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Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: Alright, Shani. So we're going to go for high energy today. I'm a little tired from Body Pump.

Jayamanne: I'm fine.

LaMonica: Yeah, no, you are fine. Do you want to talk about how you abandoned me there today?

Jayamanne: Well, you left early because you had some errands to run and I was supposed to meet you there but it started pelting with rain and I just wasn't going to go through that. So...

LaMonica: Yeah, well, you missed quite a class. I got reprimanded for doing one of the exercises wrong.

Jayamanne: Okay, tell me about it. What were you doing wrong?

LaMonica: There was some sort of weird thing where it was a lunge and you had to do something with the weight and I was doing it on the wrong side. I think she's concerned I was going to fall over. Probably just my lack of balance in general.

Jayamanne: But you survived.

LaMonica: I did. I did. I don't have to go again until tomorrow.

Jayamanne: Well, there you go.

LaMonica: Which is good news. Alright, we just had our conference.

Jayamanne: We did, yeah.

LaMonica: And just before we get into the topic that we're going to talk about today, I think both of us want to say this, but I'll say it first that it was really nice to meet some listeners at the conference and have a chance to talk to them.

Jayamanne: It was really nice. It was actually, I thought, the best part of the conference by far.

LaMonica: Yeah.

Jayamanne: And I did the agenda.

LaMonica: Exactly, exactly. But attendees got to do more than just meet us. They also got to hear everybody and literally it was almost every speaker say that bonds are back.

Jayamanne: And some listeners may think that if bonds are back, where did they go?

LaMonica: Yeah, no, that's a really good question, Shani. And we'll of course get to that but there's also a lot of confusion about bonds in general. So we wanted to go through some basics. So why don't you get us started since you have so much energy since you did not go to Body Pump today?

Jayamanne: Well, a key part of the return that investor earns on a bond comes from interest payments that are made.

LaMonica: In fact, if you buy an individual bond, if you hold it to maturity and the issuer of course does not default, that is the only place you'll get a return. So if you buy a 10-year bond paying an interest rate of 3%, you wait 10 years. Guess what annual return you get, Shani?

Jayamanne: I'm guessing it's 3%.

LaMonica: That is correct, exactly.

Jayamanne: But of course an investor could sell that bond somewhere along the way if they don't want to wait 10 years. And the price that the bond is sold at will then have an influence on the return that they receive. Same thing if you buy a bond sometime after it's issued. The price you pay for that bond will then influence your return.

LaMonica: And there are lots of things that would impact those prices but the primary thing is a difference between the coupon rate on the bond in current interest rates.

Jayamanne: And this makes sense. If you had a bond that was issued when interest rates were 3% and you tried to sell it when interest rates were 5%, nobody would want to buy it. Why would somebody buy an old bond at par value that is paying 3% when they could buy a newly issued bond paying 5%?

LaMonica: Yeah, and of course the answer to that question is of course you wouldn't buy it at par. You would want a discount so that the interest rate you received was equal to the current interest rate. That is why bond prices fall when interest rates rise. It also means that bond prices would go up if interest rates go down.

Jayamanne: And there are some other factors involved as well. Investor opinions could change about the credit worthiness of the issuer. Perhaps when the bond was issued everyone thought that there was little doubt the issuer wouldn't default. Maybe that opinion would change. If investors think there is more risk of not getting paid back, they would demand a higher interest rate to compensate them for that risk.

LaMonica: So in that case the price of the bond would also fall, which would raise the interest rate that the new investors would get from buying that bond.

Jayamanne: So that is bonds 101. There are of course lots of other factors that can impact prices but at a high level they are the current level of interest rates compared to the coupon payments on the bonds and the assessment of the credit worthiness of the issuer.

LaMonica: And this gets back to the notion that bonds are back. Since the interest rate is a large driver of the return received by investors, the actual interest rate matters. And interest rates on newly issued bonds have gone up significantly. And yes, that does make them more attractive.

Jayamanne: So rates have gone up a lot. Let's take a 10-year U.S. Treasury bond. In 2020, the average yield was 0.89% and that isn't very much. Currently a U.S. Treasury bond yields 4.7%. That is a lot higher and a lot more attractive for investors.

LaMonica: And so as we said at the conference, we heard from so many investment professionals touting bonds that of course a lot of the conference attendees started asking questions like how they can access bonds. And this is where many investors are turning to one of the most popular investment vehicles, the ETF, Shani.

Jayamanne: And that's because it's very difficult for an individual investor to buy an individual bond. So the option that many investors are left with is a fund or ETF, either an actively managed one or a passively managed one.

LaMonica: And this is also where we have to talk about some caveats with using those investment vehicles to access bonds.

Jayamanne: An ETF or a fund is simply a basket of securities. And this has a lot of advantages because it does allow investors to instantly diversify.

LaMonica: But some would argue, and by some I mean me, that while this is a fantastic way to access shares, there are some complicating factors that make them challenging for bonds. And it doesn't mean that there's anything wrong with bond funds or ETFs. But I think that many investors don't understand these complicating factors and that is a problem.

Jayamanne: Yes, it is. Because one of the biggest issues any investor can face is not understanding what they're buying.

LaMonica: That's right, Shani. So let's think a little bit about how a portfolio of bonds would work. That means that there are some bonds that were purchased a while ago and of course some newly issued bonds.

Jayamanne: And when we have had such a dramatic rise in interest rates, that means that longer-term bond ETFs and funds, so those that buy longer-term bonds, there were some bonds that are in these portfolios that were purchased a couple of years ago and some that were purchased recently.

LaMonica: All right. We're going to use an actual example, Shani. So, the Vanguard Global Aggregate Bond ETF with the ticker symbol VBND tracks an index that invests in investment-grade bonds. So that is bond issuers that have high credit worthiness with an average maturity of 8.8 years.

Jayamanne: So it's not a short-term bond fund.

LaMonica: It is not. And I took a look at the top 10 holdings and want to use that to illustrate how during a rising interest rate environment, a bond portfolio will hold some bonds issued when interest rates are lower and some, of course, when they are higher. So for instance, within the top 10 holdings is a United States Treasury note that was issued with a 1.25% coupon and there is a French bond that was issued with a coupon of 0.75%.

Jayamanne: And these rates are reflective of the prevailing interest rate at the time. Rates have risen significantly since then and this is a very issue that Mark spoke about. You may hear an investment professional say bonds are back and look at the current rates and think that it's a pretty good idea. You might rush out to buy an ETF and not get what you think you're getting.

LaMonica: For instance, you might look at rates of 4.70% and think that is what you'll be getting as a return. The problem is that an ETF tracking a portfolio of bonds has no maturity date because they're constantly buying those new bonds. So there is no time that you get your money back. You have to sell the ETF and the ETF price will be governed by changes in interest rates.

Jayamanne: For instance, if you bought the portfolio back in 2020, you did not receive even the low interest rates that the bonds were issued at during the time. Because as we talked about earlier in the podcast, the price of the bonds will fall as interest rates go up.

LaMonica: So if you bought this Vanguard bond ETF on the 1st of January 2020, you would have lost 26% of your money and that is the impact of the increases in interest rates.

Jayamanne: And many people buy bonds because they think that they are safe. And that is true if you buy an individual bond. As long as the borrower doesn't default, you will get the money back at maturity and earn a return, not necessarily if you buy an ETF.

LaMonica: Now, investing involves risk. That is why we get returns. But we want investors to be aware of those risks.

Jayamanne: But while these bond ETFs have lost money during this unprecedented rise in interest rates, the real question is what is the return outlook going forward for bonds?

LaMonica: So we need a quick lesson. We already had our bonds 101 lesson, Shani. I had a lesson how to do that weird lunge thing while trying to lift some weight up. But now we're going to do a quick lesson on interest rates. So we of course hear all about central banks raising interest rates. Central banker stands up after a regularly scheduled meeting and announces if rates have gone up or down or stayed the same.

Jayamanne: And while central banks have a huge influence on interest rates, they don't have complete control. The RBA has an official cash rate. The U.S. Federal Reserve has a Fed funds rate. But the ultimate interest rate on a bond is set by investors. What rate that they're actually willing to buy a bond at?

LaMonica: And we can turn back to the U.S. now for an example of how investors get a say in interest rates. The last time the Federal Reserve raised interest rates, so that's going up to the podium and making the announcement. Well, that was in July. Since then, we've seen a spike in rates and we can use 10-year treasuries as an example. In the last month alone, the 10-year rate has gone up from roughly 4.3% to 4.7%. And that is a lot.

Jayamanne: And there are all sorts of reasons for this. Let's go through a couple. Supply and demand plays a role and in a heavily indebted world, there is all sorts of supply. And at the end of July, investors were a bit surprised when the U.S. Treasury announced that they would issue U.S. $1 trillion worth of debt in the third quarter alone.

LaMonica: Which is shocking, right? Don't you think, Shani, $1 trillion?

Jayamanne: That's a lot of money.

LaMonica: It is.

Jayamanne: That's a lot of zeros.

LaMonica: Especially because it's in one quarter, but anyway. Another factor, inflation and the expectations for inflation matter as well. That is because bonds are a terrible investment during periods of inflation. That is because most bonds are fixed rate. So if an investor locks herself into a return of 5% a year and inflation goes up, the real return goes down. So if investors think inflation will be higher, they will demand higher interest rates. And as we probably are all aware, inflation is proving to be very sticky.

Jayamanne: And these are all factors that investors will have to weigh to determine where bond prices are headed. How about your personal view, Mark? Would you buy bonds?

LaMonica: Well, guess how many bonds I own right now, Shani?

Jayamanne: I would say zero.

LaMonica: Yes, exactly. Zero and I would say that despite everybody saying all these bonds are back declarations at our conference, I have no intention of purchasing them.

Jayamanne: Okay, so do you disagree with all the speakers that I chose out at the conference?

LaMonica: Wow.So you're making this personal. Well, I don't actually disagree. But when I decide what goes into my portfolio, it is based on how that investment aligns with my personal goals. And bonds just don't match my goals or investment strategy. My strategy is to create a sustainable and growing stream of income from my portfolio. So the immediate issue is that bond income does not grow over the life of the bond. The only way to get higher interest payments on buying a bond, when buying a bond ETF, is to have interest rates go up so that the portfolio buys more higher yielding bonds. But the problem with that is that if interest rates go up, the ETF also falls in price.

Jayamanne: Well, one reason that investors buy bonds is to lower the volatility of a portfolio. Because bonds, despite the fall in the last couple of years, are less volatile than shares. So what do you think about that as a motivation?

LaMonica: Well, I mean, obviously, I agree that adding bonds lowers the volatility of a portfolio. But to me, I look for an asset that has no volatility, that can also do that. And that is cash.

Jayamanne: So this question was actually asked during the conference. Why invest in bonds when term deposit rates are very competitive compared to bonds? And the answer was given that there was reinvestment risk of a term deposit and it's high, which isn't a problem with bonds. So what's your view on that?

LaMonica: Okay, well, first let's explain what reinvestment risk means. If you buy a 10-year bond, you are locking in the current high interest rate for 10 years. So you won't face any of that reinvestment risk for 10 years until it matures. But if I put my money into a short-term term deposit, I have to accept whatever rates are available when that term deposit matures. Perhaps they have gone down and I have to accept lower returns.

Jayamanne: So is this a risk that you feel comfortable taking?

LaMonica: It is, Shani. And there's two reasons, actually. So the first is that the problem with this view of reinvestment risk is that it wouldn't apply if I buy an ETF. With an ETF, you aren't locking in anything. No return is locked in. Of course, if rates go down, the price of that ETF will go up in value. My cash will not. But it means I can't lock in rates right now and just say, hey, whatever happens, at least I will get that. If interest rates go up, the ETF will go down. I will lose money, which I can't from a term deposit. And this brings me to my second reason, Shani. I just don't think rates are going to go down significantly. And I think inflation will be sticky. So I'm not anticipating any huge payoff from the bond ETF going up in price.

Jayamanne: And cash obviously doesn't do well in an inflationary environment. It loses purchasing power. But if inflation goes down and bond yields and bond prices go up, that will very likely be positive for the stock market. If it stays stubbornly high, history suggests that shares won't do great, but will perform better than bonds. In the 1970s, Australian bonds had negative real returns over the course of the decade.

LaMonica: Exactly, Shani. So I'm content to keep a heavy weighting to equities despite their volatility because despite what you keep saying, I'm still a long-term investor, and then I can mute that volatility by using cash.

Jayamanne: So we hope that this provided some perspective on bonds.

LaMonica: Do you think people are interested in bonds? Do you think anyone's still listening?

Jayamanne: We had a lot of questions on bonds at the conference.

LaMonica: We did have a lot of questions. That's because literally every single person got up there and just talked about how amazing they are. So we hope you're still listening. We hope you enjoyed this episode on bonds. And we also hope that you leave us a rating and a comment in your podcast app. Thanks very much for listening.

 

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)