(PUB) Investing 2015

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4 • Fund Family Shareholder Association
a bull market means the onset of a bear
market, which no investor likes, right?
Over the past few months, headlines
have touted negative yields in bonds—
something that wasn’t supposed to hap-
pen—and the former bond king Bill
Gross has described German bonds as
the short-sale of a lifetime. (In other
words, one of the worst investments on
the planet, and something to be sold,
rather than bought.)
Investors have also been bombarded
with dire warnings that the bond market
is not as liquid as it once was—in other
words, that there won’t be someone to
sell your bonds to if everyone heads
for the exit at the same time, leaving
you holding the bag. Nouriel Roubini
has called it a “liquidity time bomb.”
A Bloomberg article from June 22
discussing bond mutual funds holding
more cash than usual ran with the head-
line “Major Money Manager Braces for
Bond-Market Collapse.”
It comes as no surprise to me that
amid all these headlines, investors have
been pulling money out of bond funds.
With the Federal Reserve on course
to raise the fed funds rate for the first
time in nearly a decade, possibly before
year-end, the headlines and pundits are
only going to be ringing the alarm bells
harder.
So what do you do? Is it time
to sell and avoid bonds completely?
Absolutely not.
Bonds are too important to building
a diversified portfolio to neglect. As
with stocks, to make money in bonds,
you need spend time in the market.
Timing the stock or bond market just
can’t be done. The dire warnings and
headline-grabbing sound bites are sim-
ply the work of Chicken Littles who
always see the sky falling. But to stick
with bonds when others are bailing out,
it helps to know what you own and how
it works.
Fortunately, it shouldn’t be that hard
to understand bonds. It just takes a little
effort.
Two years ago, Jeff and I were able
to beat then-Fed Chair Ben Bernanke
to the punch with a series of explana-
tory articles on bonds and bond funds.
During the period in which we pub-
lished that series, Bernanke announced
that the Fed would begin to wind down,
or taper, its bond purchasing program
(called quantitative easing) in the fall
of 2013. Bernanke’s comments sparked
the “taper tantrum” as investors sold
bonds, sending the yield on the 10-year
Treasury from 1.66% to just over 3%
by year’s end. While I didn’t foresee
bond investors reacting so violently to
Bernanke’s comments, it wasn’t entire-
ly due to luck that our bond series coin-
cided with the shift in Fed policy—it
was a move the Fed had signaled for
some time. Today, with the Fed indicat-
ing a new shift in policy could come as
soon as September, it’s the perfect time
to revisit the bond markets to under-
stand just why this is absolutely not a
sell signal.
Once again, we’ve got a lot to say
on this topic, so we’re going to split the
coverage into four parts over the next
few months. This month, we will cover
bond basics to set the stage for a more
complex conversation.
Next month, we’ll expand on bond
risks and discuss some of the trade-offs
you should consider when selecting
bond funds. Finally, Jeff and I will fol-
low up with greater detail on specific
Vanguard bond funds.
The upcoming shift in Fed policy
may cause a few bumps in the bond
market, as happened two years ago,
but that isn’t cause to abandon bonds
and your long-term investment plan.
These articles are not a call to do that,
either, but rather a means to prepare for
a new bond market with knowledge.
Forewarned is forearmed.
Let’s start at the beginning.
Cracking the Code
A bond is, at its core, a loan. When
you buy a bond, you are lending money
to someone else (usually a company or
a government entity). The bond is the
contract that states who you are lend-
ing the money to, how much you are
lending, what interest rate the borrower
is paying you for the privilege of using
your money and, finally, when the
money you lent will be repaid.
Flip it around for a moment and
think about it as if you were the bor-
rower. When you want to purchase
something (say, a house or car) but
don’t have the cash, you go to a bank
for a loan. The bank lends you the cash
for the purchase, but you agree to pay
that money back (plus interest) over an
agreed-upon period. You don’t issue a
bond per se, but you do sign a contract,
or loan agreement. In some cases, your
payments are made up of both interest
and principal; in others, you pay inter-
est only until there’s a “balloon” pay-
ment, when you pay back the principal
of the loan. The latter scenario is pretty
much how bonds work.
When you buy a bond, the roles are
reversed: You are acting like a bank,
and the company or government selling
the bond is coming to you for a loan.
While this simple story is often compli-
cated by bond market lingo, that’s one
code that you and I can crack.
When an issuer, like a corporation
or government, wants to borrow money,
the parlance is that they “come to the
market” with a “new issue.” What they
are doing is asking to borrow a certain
amount of money (the principal or face
value) under terms including, among
other things, the coupon (or interest
rate) and the maturity date.
Bonds typically have three main
components that you’ll want to focus
on: the issuer, the coupon and the
maturity date. Translating those terms
to plain English: The issuer is the entity
borrowing the money. The coupon is
the interest rate, or how much the issuer
will pay you while using your money.
(It’s typically paid out semiannually.)
Finally, the maturity date tells you
when the money that you lent out will
be repaid to you.
Of course, there’s a fourth com-
ponent, though it’s not often used to
describe a bond, and that’s principal.
The principal (or face value) is the
amount to be repaid at maturity and on
which the issuer pays interest. This may
or may not be the same amount that you
actually paid for the bond. We’ll get to
that in a minute.
That’s the bond basics. It’s when we
start moving into bond pricing, yields
BONDS FROM PAGE 1 >