Since we bought this blog, we have written some interesting posts about asset allocation for beginner investors. However, knowing what the difference is between fixed income and the stock market is hardly enough to know how to invest your hard earned money!
This is why we are taking a closer look at how to invest in fixed income asset classes today.
First Fixed Income to consider: Government Bonds and CDs
Government Bonds and certificates of deposit (CDs) are the safest investment products you can use to build your portfolio. However, they are also the least flexible. Picture a bond or CD as you are the banker and not the borrower:
The principle behind this type of investment vehicle is that you are lending an amount of money to either a Government (Country, state or city) or a bank. Since you want your money back, you are lending your money to them for a specific period of time (called the term). Then, you don’t want to lend money for free (no one does this anyways?), so you will do it at a fixed rate of interest (called the APR).
Why bonds and CDs are less flexible investments?
Now go back to your usual borrower’s mind for a second: how would you feel if the money you have borrowed could be called back (i.e. the lender asks to be reimbursed right away) at any moment? You would probably not feel comfortable borrowing money from this person. This is the same way it works when you are lending money to the government or a bank; they want to make sure they have enough time to pay you back.
This is why it is usually harder (read very hard in the case of CDs) to break your contract and cash out your money before the end of term. You will usually have to suffer a penalty which would result in less interest paid to you than the original contract. In this time of very low interest rates, you certainly don’t want to see it reduced to even less than that!
Good news; there is a secondary market for bonds
While I mentioned it was harder to get your money back from CDs before the term expires, it is because you are dealing alone with the bank. However, there is a market (similar to the stock market) to trade existing bonds. This is where you can buy or sell existing bonds on the market. However, this doesn’t mean that your money will be guaranteed if you sell your bond before it matures (i.e. at the end of the term).
Why money invested in bonds is not guaranteed before the end of term? Isn’t it the safest investment?
Picture this: 5 years ago, you bought a 15 year government bond paying 5% interest rate. Today, after the rate goes down, you still earn 5% interest while new bonds issued in 2010 are giving 3.5% (I’m not using real numbers by the way…). Why would you sell your bond that is giving 1.5% more than anything else on the market? Answer: at the same price you paid for your bond, there is no way that you will sell it unless you really need money.
Then picture this second situation: You buy a bond today paying 3.5% for 15 years. In 5 years from now, interest rate rises and the same bonds (i.e. the same issuer) will pay 5% for new issues on the market. How can you sell a 3.5% bonds when anybody can buy a new bond with the same level of security but giving 5%?
There is an answer to both situation and this answer is found on the bond market: When you buy new issue, you buy it at a price of $1,000 per bond (i.e. if you have $10,000 to invest, you will buy 10 bonds). If the interest rate goes up in the future, your bond is less attractive since it is paying a lower coupon (3.5% vs. 5%). Since you have the option to sell it anyway, investors on the market will pay you less than $1,000 for the same bond. Since at the end of the term they will get back $1,000, the difference between what they pay (let say $975) and what they get at the end of the term ($1,000) will compensate for the lower rate (3.5%) that they will be earning in the meantime.
The same math applies if you have a high paying bond and the rate goes down; your bond will be worth more than $1,000.
This is why your fixed income portfolio can go negative from one quarter to another while your capital is secured ;-). This often happens if you buy bond ETFs or mutual funds invested in bonds. So there is no reason to panic, you just have to hold your bonds long enough to get your capital (and your interest) back!