(PUB) Investing 2015

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 >

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-

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