Bonds? Let’s face it, most private investors shun them. Just the mention of the word conjures up images of complicated maths and endless jargon. I mean, it’s much more exciting to be involved with the next big AI stock isn’t it?
Investing in bonds isn’t for everyone. But that doesn’t mean investors shouldn’t have a basic understanding of how they work.
Stocks vs bonds
Boiled down to its basic constituents, if I buy shares in a publicly traded company then I become a part owner. On the other hand, a bond is a debt instrument, which is used to help raise capital. They are most often issued by governments and companies.
A bond is composed of two elements. A promise to pay back the initial amount in full when the bond matures and a fixed or variable interest payment, known as a coupon.
So far it sounds easy. But it doesn’t really explain why I should care about bonds if I only own stocks.
Importance of bonds
Bonds issued by central governments like the US Treasury and the Bank of England are always issued with a fixed coupon. Recently, the price of a 10-year bond (referred to as Treasuries in the US and Gilts in the UK) has been declining as the yield on the coupon has risen.
A number of factors have driven this decline, but one key reason is the realisation by investors that interest rates are likely to stay elevated for longer than expected. With inflation far from tamed, an issuer needs to offer a higher yield to entice buyers.
Higher yields on bonds matter to the economy. Gilt yields play a critical role in determining borrowing costs across the economy, including mortgage rates and corporate debt. They’re the lynchpin of the financial system.
One instance highlighting this point is the run on a number of US and European banks earlier this year.
When depositors withdrew deposits en masse, the likes of Silicon Valley Bank were forced to liquidate Treasury holdings, to raise cash. But because prices were falling, the value of those assets ended up being way below what it would have received if it had held them to maturity. The result? A gaping hole in the balance sheet.
Influence on my stock-picking
The recent sharp rise in yields has meant that bond investors are facing a third straight year of negative returns. This fact is unprecedented.
For the time being I am avoding buying any more shares in banks and insurance companies. This is partly because of their large exposure to bonds on their balance sheet. I don’t see mega-cap tech stocks such as Apple and Microsoft as safe havens, either. Valuations there are too frothy.
I remain firmly of the view that we haven’t seen the end of the inflation narrative. That is why I really like commodities businesses.
If a recession does ensue, central banks will undoubtedly print more money and lower interest rates. But they can’t print energy, gold or silver. These commodities remain in short supply. Surging profits from the likes of BP and Shell are testament to that.
And as for gold, it has thousands of years of history as the one truly scarce safe-haven monetary asset. A superior alternative to any bond today, in my opinion.
