Most people are going to end up with a bond fund of some kind. In today’s episode, I will share with you what is the role of bonds and whether you need them in your own investment portfolio.
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Hi, I’m Max Keeling and this is another episode of the Expat Wealth Blueprint show.
This is the podcast for expats in Asia that already have or aspire to have $2 to $20 million and are looking for simple approaches to managing their money to end up with the lifestyle they want. And I think there’s a real lack of credible information out there for these people, which can make you vulnerable to be taken advantage of by banks and financial advisers.
Today I’m going to be talking about bonds. And this is definitely an area where we see people being sold products they perhaps don’t need. Hopefully by taking you through some principles, this podcast is going to help educate you, give you some frameworks, give you some blueprints around some core principles you can use for your own finances. And hopefully, end up with a positive financial result, which should be getting you to the lifestyle you want.
Most people are going to end up with a bond fund of some kind. How do you go about doing that? And what’s its role and how does it work?
Before I get into all of that, if you are enjoying the show, please let me know. Mentally, I’ve kind of said I’m going to do this for 10 – 15 episodes. If people like it, I’ll continue doing it. If nobody is listening then I won’t. So either send me an email or leave a review would be even better. If there are reviews, it’s more likely to bump it up the listings and more people will listen to it and that would be really helpful.
So let’s get into bonds.
Bonds act as a stabiliser in your portfolio. Now if you need to take maximum risk or prepared to take maximum risk, then you might invest 100% in equities and therefore you don’t need bonds. But if you are 100% invested in equities, you’re going to capture, hopefully, 100% of the market return, which is what I talked about last week, but you’re also going to get the full amount of volatility.
Last year 2020, markets dropped about 30 – 35%. If you were fully capturing market turns, you would have seen your portfolio dropped by that amount. Now some people are fine with that, and they see it as a long-term investment, and they’re okay with it moving a lot. Other people, if they saw their portfolio dropped by 35%, might throw up. And so that is where bonds can come in.
So when you’re doing your plan and you’re working out what kind of returns you need, if you feel that you wouldn’t want to see your portfolios moving up and down as much, then you can add bonds in as a stabiliser. And we’re assuming that bonds are not going to move that much. That’s why it’s a stabiliser.
Let’s say, you have 50% in equities, 50% in bonds. And last year, stock market dropped by 30%. That would translate into your overall portfolio only dropping by 15% instead of 30%. So still a drop, but a lot less than 30%. So that’s really the core principle of using bonds or how we think about bonds when it comes to building a core portfolio.
Of course, you’re looking for simple approaches because that’s what this podcast is all about. If you’re looking for a blueprint, that’s how I would suggest you think about bonds.
So what is a bond?
Really, a bond is just a loan. It’s a loan of money to a company or a government for a particular period of time at an agreed interest rate. For example, you could loan the Singapore government $1 million for 5 years and they’re going to pay you 1% per year. Your risk is that in 5 years’ time, the Singapore government doesn’t exist anymore and can’t pay you back your money. That’s highly unlikely. And therefore, you’re going to get a lower interest rate because there’s lots of people that are prepared to lend money to the Singapore government. And like all investments, the more certainty there is in the outcome, the lower the return is you’re going to get. So they might only pay 1% per year.
Versus your long-lost cousins who you don’t know that well. They say they’re going to start a business. Can you lend them $1 million for 5 years? Your risk now is that if the business fails or your long-lost cousins disappear. Maybe you’re going to want to charge a higher interest rate just in case. You might want to charge 10% per year, let’s say. If we approach bonds with a loan mindset, then we can start to understand the risk profile of bonds a lot more.
The interest rate that gets paid out, that’s called a coupon. Straight away we could look at a bond and if it’s paying a high coupon rate then it’s probably a higher risk bond. And then we can look at the duration. How long is this for? Obviously the longer you’re going to lend people money, the more risk there is. I might be okay to lend money to the Singapore government for 5 years. Am I willing to lend them for 100 years, for example? We can get a lot about the risk profile by just understanding the basics. How long it is? And what’s the coupon?
Now, the way that we think about investing at Providend and the way that a lot of people do, who are in this space, is we should be trying to make our returns on the equity part of the portfolio and not the bonds. I don’t necessarily need to get a high return from the bond part because I’m maximising the equity piece. And if you have followed my tips from last week, you know how to build a world–class equity portfolio, following some basic principles.
So the bond bit, I don’t need it to make that much, but I do want it to be fairly stable because that’s meant to be the stabilising part of my portfolio. So I don’t want the volatility. I don’t want it to be moving up or down.
How would you actually go and do this?
Similar to equities, there’s an active approach and there’s a passive approach. An active approach is a fund manager, he’s going to pick which bonds he thinks he should buy for you and hopefully get higher return. A passive approach is I’m going to buy all the bonds that are available.
With my blueprint mindset on, similar to the equity piece, my view would be to only lend to the best governments in the world and the best companies in the world. And if I’m going to do that, then I can buy a passive tracker, which effectively will buy any bond that gets issued by any government of a particular investment grade. Same with companies. And I’m okay if I make less money on that bond because like last year, we see something come out of the blue like Covid, I just want that company to still be around like a government. I don’t want to be told that companies are going out of business, and I’ve lost that principal amount that I’ve lent them. I just wanted them to carry on paying me. So I’m happy to take on a lower return as long as it’s less volatile.
The same people that will issue index tracker funds for equities do index tracking funds for bonds. It’s going to be like your Vanguard, your iShares. Last week, I recommended if you want some specific recommendations, go and buy Andrew Hallam’s Millionaire Expat book. Should be mandatory reading as you get off the plane for all expats, I think. There’s an older version which is Global Expatriate’s Guide to Investing.
But as an example, there’s a Vanguard Total Bond Market ETF. And that has got all of the money is investing in companies or governments that are triple–B rated or above. 63% is lent to the U.S. government.
The average duration of the bonds that are in the fund is about 6.6 years. About 50% is in bonds that are 1 to 5 years. That means after that 1 to 5 years, you’re going to get the whole amount back. 30% is in 5 to 10 years. And the rest is in different tenors. We can see that’s mainly all in 1 to 10 years maturities. All of those bonds are going to mature in the next 1 to 5 years.
Over the last 10 years, that has returned about 3.4% per year. That’s not bad considering we’re going for very low–risk companies and governments, we’ve still made an average of 3.3% a year over 10 years. Marry that with our stock market tracker, that’s where we’re going to get pretty decent returns.
And how much is this going to cost me?
They are charging 0.035%. That’s amazing.
Similar to equities, if you go down the active route, you could easily be paying 1.5% – 2% for a bond fund. Bond funds make a lot less money, so that is a big cost. Whereas similar to trackers, you can be paying less than 50 basis points, less than 0.5%, it’s going to improve the odds of you making some money out of this.
Definitely go and understand a bit more about Vanguard and iShares. Go and look at things like good high–grade corporate bond funds or government bond funds. Look for the ones with low expense ratios. Look for the ones that are tracking the market. Buying them from all issuers. And accept that you’re going to get a lower return than some of the higher return bond funds that are out there.
If you’ve got a premier banking relationship of any kind with any bank, usually the salesperson, they call him the relationship manager, is going to try and sell you bonds. Banks love selling people bonds because it’s so attractive that they say, “Hey look, you’re going to get your money back and we’re going to lend this money and you’re going to get 5% or 6% per year return”. Versus investing in the stock market, it feels risky. It’s going up and down with the gyrations all the time. And it can be confusing about the news and how it relates to what’s going on in the market. Often the coupon might pay out quarterly, so you’re going to get a quarterly amount coming in.
But if we’re being offered bonds that are paying 5% or 6% a year at the moment, we’ve got to take that with a pinch of salt. We’ve got to think that the only way to be making a higher return is that we must be taking higher risk.
I like watching car programs at the moment where they take a vintage car or an old car of somebody’s and it looks really nice. It looks like it’s been polished up. And then they take it to the sandblasters to take away all the layers of paint so they can get it prepped for painting. And often what comes back is full of holes. It’s much more rusty than they thought. It’s got some bad repairs that have gone on in the past. I think a lot of bond funds are like that. When you actually start looking into the bond funds, you find it’s far riskier than you think.
Now all I love reading fact sheets. Most people don’t. There’s a number of us at Providend who love reading them. And I love digging into what is this thing actually invested in. Now, most people don’t do that. But what you’ll find is, the only way you can make high returns is you must be lending to higher risk companies or governments, and that’s how you’re making more return.
If you are attracted by those high yields and you want to give your friendly relationship manager lots of money and commissions, by all means, go and do that obviously. But I don’t think that should be part of your core portfolio. This should be a satellite portfolio. And if it does well, great. But don’t be surprised if the value of that portfolio drops 10%, 15%, 20%, 30% when the stock market drops as well. Whereas from a wealth blueprint point of view, we want the bonds to be the stable part of the portfolio. Therefore, I‘m happy to accept if that’s only going to make 2% or 3% a year.
I hoped that has helped in terms of thinking about simplifying your approach. Think about what level of return you’re looking for and how much of a movement in your portfolio you’re willing to stomach. Some people are going to be happy investing 100% in equities, and therefore you don’t need a bond fund. Other people, depending what stage of life you’re at, bonds could make up 60% to 80% of your portfolio.
Go with a low-cost approach. Go with a passive approach. Lend money to the best governments and companies in the world. And keep the more exotic higher return type bonds in a separate portfolio. Or don’t even bother with them at all, because you’ve set your equities bit up. That’s where you’re going to make your returns.
Hope you found that useful. Happy to take any questions or leave a review if you find this useful. Hopefully now, over the last few episodes, you’ve got a good idea of how to go and build a portfolio. Go and read the Millionaire Expat book from Andrew Hallam, that’ll give you a better idea of putting stuff together as well. And there’re a few other books that I will pull out over time to help you work out how to glue some of these pieces together.
But if you follow some of these principles that are time tested, this is not necessarily the Max Keeling way of investing, then go and read up a bit more about it. Start to understand how different bond funds work. And if you’ve been sold some bonds by a bank, then go and have a look into them. Go and delve into them a little bit more. And hopefully you can avoid making some of the mistakes that lots of other people have made.