What are the advantages of holding bonds?

We have seen in this post what bonds are. However have you asked yourself what are the advantages of holding bonds. We are going to have a look at the different uses of bonds for the average investor.

1. Safety investment

One of the most important uses of bonds for the average investor especially in this recession is to secure your portfolio. Investors who anticipates a bear market, turmoil in the stock market or a recession  might not want or have the courage to watch their portfolio’s value fluctuate widely. As a result in anticipation they will want to sell their investment and flee to the safest investment. Some will invest in treasury bonds, treasury bills, high quality corporate bond or money market mutual funds. After the events the investors can sell these safe assets and then reconstitute their portfolio. 

2. To maintain the value of the portfolio

The first use of bonds for the average investor is to maintain the value of the portfolio. Most bonds can be said to be quite safe especially if you invest in government bonds and investment grade corporate bonds. Because bonds are issued at a discount and then redeemed at face value the investor is certain that he will obtain more than he invested initially. Furthermore some bonds will pay coupons twice a year. So even if the return on bonds are small, the investor is assured to end up with more that he started with. If you invest in treasury inflation protected securities then your principal will be adjusted so that you will not be hurt by inflation. thus your return will always be greater than inflation.

3. Diversification

Diversification a strategy whereby you invest in a range of securities and in various sectors so that they will not be affected equally. If your portfolio is equally diversified it is possible that some of them will increase in value while while some of them will decrease in value thereby offsetting each other. Bonds are the best asset to hedge against stocks. As you the value of stocks increases and decreases while that of bonds will remain the same. Hence when the stock market is down the presence of bonds will reduces the loss of value of the portfolio. Now when the stock market is up the percentage of stocks in the portfolio increases as a result to keep the value of bonds in the portfolio constant you will have to rebalance. You will thus sell stocks to buy bonds. This will ensure that you lock the gain in stock market by buying bonds.

4. Fixed income generation

Some people, especially retirees need a regular source of income. Because bonds pay regular coupon every six months a portfolio that has a sufficient number of bonds in it will provide income to the retiree on a regular basis. Stocks on the other hand pay dividends but it is not compulsory for companies to pay dividends so an investors that have stocks in his portfolio is not certain of receiving dividends on a regular basis. However since on the long run the stock market rises then the investor is sure that the value of his stocks will increase with time.

As you can see it is very important to have a certain percentage of you money invested in bonds for the presence of bonds will help to stabilise your portfolio. 20 % for the aggressive investor up to 40 % for the prudent investor is an appropriate allocation. However make sure that your bonds are sufficiently diversified ranging from safe government bonds to slightly yieldy corporate bonds. If you are adventurous you can invest in municipal bonds.

What are treasury inflation protected securities(or tips)?

Treasury Inflation-Protected Securities (or TIPS) are bonds that are issued by governments. The advantage that you get with this security is that the principal of the bond is adjusted yearly with inflation.Thus the principal increases every year and its real value will remain the same. This is contrary to other bonds whose nominal value remain constant whereas their real value decreases.

Since the principal is adjusted yearly with inflation, its value will increase and as a result the coupon payment will increase. This bond is thus a good investment in times of high inflation. The value of your investment will keep its real value with time. This compares to the normal bonds whose principal and the coupon remain the same thus losing its real value with time.

However in case of deflation like in Japan, where inflation turns negative, the value of the principal and coupon decrease with time. In this case a normal bond would have maintain its nominal value but would have its real value increasing.

So investing in tips is just about deciding whether the future will bring deflation or inflation.

What are treasury notes?

Treasury notes are securities that are issued by governments in order to raise funds to finance deficits. It has a maturity that ranges from 2 to 10 years. Hence it is a security that is traded in the capital market. the capital market is the market in which securities that has a maturity of more than 2 years are traded. treasury bonds is also a security that is traded in the capital market.

The treasury notes are issued at a discount and at maturity the face value is paid to the holder of the notes. The holder of the notes is also entitles to a coupon which is like an an interest paid on a certificate of deposit. This coupon is paid according to a coupon rate which  is merely the percentage of the face value of the note that would be paid as the coupon.

The 10 year note is often used to have an indication of future inflationary expectation. It is often used in the bond spread which is the difference in yield between the 10 year note and the three month treasury bill. The three month maturity date is considered to be so close in the future that the inflation in three month will be close to the actual inflation. The 10 year maturity date however is sufficiently far in the future that the inflation at that time cannot be known. However investors will want to ensure that the yield on the ten year note is adjusted for inflation. Hence the difference between two will be the expected inflation in ten years. The difference in the two yield cannot include a  risk premium like the corporate or municipal bond yield because government treasuries are considered to be the safest of securities.

What are treasury bonds ?

A treasury bond is a government security that has a maturity that ranges from 10 years to 30 years. It is thus a security that is traded in the capital market.

Like the treasury note it is issued at a discount. It also pays a coupon every six months according to a coupon rate. This security is mostly held by institutions that have long term liabilities like pension funds, long term insurers, etc. 

What is a capital market?

The capital market is a market where securities that  that has a long-term maturity are traded. These include treasury notes, treasury bonds, normal and preferential stocks. Generally securities with a maturity of greater than 1 years are traded in it. As you can see all securities that are not traded in the money market are traded in the capital market. The name capital market also indicate that companies and government raise  capital in this market.

The capital market is divided into two different markets. Firstly the stock market also known as the equity market where normal and preferential stocks are traded. Secondly the bond  market also known as the debt market where notes and bonds are traded.

Hence we can see that when companies and government need short term financing they raise funds in the money market whereas if they want to raise fund over the long term they would do so in the capital market.

Government securities: Bills, notes and bonds

Government securities are debt instruments that are issued by central banks with the aim of raising funds to finance government deficits. They can also be issued as a result of monetary policy where they are used to drain liquid. Although government usually prefer to use longer maturity to finance deficits while central banks usually like short-term maturity securities in monetary policy.

Types of government securities

There are four main types of securities that government issues

1. Treasury bills 

2. Treasury notes

3. Treasury bonds

4. Treasury inflation protected securities (Tips)

These securities given the fact that they are issued by the government they are considered to be quite safe. However you should be aware that not all government securities are safe. Investors should remember examples such as Argentina defaulting on its bonds or Dubai trying to dodge  out of its obligations by asserting that legally the bonds are not issued by the government but by a separate entity control by the government.  

These government securities are also highly liquid. In fact government securities are  the most traded of all securities. This is because by law banks, insurers and other financial institutions are required to hold a certain percentage of safe assets on their balance sheets. Hence a lot of these institutions hold government securities to reduce risk in their portfolio.

The increased liquidity comes from the fact that these institutions needs to have access to their funds at short notice. However when they do not need their money they need to invest it in a safe asset that they can sell easily. Hence this add to the increased liquidity of the government securities.

These securities can be obtained from two ways. Either over the counter at central banks and with financial institutions or though a system of auction at which financial institutions bid for them. we have already seen this system in the post on treasury bills.

What is a repo/reverse repo?

A repo is a repurchase transaction and it is a security that is part of the money market.

So what is a repurchase transaction? A repurchase transaction is similar to a transaction that takes place in a pawn shop. The owner of a property goes to a pawn shop and exchange it for cash but he promises to come back later to buy the property at a higher price.

Now the same goes for a repo.

1. An institution that needs cash over a short period of time goes to lender with government securities such as government bonds, treasury bills or any other financial instruments that have a high rating as collateral.

2. The lender will lend money to the borrower in exchange for the collateral. The borrower also agrees to buy back the security at a higher price at a particular time.  The difference between the two price is the profit of the lender. The time of repurchase can be from one day to a few months.If the repo transaction is greater than a month it is called a term repo. Less than a month it will be a simple repo.

3. At the agreed time the borrower buy back the collateral at the agreed higher price.

4. In case of default of the borrower the lender keep the collateral.   

You can also have what is called a reverse repo. This is the opposite of a repo. In a reverse repo the the institution will buy a security and later agree to sell the security to the seller at a higher price.

Technically the two terms are used in different circumstances but put simply if the transactions is viewed from the borrower’s perspective where the borrower will repurchase the security later it is a repo but from the lender’s perspective the lender is forced to sell the security to the borrower then it is a reverse repo.

A typical case is when banks obtain funds from the central bank. the bank is considered to be doing a repo while the central bank is considered to be doing a reverse repo.

However it is mostly large institutions that deal in repos.

What are treasury bills?

Treasury bills is one type of instruments that is traded in the money market. 

A treasury bill is typically a bond that is issued by a central bank or by a government that has a maturity of less that one year. The treasury bill is sold without coupon payment. A coupon is a payment that is made every six month. It is paid as a percentage of the nominal price of the bond.Hence the treasury bill is sold at a discount and then the government will pay the face value at maturity.

These treasury bills are issued by governments in order to raise funds from the market. Because these bonds are issued by the government of a country it is therefore considered to be the safest asset and as a result would have the lowest return of all. Because of its safety it is used very often to calculate the bond spread of other bonds. The bond spread is simply the difference in return between the other bond and the return on a three month treasury bill. The greater the bond spread the riskier the bonds.

Treasury bills are also the most liquid and the most traded of all instruments. This is mainly because banks and other non-bank financial companies are required by law to hold them. For banks they may be used as collaterals in repo transactions with the central banks or in the interbank market to obtain funds. Because they are highly liquid these institutions hold them so that they can be readily converted to cash to settle obligations. Otherwise if they have excess funds they invest them in treasury bill in order to get a decent return. Short term insurers also hold a significant amount of treasury bills because they also need to have access to their fund on short notice.

These treasury bills are issued in two ways. They are either issued through auctions or over the counter. Banks and other institutions participate in weekly auctions. They state the price, the discount rate and the maturity that they want and the central banks will allocate the bills starting from the one offering the highest offered price. After they are issued in the primary market they can then be sold in the secondary market where you can buy them. However you can still buy them directly from the central bank.

As an investor you might obtain treasury bills at any institutions that have them in their portfolio and are prepared to sell them or over the counter at the central bank. But I would strongly advise investing in a money market fund if you want to gain exposure to the money market.

However since treasury bills are the safest of all investment it makes no sense investing a lot of money in them. At best you can invest 5 to 10 % in them in case you want to diversify your portfolio and decrease the riskiness of your portfolio. I would myself advise about 10% in a money market mutual fund, 10% in a bond mutual fund and the rest in other instruments such as gold, stocks, and so on.