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Economy , Finance , Investing

Boring Bonds, That Will Come Back to Bite

December 10, 2018
bond bite

If you were to ask the average investor where their wealth is held, they’d probably say something like, “Stocks, bonds, commodities, cash, and some real estate.”

That’s a perfect answer according to most financial advisors. It’s a great idea to spread your wealth across a variety of different asset classes to ensure that you aren’t over exposed to any one sector.

If we were to dig deeper, and ask the average investor to explain each of the five above investments, we’d get some pretty consistent answers… except for one of those investments…

Stocks – Well, that’s easy. Stocks are what make the news. They are what everyone talks about. They are easy to understand, because stocks represent a small ownership of a company. Do you like Apple products? Great! Buy some of Apple’s stock and you own a sliver of the company.

Commodities – Also easy to understand. Commodities are raw materials or agricultural goods that we can buy and sell. Coffee, sugar, gold, silver, and even rubber are all commodities that we consume on a daily basis for food, industrial uses, or entertainment purposes.

Cash – Cash is also easy to wrap your head around because you can imagine a stack of physical cash in your hands. Cash is held in order to have a way of buying something when there is a special opportunity. Of course, no one knows when a great opportunity will fall in their lap, so it’s a good idea to always have a reserve amount just in case.

Real estate – Just like commodities, real estate is one of the oldest holders of wealth and extremely easy to understand.

Bonds – Of all the investments out there, bonds are probably the most difficult to understand. That’s mostly because you cannot think of a bond like you think of other investments. When you ‘buy’ a bond, you aren’t actually buying something (like stocks, commodities, real estate, etc.). Instead, you are ‘buying’ a contract, which means you are loaning money that will be repaid to you over an allotted amount of time with some interest added to the original amount you loaned out.

Now, I am not going to attempt to explain bonds in depth, because, well, the bond market is extremely difficult to understand and trade. That’s why you’ll rarely hear people discussing the bond market at a cocktail party – because hardly anyone knows how it all works!

(My business partner Jay Kim does a great job of explaining bonds and their current status here.)

Even though I am not going to dive into how the bond market works, we can still look at one aspect of bonds that almost no one can get right: central banks.

Remember, bonds are essentially a loan. So, if you buy a government bond, you are loaning the government money, which they will pay you back over a predetermined amount of time. The interest rate that they will pay you depends on the environment of the global economy in addition to the amount of time you are loaning the amount of money out for.

If you loan money for a longer amount of time, you will typically get a higher interest rate. That’s because you are taking a larger risk by loaning money for a longer time, so you get rewarded with a higher interest rate.

The major risk with a bond is that your loan doesn’t get paid back. The only way your money won’t get paid back is if the borrower defaults on the loan, which then leads to bankruptcy.

Government bonds are considered the safest – especially US government bonds. That’s because the only way you wouldn’t get your money back is if the US government went bankrupt. And if the US government went bankrupt, we’d probably have some much larger problems going on.

However, there is one other big risk with bonds, and that’s inflation. This is the part that starts to get extremely confusing and is also an area that almost no one knows about.

To be clear, this is not something that no one understands. Instead, the way that bonds and inflation interact is extremely difficult to forecast, and in turn, trade effectively.

That means that there are very few people who know about what to do in an environment where inflation starts to effect bonds.

Imagine that you are loaning money to a company for 5% yield. That means you are earning 5% per year in yield. But what happens if inflation goes to 6%?

In real terms, that means that you would actually be losing 1% of your money every year. That’s because inflation is causing the loss of value in a currency that is higher than the actual yield you are getting paid with the bond.

As a bond investor, you must take into account the amount of money a bond is trading for, the yield that the bond is giving, the maturity date of the bond, the quality of the company/government that the bond is being issued by, the strength of the broader market, and the direction that you think the market is headed.

Then, there is the variable that almost no one can get right: The decisions of central banks.

In a nutshell, the job of a central bank is to create and execute monetary policy which will make an economy prosperous. In the United States, the central bank is called the Federal Reserve and is currently lead by Chairman Jerome Powell.

Now, here is the crazy part… The Chairman of the Federal Reserve is nominated by the US President and then confirmed by the US Senate. The federal government even sets the salaries of the Federal Reserve’s seven governors.

HOWEVER, the Federal Reserve is NOT part of the federal government.

So, what does this all mean? Without getting too far in the weeds, the Federal Reserve is an entity which can alter the state of monetary policy with the simple stroke of a pen.

The Federal Reserve can change interest rates over night, which can then create serious repercussions across the entire economy and especially the bond market.

That means, for bond traders, the most successful way to make money is to be a master at forecasting what the Federal Reserve will do.

Or in other words, whoever can forecast the numerous factors that goes into pricing bonds AND whoever can read the mind of the Federal Reserve will be the most successful. The list of people who can do that effectively, and more importantly consistently, is very short.

To throw a wrench into all of this, the bond market is starting to invert, which means that bond yields are going higher for shorter maturity bonds. Investors are getting paid more money for lending their money out for a shorter amount of time. (Again, read Jay’s article if your mind is getting tied into a knot.)

Whenever that happens in the market, the economy almost always goes into a decline.

Anyway… the bond market is certainly difficult to understand. But, when you throw a component like a central bank into the mix – which can make decisions at the drop of a hat – then you end up with an almost impossible market to master.

By the way, if the bond market sounds too confusing and the thought of a market decline makes you nervous, don’t worry. You don’t have to be a bond whiz, or even a stock market expert, to be a successful investor.

There are plenty of great investments out there that are very simple to understand, provide great returns, and protect your downside risk. Foreign real estate is one of those investments. It’s something we have invested in before and it’s something we’ll be investing in again – and we’ll be taking a trip to check out those opportunities this coming May.