom where you can tear off their phone number that's kind of how bonds worked and each one of those little tabs was called a coupon you tear it off and literally present it to the issuer of the bond to get your interest rate well that term of course everything's digital today but they still use it so coupon rate right and we'll assume in our example it's two percent and so you would get interest effectively every six months uh two percent of a thousand dollars is uh what is it it's 20 bucks is that all yeah it's not a lot of money i started to say 200 i'm pretty sure that's 20 of a thousand so whatever the interest is you're going to get that every six months right and then if you fast forward all the way to year 10 you're going to get the last interest payment and you're going to get the return of your your one thousand dollars okay and so some of the terminology they would use they'd say the ten years they would say this is this is the maturity this is when the bond matures which is just the term they use for saying all right the term is up here's your last interest payment and here's your thousand dollars back so you could think of this as most bonds as interest only right and then the principal gets paid back at the end so in this case you know it's a 10-year bond has a maturity of 10 years you're going to get interest typically every two months and excuse me twice a year and then at the end of the term in this case 10 years you get your money back what makes bonds so fascinating in my view is that for the most part again there's always exceptions but for the most part bonds can be bought and sold so if you own a bond you could at any point in this 10-year period right you could decide to sell your bond and that raises um two important concepts because you might think well what would i sell it for what would be the price i guess it'd just be a thousand dollars right i mean that's the that's the amount of the bond they actually call this the par value right it's a thousand bucks um so i assume if i want to sell it or if i wanted to buy a bond like this i'd pay a thousand bucks right well no not so easy uh it turns out that the value of a bond will fluctuate during in this case the 10 years of its life and there are two risks associated with bonds are actually more than two but two that i think are most important for us one is called credit risk and one is called interest rate risk credit risk is simply the risk of default right it's the risk that whoever you've uh lent money to it won't pay you back they'll either miss one of these interest payments one or more or they'll default at the end and they fail to give you uh some or all of your principal backs that's the risk of default now in the world of bonds the general wisdom is that u.s government bonds have zero risk that worst case scenario the government could just print money and and and pay back bonds which i guess is kind of what they're doing uh in any event u.s government bonds are viewed as having no risk we're going to look at some other bonds though where credit risk the risk of default is very real and we'll talk about that in just a little bit that's the first risk the other risk and probably the risk you're hearing most about today is interest rate risk and if you're new to bonds it may seem odd that that interest rates could affect the value of this bond so for example let's imagine uh at year year one so we've had this bond for a year we've gotten our two percent for the first year we've got nine years left and let's say that interest on similar bonds if you're gonna buy one you know at year one has gone up it's gone up to four percent at first glance you might think well that shouldn't affect the value of my bond i mean i'm still getting my two percent at the end of 10 years i'm gonna get my thousand dollars back what what does that increase to four percent have to do with my bond well let's imagine at this point you wanted to sell it you advertise your bond and you want to charge a thousand bucks right that's the par value well why would why would folks buy that let's imagine you wanted to buy a bond and someone was selling a one thousand dollar bond at two percent and you say wait a minute why would i buy your lousy two percent bond i can go out in the market today and get four percent and if we think about it well yeah that's that's a pretty good point so if we really are in desperate need and we want to sell this bond what do we have to do well we have to discount it right we have to lower the price how much well enough so that the effective yield on the bond is four percent and the way this works there's math behind it math that i've never bothered to dive into because it's not important for the vast majority of of investors but the idea would be we want to lower this enough so that the effective yield is is four percent so let's just imagine that number i'm just going to make a number up but let's just imagine it's 950. so let's say you're the new owner you've bought this bond at year one and you paid 9.50 for it you think well so now i start to get four percent right no you're gonna continue to get the two percent remember you've bought this bond from another investor let's say the u.s government issued this bond it's a u.s government bond well they've got a contract effectively to pay two percent they don't care that you've bought this bond at a discount because the current interest rate is four percent right the terms of the bond are two percent so you're going to get two percent on what on the original one thousand dollars right they also don't care that you paid 9.50 that has nothing to do with the issue where that was between you and another investor so they're gonna continue to pay the two percent on the par value that's not going to change but you only had to pay 9.50 for this bond again i'm just making that number up uh but but it would obviously in these in this scenario be something less than a thousand but the benefit to you is that once we get all the way out here you're gonna get the full thousand dollars back once again the u.s government doesn't care that you paid 9.50 for it they're going to give you back the par value and it's that difference between this 950 that you paid for it and the thousand dollars that you eventually get when the bond matures that makes up the difference between this two percent and four percent now here's the the really important thing to take away from this and it's it's the following as interest rates go up the value of existing bonds go down and we saw it right here interest rates went in our hypothetical from two percent to four percent and the value of the bond went down again it went down here by a made-up number but it would go down by something and the reverse is true or the inverse right if interest rates go down the value of bonds go up imagine if interest rates fell to one percent after a year well now you've got a bond paying two percent when prevailing rates are only one percent you want to sell your bond you're gonna get a premium again the same concept someone might pay and again i'm gonna make up a number for this premium we gotta bridge this gap maybe they pay one thousand and um twenty dollars so they're paying a premium a premium over and above and i know this is getting a bit messy over and above the par value to make up the difference between these two interest rates because interest rates went down and if they fast forward to the end are they going to get 1020 nope they're going to get the par value and the difference between that par value and what they paid makes up the difference between these two interest rates so again the important concept to understand is that as interest rates go up the value of existing bonds go down and as interest rates go down the value of existing uh of bonds go up and that presents a a problem for you and i today and i'll show you why um what you're looking at now is uh the yield on the 10-year treasury by year so we're looking here the latest update was just a few days ago the yield is 1.31 percent i'm gonna go all the way down to the bottom believe it or not they have data going back to 1871. uh yeah and back then if you live back then you'd get three two percent and as we just slowly sort of scroll up five percent four percent three percent going down back up to four percent now we're in the 1920s five percent we hit the great depression rates from the 3 now down to the 2 it's not until 1941 that we see a yield under 2 now this is on an annual basis there may have been intermediate you know months where perhaps it fell below but on an annual basis first year of course we're in world war ii at this point so um obviously a lot of things happening that affect the economy you know globally but it only stayed there for a year jumped back up to two percent and then up to three percent four percent and those of you that are old enough to remember the 70s and 80s you know what's coming see these interest rates now we're up to nine percent 10 percent 14 1982 i remember earning 16 on a six-month cd i still have the paperwork for that cd anyway um and around here as crazy as this was by the way i remember you know you say six months cd why didn't you lock in for five years we were scared uh interest rates would go would go up who wants to lock in at 16 for five years if rates go you know 20 i know it seems crazy by today's standards in any event we enter what many call like a 30 plus year bull market on bonds which basically means the yields were going down as prices go up and we see that we're still in the eights the sevens um sixes now we're in the fours the threes and uh back now for the first time since 1941 2012 for under two percent pops back up but then as we all know 2020 176 beginning of this year was just over one percent it currently stands at 131 now why have i gone through all that history the history is to show you that we really are in unprecedented uh what time when it comes to bond yields um and the concern that many folks have uh is that the yields will eventually go up we might not know when but they you know the thinking is they can't stay that low forever and when they go up all the bond and bond funds that you and i own are going to go down in value that's the concern and it's a valid one trust me the question now that we want to answer though is is there some way we can figure out how uh an increase in interest rates will affect the value of the bond when we were looking at just a minute ago a sort of a made-up example i was just pulling numbers out of the air but is there a way to actually sort of get a you know a better estimate of how an increase in interest rates will affect a bond and the answer is absolutely and it's called duration and let me just show you i'm going to show you how it works i'm going to clear this screen i'm going to first explain the concept behind duration there's different ways to calculate we don't have to worry about that all we need to know is the concept and then we're going to actually look at some specific bond funds to show you how that works let's go back to our 10-year example here's uh year 10 right and we've got our bond we're going to invest a thousand dollars and it's we know the maturity right the maturity is 10 years that's great so um the idea of duration the concept is to figure out the average amount of time it will take to get our money back and at first when i was learning about these concepts i thought that doesn't make any sense we get we get we get our thousand dollars back here year 10. why isn't the duration 10 well duration is measuring all of the money that we're going to receive from this bond and we don't get all of the money at year 10 we get some interest it's the six month mark the 12-month mark twice a year all the way right to the very end and of course at the end we get the pot of gold so to speak we get a thousand dollars back so yeah most of the money comes back to us in year 10. but we do get currently small amounts since the yields are so low we do get small amounts of money along the way and so what you could think of duration is calculating the average the weighted average time that we get our money back that's i think it's a a good enough definition of duration for our purposes and um typically there are some exceptions but typically the duration uh is you know shorter than the maturity because the maturity is you know all out here at year 10 because we're getting some money along the way when you calculate that weighted average it's going to be something less let's just assume again hypothetical we'll look at some real life examples in a minute let's assume that the maturity is 10 years but the duration is 8.5 years we'll just make that number up what does that tell us well that's what we need to know to understand how interest rates will affect an individual bond or a bond fund and here's how it works if rates go up for every one percent that rates go up in our hypothetical the bond will fall in value by an amount uh by a percentage equal to its duration so in this case eight point five percent if rates went up two percent this fund would fall twice that right what is that seventeen percent i hope i got my math right and of course the reverse is true if rates go down by one percent the value of this bond will go up by 8.5 so the duration is a really important thing concept to understand and the good news is when you're talking about a duration for an etf or mutual fund it's really easy to figure out what the duration is and i'll show you how to do it let's go back to the computer we're gonna run over to morningstar we're looking at the moment at the vanguard total bond market etf it's a fund that i've owned in the past ticker's bnd and it touched right here effective duration boom there it is and it's 6.68 right so again for this fund if rates on on on bonds similar to the bonds owned by this fund were to go up by 1 the value of this fund would go down by six point six eight percent or you know approximately we can see other durations this is a long-term bond fund from vanguard the duration is a lot higher right more than double and so that's why you may hear that the interest rate risk is really significant for longer maturing bonds and and this is sort of the in part the math behind that the duration is longer and conceptually i think it's easy to understand if you wanted to sell your two percent bond and uh the prevailing rates were four percent you're trying to convince someone to buy it you know you're gonna have to sell a discount well uh one question that might come up is well how long will the buyer get stuck with this two percent bond when current rates are four percent you know how how long am i going to have to endure you know this lousy yield well if if the answer is 30 days and yes there are bonds that mature in 30 days well that's not very long okay i don't need i don't need a huge discount just just you know lasts for 30 days with this difference on the other hand if it's a hundred years and yes there are century bonds that mature in 100 years believe it or not okay that's a long time now of course there's a lot that goes into valuing a bond that lasts 100 years but you get the concept the longer the duration uh the longer you're sort of stuck with that lower interest rate the more you're going to want to discount that bond before you're willing to buy it so that's sort of the basic concept behind it and as we see here you can easily find the duration of any bond etf or mutual fund right here in morningstar uh very very easy uh to figure out now this raises another uh question so if interest rates go up uh and the value of a bond goes down what if i own a bond and i just don't sell it i mean okay the value of the bond has gone down um you know but but what do i care i'm not selling it and can't the same thing happen with the mutual fund or an etf and this is where it's important to understand the difference between a bond and a bond fund let me go back to the digital whiteboard we're going to clear it if you think about a bond again we'll use 10 years and we'll assume a duration of 8.5 years again making that number up and we're right here we buy the bond it's a thousand dollars sorry for my poor handwriting um one thing to keep in mind is that these numbers change over time right so after a year it's no longer 10 years until maturity now it's nine and the duration is whatever we'll just assume 7.5 it doesn't go down you know year by year it changes a little bit over time but we'll just assume for a moment the point is as a bond matures right and we move closer to that 10-year mark the maturity goes down and the duration goes down and so what what that means is over time the interest rate risk of a bond also goes down and so you imagine if we're right here and interest rates plunge and our bonds only worth 950 dollars well just hold on to it i mean because you know again if we can if we can last all the way to year 10 we'll still get our thousand dollars back and we haven't really lost any money uh that's how an individual bond works now there are some things to understand about that which we'll get to in a minute but let's compare that to a bond fund we're going to go back to vanguards how many bonds does the vanguard total bond market fund actually own well we can figure that out the number may surprise you here we go bond holdings 18 481 bonds i mean they are busy over at vanguard can you imagine managing that portfolio i'm guessing they use computers anyway they are dealing with a lot of bonds and unlike an individual bond that you and i might own vanguard isn't just holding these bonds until they all mature and then shutting down the fund they're constantly buying and selling bonds so that they can maintain an average uh duration and maturity in line with the goals of the fund in this case given the maturity of eight and a half years and the duration of 6.68 i would call this an intermediate term bond fund there's short term bond funds intermediate term and long term this i think would fall into the intermediate term category and so they're constantly buying and selling bonds to maintain some range of maturity and duration and if interest rates go up well they still have to do that so they're still selling bonds and taking losses and at first that may seem like a really bad idea why why lock in the losses just maybe we should just buy individual bonds well there's at least two reasons why individual bonds prop probably for most of us not a great idea the first first off it's a real pain to start trying to buy individual bonds um it just it's just as a practical matter for most folks it's just it's not going to work but the other thing is there's there is a silver lining when a when a fund sells a bond even at a loss and it's simply this interest rates are going up yes they're selling some of their bonds at losses but they're replacing them right what are they replacing them with well bonds that are now have that higher yield because remember interest rates are going up so if they're buying new issues they're getting uh bonds with a higher coupon rate if they're buying uh bonds in in the market because interest rates are going up they're going to get a deal such that the yield is going up on the fund overall now that an increased yield won't offset the losses that a bond fund incurs overnight it can take some time it can even take years how long it takes that sort of crossover point depends uh largely on what interest rates do but the duration of the fund but eventually you sort of earn your money back if you will through higher yields so yes you can buy individual bonds it's it's a real chore except for maybe i-bonds we'll talk about that in a minute but i really think for most of us and certainly for me etfs and mutual funds are the way to invest in bonds yes they can go down in value when interest rates go up how much they'll go down depends on their duration but over time they will make that back up with higher yields on the new bonds that they are are buying so i know sort of a lot to digest but i do wanted to point out that there is a difference between a bond and a bond fund um and uh two things i want to show you uh before we move on the first is this box they call it the style box they have these for stocks which you may have seen but they also have them obviously for bonds over at morningstar and what this tells us the the horizontal tells us the interest rate risk is it limited is it moderate or is it extensive so limited would basically be short-term bonds and i think i might have an example let's see yeah so this is a vanguard short-term bond fund and you can see the box that's colored is in the limited column and that makes sense we see the duration's only 2.79 years so that's limited we were looking at uh the the total bond market fund it's got moderate interest rate risk if we go to long-term bond fund it's extensive so that's what those three mean across the top down the side this references what we talked about earlier credit risk the risk of default and the way they look at it is what's the quality the credit quality of the bonds is it high is it sort of in the middle or is it low so in terms of safe bonds you want something in the high range and if we go to here we go this is um vanguard short-term inflation protected secure so these are tips issued by the u.s government so as you would expect credit is high what about bonds issued by corporations that kind of uh are below investment grade maybe have shaky financials well that would be a vanguard high yield corporate fund and you can see the credit quality is low so that's what those that's kind of how to read the style box now i want to show you one other thing before we move on and these are called bullet shares they're issued by invesco and now it's making me answer some questions i mentioned this just because it may be of interest to you remember i mentioned with an individual bond if interest rates go up you could just hold the bond if you want to to maturity and you get all your money back i still kind of view that as a loss because you're giving up opportunity right but that's how an individual bond works and as i mentioned with funds you know they're constantly buying and selling so if interest rates go up at least at least initially you're going to take a hit well are there are there funds that allow you to invest easily in hundreds if not thousands of bonds but actually work like an individual bond where they don't buy and sell and you just hold the fund until maturity and in maturity uh the fund basically shuts down and gives you your you know the last interest payments and the rest of your principal back and the answer is yep bullet shares and they have corporate bond funds i didn't mean to click on that let me go back they have high yield corporate bond and they have emerging market portfolios and they also have municipal bonds which we haven't talked about yet but we'll come back to that so i want to just mention bullet shares i i personally don't feel a need for that kind of product but i understand why it exists and it could be useful to some of you so i wanted uh to mention it there you go so having said all of that now let's talk about sort of the types of bonds and i'll start with actually municipal bonds since we just mentioned them a second ago there you sometimes hear them called munis they're issued by local governments they might fund i know bridges where you live or hospitals or or whatnot and um the big thing to understand about munis is that there's no federal income tax there may not be state income tax it depends uh vanguard has a muni bond fund i mean most of the big um uh mutual fund companies do and uh but they have because they don't have they have tax advantages the yields are are tend to be lower than other comparable bonds based on maturity and so the the real key there's really two things to know about municipal bonds one if you're going to own them you want to own them in a taxable account there's no point in owning a municipal bond in a in a retirement account and two they're basically best for people in the high tax brackets because you know the higher your tax bracket the bigger the advantage of of having not having to pay some taxes on it so those are municipal bonds there are of course treasuries u.s government issued bonds they they kind of break them down into treasury bills which are short-term under a year maturities and bonds which go up to 30 30 years you have treasuries you have mortgage-backed securities which just as the name suggests bonds that are backed by mortgages you have corporate bonds so these could be issued by apple or microsoft or you know foreign companies but you have corporate bonds part of the corporate bond you have are what are called high-yield corporate bonds and let me actually show you those we looked at them briefly this is uh here we go this is the vanguard high yield corporate bond fund high yield another name for that which you may have heard are junk bonds now junk bonds i i don't like it's kind of a cool name i don't like it because it suggests they're junk and they're not but high-yield bonds are issued to companies that are below investment grade so we can look at that here and let me make that a little bigger for you if i can here we go so basically anything below triple b would be considered below investment grade right b being higher is investment grade so for this high yield bond fund you can see the vast majority of the bonds are either double b or b there's some that are below b not a lot and there's actually a little bit that's a investment grade but the vast majority falls into this category and the thing to keep in mind uh is that uh you know there's a greater risk of default default now that's the bad thing that's the bad news the good news is yields tend to be higher right so i guess that's uh the good news and in fact we can just take a stroll through these funds briefly um and look at the different yields so this is a total bond market fund uh it's got a 12 month yield of 2 percent it was an intermediate term fund vanguard's long-term bond fund has a yield of 2.91 the corporate the high-yield corporate 4.3 you can see that right there 4.3 so in effect it's trying to compensate you for the additional risk of default or credit risk we can look at short-term inflation-protected securities and this yield ain't going to be pretty at least i'm not expecting it to be well 1.35 12-month yield the sec yield which is there's a formula over the the yield for the last 30 days they may even give an explanation if we click on this yeah based on a 30-day period ending on the last day of the previous month the purpose of the sec yield is so that you can compare one fund to another there's a a way that it has to be calculated and and that way you're comparing apples to apples and yes the sec yield on this short term tip is negative and if you think to yourself wait a minute what's that due to duration because you're supposed to get these interest payments along the way which makes duration shorter than maturity what happens when the yield is negative well at least according to morningstar yeah the duration and the maturity are the same i'm not sure that's technically correct but you get the idea and then we could go to just a regular short-term bond fund by the way here maturity and duration are not the same but this fund probably has a positive sec yield let's see yeah positive sec yield of 51 basis points and um 12 month yield of 148 basis points so um i know i'm throwing a lot at you i hope this is helpful what i want to do is talk about tips for a second and then we're going to finish up with to kind of taking everything we've learned and and i'm going to give you at least three approaches to the bond portion of a portfolio that i that i like so um remember we talk about interest rate risk obviously a big big risk and what causes interest rates to go up well certainly inflation right if we start to see inflation um it causes interest rates to go up for a number of reasons one the federal government the fed could raise rates to try to keep inflation in check and just investors you know if you if you believe inflation's going to go sky high you want more interest to to compensate for that higher inflation so we could see inflation go up who knows but there are a couple of types of bonds that rather than having a fixed interest rate which is kind of what we've been talking about so far they'll actually adjust the the uh the interest rate or the way interest rate is calculated based on inflation and the two i'm thinking of are i bonds and tips now i'm going to do a separate video just on i bonds and tips for today i want to focus on tips why because i bonds can't be purchased as part of a mutual fund you have to buy them direct for the government and you're basically limited to ten thousand dollars a year so when you're trying to do an asset allocation in a portfolio yeah you may own some eye bonds but it's kind of hard to to really use them effectively as part of a 60 40 or 80 20 or 90 10 portfolio so the idea of tips i want to talk conceptually is that if if inflation goes up there's an adjustment that gets made to tips they actually adjust the principal amount of the tip the the par value sort of rather than the interest rate itself but the mechanics don't matter if interest rates go up uh what you earn from the tip can go up to it can protect you from inflation the way to think about a tip is that it's just like a treasury but they've they've added an insurance policy now it's not literally an insurance policy but i think this conceptually is an easy way to understand it they said look we're going to give you this insurance policy so if inflation goes up you'll get more from this bond if you buy a treasury you get whatever the the rate is you're not going to get more but with tips you got this insurance policy and um you know you could get you get more when there's inflation of course as you know there's always a catch there's a cost uh to that insurance policy right the the through the yields on tips there's a cost that's why we saw just a moment ago the current yield on the on the particular tip fund we were looking at was negative right so you're paying for that that benefit nothing's free in life right there's no free lunch you're paying for that insur that inflation protection and the question becomes well will it pay off i mean is it work should i buy that insurance or not right well the short answer is no one really knows if inflation ends up being more than we expect we be in the market yeah you would have wanted the policy tips will pay off if it turns out to be lower than expected you've just wasted your money on an insurance policy and you'd have been better off with just a regular old u.s treasury bond now the question becomes okay well what should i do we're going to get to that in just a minute when i talk about the three approaches to bond investing before we do that i want to show you one more thing that you may you may find useful fred right this is an economic this is a basically a database it's from the st louis fed you can see that i think you can see that up here in the url and this is what's called the five-year break-even inflation rate and this is basically looking at the difference in yields between a five-year treasury and a five-year tips and actually if we scroll down here and i will try to make this a bit bigger for you but it says the break-even inflation rate represents a measure of expected inflation derived from five-year treasury and five-year tips basically and you can see it over time so right now they're expecting inflation and when i say that they i mean the market based on the buying and selling of tips and treasuries they're expecting inflation over the next five years to be uh as of july 16th 2.52 if we go down to the to the terrible you know beginning of covid when the entire global economy shut down no one could work you couldn't buy much you know people weren't spending look at that the the expected inflation uh rate the break-even inflation rate was just .14 now of course it it turns out uh that the market was wrong or at least so far they've been wrong but the market is never right it's always evolving and changing based on you know the best information that we have but this shows you the break-even point and right now it's at 2.52 all right so i hope this has been helpful i want to walk through what i think are just three sort of simple ways to think about bonds for an an asset allocation again whether it's 60 40 80 20 90 10 and i will tell you that my preference is to keep things simple i avoid high-yield corporate bonds and my reasoning is i'm looking for my bond fund to be the source of safety and security and you know solid i'm not looking to take risks in my bond fund i've got my stocks to do that for me thank you very much so that's my approach i don't i don't use high-yield corporate bonds i used to i don't anymore don't generally get into emerging market debt funds either for the same reason and generally i don't even bother with international bond funds i will tell you that i'm starting to look at those things a little more given the terrible yields that we have right now but frankly they're bad everywhere so that's just my approach so given that i'm going to show you three approaches to to your to your bonds we've looked at looked at some of them the first one something i did for many years is just uh you know the vanguard total bond market fund and if you're at fidelity or schwab or wherever they're going to have similar funds and it's just one fund and you're done that's your bond portfolio i think this is a perfectly reasonable approach it's an intermediate term bond fund i like that i'm i'm just too risk averse on in the bond portfolio to go with long-term bonds and that's hurt me at times long-term bonds have performed extremely well in recent years if we look at the portfolio though of this bond again we've looked at this the duration about 6.68 years so that's an intermediate term bond fund here's what i want to show you this is these are the types of bonds it owns about half of it is government bonds it's got about a quarter in uh corporate and securitize i'm guessing i think these are mortgage-backed securities pretty sure i'm sure some of you will correct me in the comments if i got that wrong but i'm guessing that's what that is and we can look at the the credit quality it's all basically with some minor minor exceptions uh investment grade bbb all the way up to aaa and um so you get you know you get a mix of corporate um government some mortgage back now the one thing you won't see in here are tips so if tips are important to you this this approach won't work uh i've got something else for you guys in a minute um but this i think is a perfectly good approach the second approach would be just a u.s government bond fund and so let me show you one and i just realized i don't have it up so we're just going to google it vanguard i will do enter intermediate term u.s government bond etf it could be an etf for mutual fund and here it is let's pull it up in morningstar vgit you could also do short term again it's a trade-off short term the interest rate risk isn't as much intermediate term there's a little more interest rate risk but you also have potential for more yield i tend right now i'm kind of split between short term and intermediate term normally i'm intermediate term it's just that yields are so low that i've drifted towards shorter term so you could do either but we'll look at this fund as our example and again it's all us government bond funds but i think that's perfectly fine it's got a duration of 5.4 you can see that there and yep 99.91 of the fund is in government bonds and a hundred percent in aaa the 0.02 maybe they've got some derivatives or something in there i don't know but the point is very secure bond fund so this is a second approach and i think it's certainly a reasonable approach the third approach would be to do a mix to take 50 of whatever your bond allocation is and put it in something like uh an intermediate term u.s treasury fund right and and put the other half in tips i would tend to match the duration so for example if i were going to do a vanguard intermediate term treasury fund i would be inclined to do a vanguard intermediate term tips if they have that let's see yeah here we go i'm gonna actually go over to morningstar if i can find it that's short term maybe they just well they haven't made a term i'll just look at it at vanguard let's see if we go to portfolio they'll tell us the duration yeah effective duration is five five point seven years and it is tips right yeah intermediate term no that's intermediate term treasury what if they had they may not have an immediate term tips fund well in any event you could do short term which would be i'll look that up and leave a note in the comments here's a short term fund the duration is is of course shorter but i would take half and put it in treasuries as the real point and the other half in tips and you might say what's the logic behind that i actually got this from david swenson we've talked about the swinson portfolio he unfortunately passed away recently but he ran the endowment at yale and in his sort of recommended portfolio that's exactly what he does half the bonds and treasuries half the bonds and tips and the idea is if inflation is higher than we expect tips will pay off if it's lower than expected the treasuries will pay off and since we don't really know which way it's going to come out what is cover our bases half of the bond fund and treasuries half of your bond allocation and tips so that's the swenson approach i followed that for for quite a while my only uh concern about that approach today is that man it's hard for me to stomach putting money in a negative in a in a fund with negative yields um even if it does give me that inflation protection i really have a hard time doing that but generally i think it's a certainly a good approach so there you go i know i kind of moved through this quickly there's certainly a lot more we could look at in bonds but i think this gives you at a high level what you need to know to begin investing the bond portion of of your your asset allocation you know with some understanding of how bonds work i've given you three approaches uh to how you might build the bond portion of your your investment portfolio certainly not uh the only three ways but i think they're pretty solid uh so if you have any questions leave them in the comments below uh i would love to help you out any way i can and of course if you have other approaches to the bond portion of your portfolio we'd love to hear that as well i know some of you are avoiding bonds completely i've already done a video on 100 stock allocation certainly if you're young and have many years to retirement a good approach yeah for us folks in or nearing retirement i'm not convinced 100 stocks make sense even though as if you've watched recent videos there are some studies that suggest that in any event hope this has been helpful uh leave comments i'll be happy to help you out anyway i can if you liked the video and you've made it this far do you mind giving it a thumbs up appreciate it hey until next time remember the best thing money can buy is financial freedom

Channel: Rob Berger

Views: 234,110

Keywords: what is a bond, what are bonds, bonds explained, bonds 101, fixed income, corporate bonds, investing in bonds, how to invest in bonds for beginners, municipal bonds, interest rate, government bonds, why invest in bonds, bonds explained for beginners, bond investing strategies, investing in bonds for beginners, how do bonds work, are bonds a good investment, how do bonds work simple, how do bonds work for dummies, investing in bonds 2021

Id: kPTdUZpBlj8

Length: 45min 0sec (2700 seconds)

Published: Sun Jul 18 2021