Bonds for Grandad

Hi, I recently saw a Youtube video (I can’t remember which one) in which it was suggested that mature adults should be investing in bonds rather than individual stocks.

I know that limited life time left to build up funds was the reason implied but don’t understand why bonds should be any better than other type of investments in this case.

I’d appreciate views/comments on this.

Bond holders have priority over equity holders (they get paid out first) so they are inherently less risky. If a company goes bankrupt bond holders may get all or most of their money back during the liquidation process, share holders may get less or nothing.

For people with shorter investment horizons (i.e. older people) this may make bonds preferable as there will be shorter periods where you experience a negative return, so you should be less likely to lose money.

People with longer investment horizons (i.e. younger people) can assume more risk as they can afford to lose money over a 5 or 10 year period as long as they are happy to wait 10+ years.

The reason why younger people are willing to make this decision is that in efficient markets the only way to make a greater return is by assuming more systematic risk. So you expect to be rewarded in the long run for picking stocks over bonds.

To clarify, non-systematic risks are not compensated in the same way, so while picking an individual stock over a comparable ETF may be more risky you shouldn’t expect a greater return.

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So, the idea is government bonds as an asset class are like very slow and steady gains, whilst providing you with income.

You take this slow and steady growth, as opposed to a stock’s super duper gain, so that when the stock markets go tits up, stocks crash and bonds will go up (or at least level out). And the reason you want that as you get older, is because you won’t generally have time to recover the losses from the crash in stocks, like the YouTube video said.

That’s generally why they’d advise for ‘mature’ people to get into bonds. And that’s generally government debt (US Treasuries, UK Gilts) because corporate bonds tend to act like stocks, which is a no-no.

That doesn’t mean that granddad shouldn’t invest in equities though, I don’t think many people go 100% into bonds, it just means that the vast majority of his portfolio should be into bonds depending on his age.

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Thanks for the reply Cameron. A great explanation.

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Thanks Rob. Yes, I should have said that Grandad should have a portfolio more heavily weighted towards bonds but not exclusive of stocks. Cheers.

I think it’s worth noting that bonds are a debt instrument whereas stocks are equity, giving you partial ownership in a company. That’s important because when you buy a bond, you’re effectively providing a loan to the issuer (governments or companies) of that bond which means they have a contractual obligation to repay your principle at maturity on to top of the interest or coupon, regardless of the present value of the bond.

So inflation notwithstanding, your grandpa could view bonds as a relatively lower risk means of capital preservation, offering surety of income over predetermined periods of time.

On the risk side, @Cameron is right in that in a liquidation event, bondholders tend to be higher up the creditor rankings, but that doesn’t mean risk free as defaults do occur. One indicator of the quality of the borrower or bond is a rating by one of the big agencies such as Moody’s, Fitch or S&P. Each notch, from AAA to CCC represents the credit quality of a borrower and a probability that they will not repay. Lower rated bonds tend to offer a higher coupon, which reflects the increased risk of either the issuer or the bond not repaying.

The secondary market and pricing dynamic is another conversation…

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Also always consider duration risk. It’s a massive one, especially in times of almost 0 interest rates (assuming you buy on the secondary market and don’t sign and hold until maturity).
I dislike bonds in the current environment. Just not worth the risks. Currency risk is another one if you don’t stick to one denomination. Just a small change in ghe exchange rate can wipe out years of bond returns.

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Understanding duration dynamics is absolutely essential, but worth noting there are funds that specifically seek to proactively mitigate sensitivity to interest rate movements.

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