Mostly Voices [0:00]

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines.

Mostly Mary [0:16]

If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. A different drummer. And now, coming to you from dead center on your dial, welcome to Risk Parity Radio, where we explore alternatives and asset allocations for the do-it-yourself investor. Broadcasting to you now from the comfort of his easy chair, here is your host, Frank Vasquez.

Mostly Uncle Frank [0:37]

Thank you, Mary, and welcome to episode 14 of Risk Parity Radio. Now today on Risk Parity Radio, we are going to start discussing bonds as an investment. And to do that, we are going to use the money for the rest of us 10 questions to master successful investing that we've referred to before and I will put into the show notes. We'll go through these questions to cover all the aspects of bonds that may be relevant to risk parity investing and decide which ones might be the best for our portfolios. So let's get right into it. The first question of the 10 questions is What is it? What is a bond? Well, a bond is a fixed income instrument that represents a loan made by an investor to a borrower. A bond could be thought of as an IOU between the lender and the borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, sovereign governments, and others to finance projects and operations. Owners of bonds are debt holders or creditors of the issuer. Bond details include the end date when the principal of the loan is due to be paid to the bond owner, and usually includes terms for variable or fixed rate payments made by the borrower. So let's break this down a little bit into its components. The features of a bond are that it has a duration and an interest rate. Now that duration is how long the bond will be outstanding, and that's usually from one to 30 years for most bonds, and that is the duration of the bond. Now the interest rate is what the bond pays, and that could be a fixed interest rate, or it could be a variable interest rate, like Treasury and inflation protected securities have variable interest rates on them. and many other corporate bonds do as well. But that interest rate is in the documentation, and that is how much the bond will be paying. And the bond might pay quarterly, or it might pay annually or semi-annually. There are bonds that pay monthly, but they're fewer and farther between. And that is called the coupon, and it is paid on a regular basis. Now what else is important about the bonds from the definition that I read? What is important is who is issuing the bond. Now that bond could be issued by a foreign government or a domestic government. It could be issued by a locality or it could be issued by a private party like a corporation. Why is that important? Well, you'll see when we get to the upside and the downside, because that tells you what kind of risk is involved. And there is also a feature of bonds that we have to think about when we're talking about international bonds or bonds outside the United States. They may be issued in other countries' currencies. And one sovereign may also issue bonds in another country's currencies. So you will see bonds from Latin American countries frequently issued in dollars, for example, because there is not a lot of demand for bonds in Latin American currencies. People would prefer to be paid in dollars or Euros or Yen or some other reserve currency or reserve-like currency. and so oftentimes you'll see that situation. Now let's talk a little bit more about the types of bonds that you find in the bond universe, because there are many. And I'll be linking to a correlation analysis that also includes standard deviations and returns for a variety of bond funds that cover most of the universe of bonds that you might want to consider. And in that universe we have Treasury bonds issued by the US government. And there are three funds that we'll have representing those. One fund is a short-term Treasury bond fund. One fund is a intermediate Treasury bond fund. And the third is a long-term Treasury bond fund, and those are represented in our analysis as SHY for the short term, IEF for the medium term or intermediate term, and TLT for the long term. Now those are all issued by the US government. A second category of bonds are also issued by a government agency, and those are mortgage backed securities. And we have one fund to represent those, although you could have them in multiple durations. We just took one fund to represent the whole duration or all of the durations. They're usually fairly long term. And that fund is VMBs, the Vanguard Mortgage Backed Securities ETF. Now what other kind of US government bond funds will you find out there? You will typically find tips. These are the treasury inflation protected securities. And we have two funds that are matrixed to represent those, one for the shorter term and one for the longer term. So tip x, tip x will represent the short-term treasuries. I'm sorry, the short-term tips and ltpz will represent the long-term tips. Now let's go beyond Treasuries. Let's talk about corporate bonds. Now we have three bond funds that will represent corporate bonds and these are the highest grade corporate bonds and so they come in short, intermediate and long term just like the Treasuries do. For the short term corporate bond fund we're using IGSB. As an example, for the intermediate term corporate bond fund we are using IGI B, it's an iShares product. And for the long-term corporate bond fund we are using IGL B. And that gives us all three durations for corporate bonds. Now what other kinds of bonds are there? Well beyond those bonds, You also have something called high yield bonds or junk bonds. And these kind of bonds generally are lower quality. There is a risk of default in them because they're usually issued by corporations that don't have very good credit ratings. And the fund we have to represent those is called HYG, the iShares High Yield Corporate Bond Fund. And there's more. There are also municipal bond funds, and those are issued by localities and municipalities in the United States. What is typically advantageous about municipal bond funds is they have favorable tax treatment in many circumstances, both at the state and federal level. and we're using for to represent those a iShares National Muni Bond Fund called MUB. Now, what other kinds of bonds are there? We're not done yet. We have the international bond funds and we have divided those into two. We have international government bond funds, international treasuries is what they call. We're representing those with IGOV. That's the iShares International Treasury Bond Fund. and there are also corporate international bonds. And we're going to represent those with the fund IBND, which is the Spyder Bloomberg Barclays International Corporate Bond ETF. So you can see from this, and as we go through you'll learn more about the differences in these bonds, that the bond universe is actually much more varied than the stock universe. So if you're used to thinking about value stocks and growth stocks and small and large, you'll find that those are by and large all correlated. When you look in the bond universe, you'll find very different performances out of different types of bonds. The universe is much broader and much more deep and much more interesting, frankly. Now, most of you are probably familiar with total bond funds because that's usually the only thing somebody considers. They think that, well, I'll just buy this total bond fund and it'll cover the whole market. Total bond funds are actually misnamed. They do not cover the whole bond market like a stock market fund does. So the total bond fund that we have in our matrix is BND, the Vanguard Total Bond Market Fund. What is actually in that is not all the total market. What is actually in that is about 40% Treasury bond funds of all durations, about 30% corporate bond funds, high quality corporate bonds of all durations, and the rest mortgage backed securities. What's not included there is any international bond funds, any municipal bond funds, any high yield bond funds, or any tips. So you really need to look underneath the hood at whosoever total bond market fund you're looking at if that is what you're interested in. Because what we're going to find is that these total bond market funds probably don't suit our needs simply because they're just an amalgam of what whomever put the thing together thought was interesting or useful, which isn't necessarily what we want. Now we have also not discussed yet the possibility of buying individual bonds, which you can do in any of these circumstances. We are focused mostly on funds for asset allocation purposes. because it's simpler, but we will be talking a little bit more about that as we go on. Now to question two, are bonds investments, speculations, or gambles? This is an easy question to answer. Bonds are investments. The reason we categorize bonds as investments is they do produce an income, and you can see it right on the bond itself. They are the simplest kind of investment you can make. Question three. What is the upside of bonds? Now this question is actually more complicated than most people think. Most people think that the only upside to bonds is the interest rate that bonds pay. And that is the most obvious upside to bonds. A bond that pays 5% interest will be paying 5% interest, although you won't find too many of those in the world these days. But there is a second component or upside to bonds that is actually much more important when you're talking about certain kinds of bonds. And what is that? It is capital appreciation. Bonds can go up in value, a bond that you purchased for $100 can go up to 110, 120, or 130 in value in the future. Now why would that happen? Where you see this happen is when you see interest rates fluctuate, interest rates for the particular bond in question. It's not generic interest rates that matter, it matters what interest rates apply to the bond in question. So when does this apply? When do you see this? You see this happen with longer duration bonds, those long-term treasuries or long-term corporates or the intermediate term corporates or intermediate treasuries. You don't see much capital appreciation with short-term bonds. When you see this is when interest rates for that particular bond class drop. If interest rates go down a percentage, usually for a long-term bond with a duration of between 20 and 30 years, that bond will go up about 25% in value when you see that happen. We saw that happen earlier this year. It was actually going on since 2019. that interest rates were falling and so long duration bonds were increasing in value. And at the beginning of this year and through March, when interest rates fell considerably for treasury bonds in particular, those bonds went up. The long duration treasury bonds like TLT went up about 25 to 30% in capital appreciation. Why this is important is that for those kinds of bonds, the long duration bonds, that is the most relevant kind of upside you can have. The interest rate itself is relatively trivial for long duration bonds. What is important is the direction of interest rates and how they behave. Now, obviously, if interest rates go up, the value of your long-term bonds is going to go down. What this also tells you is that you can look at volatility and duration as correlated attributes. The longer duration a bond or bond fund is, the more volatile it will be. Short-term bonds are very stable. They don't move around very much. Long-term bonds can be very volatile. They can be as volatile as stocks. So if we go and look at the standard deviations in that correlation table that we're linking to, we can see how the volatility of these various types of bonds compares to each other and compares to the stock market because we've included VTI on the matrix for comparison purposes. And you will see that if you look at, we'll just look at the standard deviations for the dailies, which is representative of the monthlies and the annualized, which are also there. But you see the daily standard deviation for the stock market is around 1% for the total stock market fund. Now, a short-term bond fund like SHY for the Treasuries or IGSB for the corporates has a low standard deviation. The short-term Treasury bond has a standard deviation of 0.06% and the short-term corporate is 0.21%. and those are 5 to 20 times less than the total stock market. Now moving up the duration ladder, if we compare say the intermediate term treasuries and the intermediate term corporates, we see those come in with standard deviations of about 0.36% or 0.30% for treasuries and corporates respectively, what that tells you is that these are about as one-third volatile as the stock market. And then we go out to the longest duration and we see the long-term treasuries and the long-term corporates. And the long-term treasuries have a standard deviation, a daily standard deviation of 0.87%. and the long-term corporates have a standard deviation of 0.72%. And if we look at the long-term tips, they have a standard deviation of 0.91%. And so those are more comparable to stock market like volatility. They're still less than the stock market in terms of volatility, but they're up there in the same order of magnitude. And that gives you a good idea of how risky each one of these are in a vacuum. Now we'll see later how they work together to reduce risk, but that comes in question nine. Now let's move on to the downside of bonds. Well before I get there, I should say the other upside of bonds is you're supposed to get your money back in the end of the bond term. and generally you do, but for this downside we're going to talk about. The first downside is you have to be wary of the issuer itself. This is called counterparty risk. Can the person that issued the bonds actually make the interest payments and pay you back when it's time to pay you back? Now for governments that issue bonds in their own currency, That's pretty much an ironclad guarantee because they can print their own currency and pay you back in it. And in the United States, this is actually guaranteed by the 14th Amendment to the Constitution, believe it or not. Because in that amendment there was a question of whether union debt or Confederate debt would be paid. And what it says in that amendment is that the debts of the United States must be paid, that the debts of the Confederacy were not to be paid, which answered that question. That has been applied subsequently to indicate that the government must pay its debts in dollars, but that does not mean the dollar is necessarily tied to anything in particular. So the government can print money and pay off its debts. Now, that is not the case with a corporate bond issuer, because obviously a corporate bond issuer cannot print its own currency. And so you have a counterparty risk. And that is why you have various qualities of bonds. You have high quality corporate bonds issued by companies like Apple. And then you have low quality corporate bonds which go in that high yield or junk category. where there is some risk there that the corporation is not going to be able to make enough money to pay back its debts. And so that's why those kinds of bonds carry a higher interest rate because they are compensating for that counterparty risk. If you look at international bonds, international bonds are often issued in currencies other than the country's own currency. So if you have a country like Argentina issuing debt in dollars, you can bet that that carries a very high interest rate because there's a very high risk that that country will not be able to repay its debt in dollars. Now why would a country issue debt in a currency other than its own? Well, that's what people want on the open markets in the world. And so typically you'll find many, many countries issuing debt in dollars or euros, even though that's not their own currency, simply because they're going to be able to attract more buyers for that debt. But that is really the principal risk of a bond is the counterparty risk that the party on the other side will not be able to repay the debt. What is the other key downside to bonds? Well, if you have those long duration bonds we talked about, the downside risk is if interest rates for that particular bond go up, that bond is going to be worth less intrinsically, so it could go down in value. So if interest rates for long-term treasury bonds go up 1%, it is likely that that bond or that bond fund will decline in value of 1 times its duration, which will probably be 20 to 25%, depending on how long is left on the bond. So that is the other risk. And then there's the risk known as opportunity cost, but that really applies to any investment. that obviously if you are invested in bonds, you are not invested in something else that may or may not yield more. Now the downsides of bonds also lead us to a discussion of how interest rates are set for bonds, at least in an open market. Now treasury bonds and international bonds are not an open market because they're largely controlled by central banks. But the main principles still apply that the more credit worthy the issuer is, the lower the interest rate is likely to be. That's why the interest rate on treasury bonds is typically the lowest. Corporate bonds, it's a little more for the high quality ones. And then as you get out to the more speculative junk or high yield bonds, you'll see the highest interest rates there. Now there is also something called the yield curve you may have heard of. And on a yield curve, typically a longer duration bond will yield more than a shorter duration bond, at least in a normal economy. Now occasionally you see that flip, and a longer duration bond will start yielding less than a shorter duration bond. What that really is telling you is that the marketplace does not think that economy is likely to grow in the future and are discounting the future with the interest rate. Thinking that interest rates in the future are likely to sink because economic growth is slowing. But ordinarily longer duration bonds will yield more than shorter duration bonds. Which leads us to question five, who is on the other side of the trade in bonds? Well, you can buy them directly from issuers, so it could be a government, an agency, or a corporation. But typically you are buying bonds or funds in an open market. Now, the bond market worldwide is about $128 trillion. The bond market is about twice the size of the combined world stock markets. Two-thirds of that market and global bonds is in sovereign bonds or agency bonds or local municipality bonds. And one-third is corporate bonds. Now of the part that is sovereign and agency related bonds, that is divided about 75% Sovereign, that means treasury bonds, and 25% agency, municipality, and local. In the United States, the total bond market is somewhere between $32 and $40 trillion, and again it is about twice the size of the stock market. About two-thirds of that, about $22.4 trillion in 2020, are treasury bonds and agency bonds, and about 10. 2 trillion in 2020 are listed as corporate bonds. Now who is trading these things? Besides the issuers, there are a lot of institutional investors that are required to hold bonds or hold them simply because they are conservative when compared to equities. And so you'll see a lot of pension funds in this area. insurance companies, and others, other institutions, and then a much smaller group of individual investors, or what you would call the retail trade in bonds. What you should get from this is it's a very liquid market. It's very easy to buy and sell bonds, particularly these days when you can do it through funds. You can also buy them directly from the federal government through treasurydirect.gov, and there are a number of different bonds you can buy there, including some ones we haven't really discussed like I bonds, which are more of the savings bond vehicles. Now that takes us through our first five questions. We have five questions left, which we will address in part two of this episode next week. And those questions are number six, what is the investment vehicle? We'll talk about individual bonds and funds. Number seven, what does it take to be successful? Number eight, who is getting a cut? Number nine, how do bonds impact your portfolio, which is going to be a very interesting discussion. And number 10, should you invest in bonds? And which one? But we will be saving all of that for next week. In the next episode will be our portfolio review episode. which will come out on Sunday, and we'll be looking at the performance of the sample portfolios this week. Those portfolios are at www.riskparadioradio.com on the portfolios page. If you have any questions for me, please send them to frank@riskparadioradio.com. That's frank@riskparadyradio.com, or you can input them on the portfolios page. But this has been a long session, and now I see our signal is fading, and it's time for me to say goodbye. Thank you for tuning in to Risk Parity Radio. This is Frank Vasquez signing off.

Mostly Mary [28:29]

The Risk Parity Radio Show is hosted by Frank Vasquez. The content provided is for entertainment and informational purposes only, and does not constitute financial, investment, tax, or legal advice. advice. Please consult with your own advisors before taking any actions based on any information you have heard here, making sure to take into account your own personal circumstances.