An Introduction to Bonds

A Look at the Markets: Vanguard EUR Corporate Bond

Bonds have had a positive year in 2024, thanks to the reduction in interest rates.

However, a closer look at the 3-year chart reveals a stark contrast. Interest rates surged during 2022 and 2023, leading to a decline in the value of bonds.

The chart illustrates a decline of approximately 15%. Investors who have held their investments for this period are almost back to breakeven.

An Introduction to Bonds - Understanding Fixed-Income Investments

What are Bonds?

Bonds are loans that investors make to governments or corporations. When you purchase a bond, you're lending money in exchange for regular interest payments (known as coupons) and the return of the principal amount at a specified future date (known as the maturity date).

Key characteristics of bonds include:

• Fixed interest rates (coupons)

• Predetermined maturity date

• Generally considered lower risk compared to stocks

• Provide a steady stream of income for investors

What is a Coupon?

In the world of bonds, the "coupon" represents the annual interest rate paid by a bond issuer to the bondholder. For instance, a bond with a 5% coupon rate means that for every €1,000 of bond value, the investor receives €50 in annual interest payments.

Key Coupon Characteristics:

• Fixed-rate determined at bond issuance

• Typically paid semi-annually

• Calculated as a percentage of the bond's face value

• Provides predictable income stream for investors

Why You Should Consider Bonds in Your Portfolio

Bonds play a role in investment strategies for several important reasons:

1. Portfolio Diversification: Bonds help balance investment risk by providing (possible) stability when stock markets experience volatility. They typically (but not always) move differently from stocks, which can help protect your overall investment value.

2. Steady Income Generation: Unlike stocks, bonds provide predictable interest payments, making them attractive for investors seeking regular cash flow, especially those nearing retirement.

3. Capital Preservation: Bonds are generally less risky than stocks, offering a more conservative approach to growing your wealth while protecting your initial investment.

Traditional 60/40 Portfolio

The traditional 60/40 split between stocks and bonds has long been a standard recommendation for balanced investing. However, this approach isn't universally applicable. If you're younger with a higher risk tolerance and don't anticipate needing to withdraw funds in the short term, you might consider a lower bond ratio.

Younger investors can typically:

• Tolerate more market volatility

• Benefit from potential higher returns of stock-heavy portfolios

• Gradually increase bond allocation as they approach retirement

Bond ETFs: A Modern Investment Solution

Bond Exchange-Traded Funds (ETFs) offer a flexible and accessible way to invest in bonds:

Benefits of Bond ETFs:

• Easy diversification across multiple bonds

• Lower investment minimums compared to individual bond purchases

• Increased liquidity

• Ability to trade like stocks

Types of Bond ETFs:

• Government bond ETFs

• Corporate bond ETFs

• Municipal bond ETFs

• International bond ETFs

Investment Tip: When selecting bond ETFs, consider factors like expense ratios, credit quality, duration (i.e. the length of time to maturity), and your personal risk tolerance.

Final Thoughts

Bonds are a sophisticated component of a well-rounded investment strategy. While they may not offer the same excitement as stocks, they provide stability, income, and risk mitigation that can significantly enhance your overall financial portfolio.

It is important to note that bonds are not risk-free. We will examine the risk associated with bonds in next week’s newsletter. I will also explain why my portfolio often does not contain many bonds.

As always, none of this is financial advice. Everyone should invest according to their personal circumstances, risk tolerance and financial goals.

Annual Financial Review: My 4-Step Approach to Investment Management

On Wednesday, I wrote an article in our sister newsletter, Business Fluency, about the importance of a personal annual review. In this newsletter, I'd like to share my approach to conducting the financial part of the review. This process helps me maintain a clear, strategic view of my investments and ensure I'm aligned with my financial goals.

1. Performance Analysis

I begin by thoroughly examining the performance of my investment portfolio. This means looking at returns across different asset classes: bonds, ETFs, individual stocks, and alternative investments like cryptocurrencies. I compare these results against the financial goals I set the previous year.

My analysis goes beyond simple number-checking. I investigate the broader economic context, reviewing major interest rate decisions and the current stage of the business cycle. This deeper examination helps me understand the reasons behind my portfolio's performance and anticipate potential opportunities or challenges in the coming year.

This assessment is crucial. If you’ve had a successful year, it doesn’t necessarily mean you’re a genius investor. It could also be due to the current stage of the business cycle, with many assets experiencing an upward trend. Conversely, a poor year could also be attributed to the same factors.

2. Portfolio Rebalancing

Rebalancing is a critical step in maintaining a healthy investment strategy. Essentially, this means adjusting my investment mix when certain asset classes have grown or shrunk beyond my target allocation.

For example, if my initial plan was to maintain a 60% stocks and 40% bonds portfolio, but stocks have grown to 75%, I would need to rebalance to realign with my original strategy.

There are two primary ways to rebalance:

• Sell an overperforming asset and reinvest the proceeds into underrepresented asset classes

• Direct new investment funds into asset classes that need to reach your target allocation

The decision of how to rebalance occurs in the next step.

3. Profit-Taking Considerations

Based on my performance analysis, rebalancing needs, and current stage of the business cycle, I carefully evaluate whether to sell any assets. This decision isn't just about performance – it also considers potential tax implications. Timing can be crucial in maximizing investment efficiency.

If there aren’t any obvious assets to sell, I’ll rebalance my portfolio by investing in underweight areas during the following year.

4. Forward-Looking Investment Planning

The final step is creating a comprehensive investment plan for the upcoming year. This involves:

• Reassessing my financial goals

• Anticipating significant expenses in the next 3-5 years

• Identifying how these potential expenses might impact my investment strategy such as prompting a move to less volatile assets

By conducting this annual review, I ensure that my investment approach remains dynamic, responsive, and aligned with my long-term financial goals.

Crypto Tax Climb Down in Italy?

Italy's government is reconsidering a proposed tax increase on cryptocurrency capital gains from 26% to 42%, initially planned under the 2025 budget. Following criticism from industry leaders and concerns within the co-ruling League party about driving investors into the shadow economy, the tax hike is set to be “significantly reduced” during parliamentary revisions. It is even possible that the 26% rate will be left unchanged.

Hopefully, Italians can continue investing in the world’s best-performing asset over the last 12 years without increased financial penalties.

Phrasal Verb of the Day: Climb Down

Phrasal verb - to change opinion or admit that you are wrong

Word of the Day: Bond

Bond (finance) - noun - countable - a fixed income instrument that represents a loan made by an investor to a borrower such as a government or company.