Another post in my Teaching my kids series – Bonds
As frequent reader of my blog you know that I’m writing some posts to try to financially educate my kids. I know they are still very young (6 and 9) but it is never too early to start. And they can read these blog posts later on in life 😉 (This is probably the case, because they don’t speak or read English very well at this moment – You got to love an understatement!).
This is another blog post to keep the “snowball of knowledge” rolling.
I think when you educate kids about money, they will benefit from it for the rest of their lives. Or as the saying goes: “What is learned in the cradle is carried to the tomb”. And to educate your kid is your responsibility as a parent.
This blog post is a post for my kids when they are a little bit older. I did not talk to my kids about this subject (yet).
This week we saw a decline of the markets world-wide. That got me thinking about diversification (see also my Goals 2018), the beta-factor of my Vrijheid Fonds and other ways to reduce risks.
In this post I will look at one of the other ways to reduce risks in my Vrijheid Fonds. I will try to explain to my daughters what bonds are. Bonds are an important part of my Vrijheid Fonds. I have corporate bonds (Rabobank Certificates) and government bonds (in my mutual funds).
In general, investors see bonds as more stable and less risky than equities. However, interest rates have a direct impact on this investment category. Lets explore bonds some more.
What is a bond?
A bond is a loan issued by a company or government. The buyer of a bond lends money to a government or a company for a certain period and receives a fixed annual fee for this: the coupon rate. Bonds can be bought and sold (traded) on the financial markets. The price of a bond is subject to the laws of supply and demand. When you look on the internet for the price of a bond, you see a yield and price written behind the name of the bond.
Yield is the expected return at the end of the term. If the price of a bond goes up, the yield falls and vice versa. The yield (and therefore also the price) can change if the general interest rate level goes up or down. The yield / price can also change if doubts arise about the creditworthiness of the issuer of the bond. If investors are more at risk, they want a higher compensation: the yield goes up, but the price goes down.
Bonds and interest rates
If the general interest rate level falls, the price of existing bonds will rise. New buyers want to pay more for a bond because it yields more than a bond that is newly issued with a lower coupon rate. If the general level of interest rates rises, the price of an existing bond will fall: new investors can get bonds that pay more coupon interest and therefore want to pay less for a bond with a lower coupon rate. At this moment we have very low interest rates and thus expenses bonds. In the US the interest rates are slowly rising, so we will see lower prices for bonds in the near future.
The interest rate sensitivity a bond is expressed in “Duration”
The duration is a measure of the interest rate sensitivity of a bond. The duration indicates how much the price of a bond changes with a given change in the yield of the bond. The duration is calculated on the basis of the (remaining) maturity of the bond, the coupon rate and the yield. The higher the duration, the greater the influence of an interest rate movement on the value of a loan. The lower the duration, the smaller the response of a bond to an interest increase or decrease.
In my opinion bonds provide important diversification in every investment portfolio. Because of their interest rate sensitivity bonds often respond differently than equities on economic scenarios. And by have both assets, your portfolio can handle all economic scenarios better (never bet all your money on one horse).
This is my sixteenth blog post about teaching my kids. I hope my kids at the age of say 18, have all the financial knowledge I’m having right now. This would be a huge advantage for them! And that’s why I started these blog post series.
What do you tell your kids about money and investing? I like to hear from you!
Help me get the “snowball of knowledge” rolling and share this post.