Should I Invest in Bonds?

Tyler Gardner (0:00)

Hello, friends. This is Tyler Gardner welcoming you to another episode of Your Money Guide on the Side, where it is my job to simplify what seems complex, add nuance to what seems simple, and learn from and alongside some of the brightest minds in money, finance, and investing. So let's get started and get you one step closer to where you need to be. Today, we're talking about something that might ruffle a few feathers in the old finance world, and I get it. This is one of those sacred cows that I'd like to slowly watch pass away. That sounds terrible. But it's also just how I think about it. This episode will be dedicated to why I hate bonds, or more lovingly, why I don't love bonds. Now, don't get me wrong, bonds have their place, and I will get to what that place is, and why you'd be silly to dismiss such a beloved asset class based on some rambling ding-dongs' thoughts. They serve a function in portfolios, as most things do, and they're often seen as the conservative, steady anchor in a well-balanced investment strategy. They're also seen as safe, by many, a term associated with them that is anything but safe. Bluntly, bonds are overrated, especially when you consider three major factors, all of which we'll get to throughout this episode in more detail. Interest rate risk, inflation risk, and opportunity cost.

And by the end of this episode, my goal is for you to at least see slightly more clearly as to the true cost and potential lack of safety associated with bonds. First off, I never want to assume my audience is at step two when we need to take a moment to explore step one. A bond is essentially a loan you give to a government, a corporation, or some other entity. Think about it as you're loaning money to a friend. And now this friend can either be a very trusted friend who is good with paying back your debt, and you might ask for 3% interest on the loan because it's not that high risk of a loan to you. Or it's a friend who you should never have loan money to in the first place, but they needed it, as they usually do, and told you they're really good for it this time. For them, well, you might ask for a higher interest rate to account for the fact that they don't have a great credit rating as a friend. Either way, this friend promises to pay you back with interest over a set period of time. The problem with either situation is that no matter how trustworthy or untrustworthy the friend, that interest rate, the return you get for lending your money, is capped at the outset no matter what happens to the company or the government. Hence, a bond is classified as fixed income. This is unlike stocks or real estate, which can grow exponentially with unlimited upside. Our bond guy at my old firm once said it best. With bonds, the single best-case scenario is you get your money back with the interest that was promised. Unfortunately, this is where most people leave the conversation and believe that bonds are literally fixed income with interest. And this is where we need to up our educational initiative to make sure that you know that the best, the single best scenario, is getting paid back all of your money. The worst-case scenario is that you lose all your money. Yeah, that can happen with bonds. Now, back to our examples, there are safer bets than others. Lending money to the US government is backed by the full faith and credit of said US government. Insert whatever one-liner you want here about what that means to you. But if you lent that money to your friend who wasn't so trustworthy, well, they might not pay you the high interest rate you expected, and they might default altogether and you never get your money back. If you're interested in learning more about this, this is why there are grades that we have used to classify different bonds, investment grade, non-investment grade, and I would encourage you to do a deep dive at some point into not only the rating systems of bonds in the US and other countries, but also where that very rating system has been flipped on its head and has deceived investors, aka the subprime housing crisis, where big name lenders acknowledged that they were ranking debts way more casually, let's say casually, than they should have, mostly because they were too lazy to stop and look at what was happening and what was actually backing the assets. Now that we've established that the coolest thing about bonds is that you get paid back, cool, let's look at what's not so cool about bonds. Number one, interest rate risk, or the hidden danger of safe bonds. Bonds are often pitched as safe investments. You loan out $1,000 at 3%, you get $30 a year, and paid back the $1,000 at maturity. Well, yes and no. One of the things that people value about bonds isn't just that they're stable income, but that it's supposedly principal protection, meaning that at any point, if you invest in high-grade investment bonds, you could turn around and sell those bonds for what's called par value, meaning what you paid for them, usually in increments of $1,000. But, and this is a massive but, that is only if interest rates remain consistent from the time that you bought the bond in the first place. When interest rates rise, the price of your bond will fall. Why? Because newly issued bonds will now offer a higher return. Let's say, instead of 3%, they're now offering 4%.