When you first learn about investing you are told to diversity – to spread out your risk. But if you invested in bonds, certificates of deposit, or put your money in a savings accounts lately you could be losing money. Now and for recent history, the return has been near zero versus 5% historically. So you may be wondering if this advice is out-of-date? More importantly – you may be asking how do I generate income in a zero-rate market?
Important Points:
(0:00) – Intro
(1:15) – Interest Rates Historically
(1:40) – 1998 vs 2020 U.S. Treasuries Yield-to-Maturity
(2:40) – Why Bonds in a Zero-Rate Market
(4:00) – What is a Bond
(4:40) – What Types of Bonds
(6:10) – Bonds & Risk
(10:40) – Why invest in Bonds
(13:30) – Bonds Pros &Cons
(18:00) – Seeking Higher Returns
(21:10) – Ask the Experts
Transcript:
Joe: Do you want bonds in your portfolio? Should you own bonds in your portfolio? As people approach retirement, they are looking for ways to create income. Traditional view is to buy a bond and CD that creates income. Is that the right move today? Stick around, folks. We will fill you in. Show is called Your Money, Your Wealth®. Joe Anderson, CFP® here. I’m a CERTIFIED FINANCIAL PLANNER™, President of Pure Financial Advisors. Today we have a special show, Big Al’s on vacation, so we have Bond Man Brian. Welcome to the show, Brian.
Brian: I am dying to make some sort of cool James Bond joke, but I don’t have any.
Joe: We’ve got Brian Perry, CFP®, CFA®. He’s our executive vice president, director of research. He was a bond manager in a previous life.
We’re going to break things down. Should you invest in bonds in the zero interest rate environment? That’s today’s financial focus.
Let’s walk down history lane, interest rates, 10 year. Back in 1945, 1.7%. Remember the 80s? Your house mortgage; 18, 15%. But you could also purchase a CD for 16%. Could you imagine getting 16 % on your money right now with a CD? Now you look at today, it’s almost zero, 1.6%. What does this really mean? If I look here in 1998. If I look at the 10 year Treasury, the safest investment almost, in history, was 4.5% in 1998. Today, it’s 1.6%. Let’s say you have $1,000,000 that you can invest. That’s your nest egg and you don’t want to take any risk. What do you do? You buy the Treasury. Back in 1998, guess what? You received about $45 to $46,000 on that safe investment. Today with that same $1,000,000 you’re getting $16,000. This is the issue. People are retiring. They want to protect their money. But can you live on $16,000? The answer’s probably no. The problem is even worse. Half of you don’t even know what I’m talking about right now because we’re talking about bonds and people are like, what the heck is a bond? Let’s bring in Bond man Brian to break things down.
Brian: Thanks, Joe. You’re right. I’ve been doing this a long time, and in my experience, the majority of people don’t understand bonds. They may understand stocks they’re on CNBC.
Bonds are a foreign concept. What we want to do today is cover a few things to leave our viewers better educated. Starting with bond basics. Like you said, what the heck is a bond? More importantly, once you understand what a bond is. Why should you invest in it? Interest rates are low. Should you invest in bonds? If you want higher returns, how do you do that in the bond market? As a last resort, if you don’t want bonds but you still want income, how do you stretch and get even more income? Those are things we want to dive a little deeper on today.
Joe: When you look at it, Brian, it’s crazy to imagine just a few years ago you could get, you know, almost $50,000 in one of the safest investments. Now you have to build a pretty diversified portfolio to get that. Let’s dive in and talk about what is a bond. Let’s just start real simply, how does it work?
Brian: I mean, at the end of the day, a bond is a loan. Stocks are ownership in a company. You own a part of that. A bond is simply a loan. You’re lending somebody money. Maybe you’re lending the US government money. That’s a Treasury bond. Maybe you’re lending a local city, the state of California, the state of Texas, the city of New York money, that’s a municipal bond. Maybe you’re lending a company like Microsoft or Oracle money, that’s a corporate bond. You’re simply lending money. In general, the way a bond works is that you lend the money for some period of time. Maybe it’s 5 years, 10 years with the agreement that you’re going to get that money back at the end of the time. Along the way, in return for that, you get interest, you get coupon payments generally every 6 months. Let’s say you lend somebody $100,000. Your hope is that at the end of the time, you get that $100,000 back. Along the way, maybe you get a few bucks in interest. But like you talked about, that level of interest has come down quite a bit. Here’s the issue: what if you don’t get your money back? You have to consider how safe is the person or entity or lending the money to?
Joe: Why did corporations issue bonds?
Brian: They need the money to fund their operations. Maybe they want to run a new factory. Maybe they want to try a new product launch. They need the money. They can sell stock and raise money that way. But it’s giving up a share of their future profits. When they issue a bond, there’s no share of their profits. They’re not giving away ownership in their company. They’re simply borrowing the money with the agreement to pay it back. You want to be careful. If you lend money to, let’s say, Apple, that’s probably pretty safe. If it’s a tech start up in the garage, it’s a lot less safe, so you need to look deeply into that.
Joe: Looking at municipal bonds, treasury bonds; why does the federal government issue bonds?
Brian: The federal government issues bonds to fund what they’re doing. The federal government, on a day to day basis, runs a big deficit. It’s trillions of dollars at this point. In order to fund that, they issue Treasury bonds. That’s what they use to operate. It’s considered the safest investment in the world. The problem is, there’s not much return there because it’s so safe.
Joe: When people look at bonds, they kind of consider them the same. It’s like, well, bonds are safe. Then you have junk bonds. Remember the good old junk bonds? What the heck is a junk bond?
Brian: A junk bond is nothing more than a bond issued by a lower credit quality. I talked about where maybe Apple is really safe, that tech start-up in the garage, not as safe. If you lent money to that tech startup, it might be considered a junk bond. Why the heck would you do that? You do that because you get more return. It’s like everything we talk about, it’s risk and return. You might have the chance to get more interest. But you’re going to have to take on more risk, more possibility that you don’t get your money back.
Joe: The problem is that when people look at bonds or bond mutual funds, they might be looking at past performance. When you pick your mutual funds in your 401(k) plan, you have fund A and fund B. Fund A had a 10 year return of 14 % and Fund B had a 10 year return of 3%. What do you think most of you would select? Of course you would select fund A because that did 14 %. Of course, it’s going to do 14 % in the future. You have to look at the risk. You have to have a risk right to create that overall return. Looking at this matrix in regards to bonds. You’re not buying profits in the organization, they’re just lending your cash and they’re charging you an interest rate. If I want really safe money, I want to go short on my loan. I only want to lend Brian $100,000 for 30 days. Not necessarily 30 years. The shorter the term the safer you are but the lower the interest rate. The longer you lend that money out, you’re going to be taking on risk. When you look at, let’s say, corporate bonds, you’re probably sitting here. If you’re looking at treasury bonds, you’re probably sitting way over here. On the biggest side could be the junk bond, where I’m lending my money to a lower grade company that could be on the verge of default where they need cash. You give them a loan for a long time, you should get compensated for that. The problem that we see is that you’re looking at returns and not necessarily understanding the overall risk.
OK, that’s enough of the technical bond talk for a lifetime. Go to our website. Our special gift is why bonds in a zero interest rate environment. It’s our bond guy. Go to YourMoneyYourWealth.com. Click on Your Money, Your Wealth® special offer this week. If you fell asleep here, just wait till you read that guide. YourMoneyYourWealth.com. Click on that special offer. We’ll be right back.
Joe: Welcome back to the show, folks, the shows called Your Money, Your Wealth®. Joe Anderson here with Bond man Brian. Brian Perry is a CFA and executive vice president of Pure Financial Advisors to break things down. We’ve got a lot more bond talk. Let’s see how you did on the true false question.
Brian: Today’s true false. When you buy municipal bonds from a state you don’t live in, you don’t have to pay taxes on the earnings. Remember, the whole reason for buying municipal bonds is that they are generally speaking, tax free. The true answer to this question, though, is it’s partially true and partially false.
Joe: Please elaborate.
Brian: The truth of the matter is that most municipal bonds are exempt from taxes at the federal level. If you don’t live in the state but you buy the municipal bond, you don’t owe any taxes on the federal level. However, you do owe taxes on the state level. If your answer was true, you’re probably right. If your answer was false, you’re probably right on this one.
Joe: If I live in California and I buy a bond in a municipal bond in Florida. That’s going to be tax free federally, but I have to pay California state tax on it?
Brian: 100%. And why might you want to do that? You might do that if that bond in Florida pays you more interest than the bond you would get in California. When you’re buying a municipal bond, what you want to do is compare your after tax return to what you would get versus another bond. If after paying taxes to Florida, you still wind up with more money in your pocket than on a potential California bond. It may make sense to buy the Florida bond. You also might just do it to diversify. If you live in California and all the bonds you buy are in California, you’re very exposed to the local economy. If you buy some bonds in Florida, you’re spreading out that risk a little bit.
Joe: If I just buy bonds in California, it’s tax free, state and federal.
Brian: Correct. If something happens at the state level; whether that’s a financial thing like, let’s say, Sacramento runs into trouble or it’s a regional disaster you could have some exposure there. It depends really on what you’re doing in your overall portfolio and what role the municipal bonds are playing. For people that have very large exposure to municipal bonds, sometimes it makes sense to step out of state and buy a few bonds in other areas.
Joe: Let’s break some other things down here. We’re looking at why we invest in bonds? Zero, almost zero interest. We hear this quite a bit, this is a guarantee to lose money. Interesting enough, as interest rates go up, your bond price will fall. It’s kind of a weird dynamic there. As interest rates go up, the face value of the bond goes down. We’re in a really low interest rate environment. If I were to poll all of you out there and say, where do you think interest rates are going to go? I would probably guess 90% of you would say, they have to go up at some point. As interest rates go up, the bond price falls. As long as you hold that bond to maturity, you’re going to get your face value back. The problem is why would you want to continue to hold this bond that’s only paying you 1% while now the market is paying 4%. You will receive a discount if you sell that bond early. That’s why people are like, Get me out of here. I don’t want anything to do with this crazy investment. Brian, let’s break this down. Number one, potential diversification benefits. I just said it’s the worst investment ever. Talk me into why I should invest in them.
Brian: Part of investing is that when you build a portfolio, you want some things that are going to zig when something else zags. A lot of the time when the stock market’s going like this, bonds may kind of muddle along. By the same token, when the stock market’s going down, which you all remember, March of 2020, bonds tend to hold their value better, maybe even go up. That’s the whole nature of diversification. It’s not that everything’s doing great all the time. It’s that some things are performing differently and the whole becomes greater than the sum of its parts.
Joe: When you’re looking at diversification, it’s like, alright, I think we have recency bias a little bit. The stock market is doing so well and the bond market is just doing terrible. Why do I want any bonds whatsoever? Remember, this is your safety net. All bonds are not created equal. We talked a little bit about this, but let’s share a little bit more. In this type of environment with interest rates as low as they are, as we can see them go up; Where should people look to invest? Long, short corporate, municipal?
Brian: It’s always going to depend a little bit on people’s situation. The longer the bond, the more risky it is if interest rates go up. If you play out the scenario in which interest rates are low and they head higher, the natural conclusion is you want relatively short term bonds. Particularly because you’re not getting a lot of extra income for going out longer. People should look at, how much can I get for a 5 year bond or a 10 year bond, as opposed to a 30 year bond. It might make more sense to stay a little bit shorter in a low interest rate environment. It might also make sense to own different kinds of bonds. Maybe you own some corporate bonds, they tend to get a little more return than a Treasury bond would.
Joe: The advantages, which we’ve talked about, is going to be a buffer. As the market zigs and zags and goes up and goes down, your bond portfolio should be there to create that safety net. Some people look at buying bonds to create income. When you look at interest rates today, you have to take on quite a bit of risk in some cases to get the income that maybe would be sustainable.
Brian: Although you’re not getting all the income you want, you’re still getting more income than you would get sitting in cash. At least you’re hopefully keeping pace with inflation and not losing purchasing power like you would if the money was just under the mattress. The other thing is you’re still getting those diversification benefits from bonds and you’re getting safety. A bad year in the bond market is really different from a bad year in the stock market. That’s important to remember. Like you said, Joe, we’re so used to seeing stocks go up given the last decade. Remember what happened in March of 2020? Remember what happened back in 2008? The sharp collapses in stocks. Bonds have never really fallen that way. High quality, short term bonds; a really bad year, historically, has been 2 or 3% to the downside.
Joe: Disadvantages of bonds, we’ve talked about this, is that as interest rates go up, bond prices go down. You can absolutely lose money in a bond. It’s not necessarily always the safest investment, just depending on the type of bond that you own. Again, a simple example is that I’m going to lend Brian $100,000. I’m going to charge him $5,000 or 5% for that $100,000. All of a sudden, as interest rates go up to, let’s say, 7%; Brian’s paying 5%, so he’s got a pretty good deal. If he’s paying me 5% versus the market paying 7%. If I go back to Brian and say, Hey, can I get that money back? He’s going to say no, because I still need the use of the capital and if I have to borrow it again, I have to pay a higher price for it. I just want to make sure they understand the dynamics of the overall instrument because it gets a little complicated.
Brian: People don’t understand bonds as well. The reality is they are really complicated. There’s only one stock for every company, for the most part. GE has a stock or IBM has a stock. But those same companies might have hundreds or even thousands of bond issues. It’s really important as you look at this to figure out how you are going to invest in bonds. It’s not as easy as just saying, Hey, I want IBM. You then need to decide which IBM bond you want. If you’re going to go out and do it yourself. You need to figure out how to buy it because they don’t trade like stocks where you just go out and you know what the price is and you buy. They trade more like real estate where you have to figure out who’s going to sell it to you, and you have to come up with a fair price on your own. If you’re not an expert, that price may or may not be fair. Then you need to track it on an ongoing basis. Buying bonds is really complicated compared to stocks. That’s why a lot of people wind up going the mutual fund or exchange traded fund route.
Joe: We’re going to take a short break. Why buy bonds in a zero rate environment? I don’t know, have we convinced you yet? Who knows. Go to our website, YourMoneyYourWealth.com. Click on our special offer. It’s our bond guide for this week. You can learn all about the pros and cons.
Hey, when we get back, we’re going to talk about alternatives if you don’t want to buy a bond. Can I get something else? The answer’s yes. Now I sound like a bond salesman. That was Brian back in the day. We got to take a break. Shows called Your Money, Your Wealth®.
Joe: Welcome back, hopefully you’re back. We’re talking all about bonds today. Why should you own bonds? We’re trying to educate you on the instrument to see if it makes sense in your overall investment strategy. Before we get into alternatives, let’s see how you did on the true false question.
Brian: In a zero rate market, you should only invest in bonds with a short maturity date? I’m going to go with a false on that; My reason for going false is that I think a lot of the bonds you own should be reasonably short, but you probably want to blend in some longer term bonds as well. We talked earlier that interest rates have to, they’re guaranteed to go higher, that’s not always necessarily the case. If you look over the last decade or so, rates have been pretty low and a lot of people have been waiting for them to go higher. Hasn’t happened yet. Owning a couple of longer term bonds gives you a little bit of protection against that. My answer is false. What about you, Joe?
Joe: False. It’s a good way because we don’t know what’s going to happen to interest rates. I think you’re right. We’ve talked about that, interest rates have to go up. As interest rates go up again, your bond price falls. If I’m in a low interest rate environment, we’ve got to keep the maturities short so my risk is very limited. Think of a teeter totter; the longer you go up, you’re going to see that decrease or your discount or premium go higher or lower, depending on the maturity or the duration of the overall bond. I agree with you, though, you’re the bond expert. I think you’re right because if you follow my advice and say just stay short, you probably would have lost some money because over the last decade, longer term bonds have performed quite well. Yeah.
Brian: It’s balance. When we say longer term, we don’t mean that all of your bonds should be longer term, it’s just blending it out as opposed to staying. I think some people hear, short term bonds and they go out and they buy a bunch of one year bonds or something and their yield is effectively zero or 0.05% as opposed to buying some of those and maybe some 3 and 4 year bonds and then maybe sprinkling in as appropriate, some 10 and 20 year bonds. You wind up with a blended average that’s still reasonably short, but gets you a little bit more return and also a little bit more of a hedge, too. If you think about the idea that, in some scenarios, when stocks fall sharply, the bonds go up. The longer maturity bond in that scenario generally goes up more than the shorter maturity, so it gives you even more protection in a volatile stock market.
Joe: Can you tell he’s pretty passionate about bonds. Let’s switch gears. Increased exposure to real estate. Let’s say you don’t want to get into a bond. Maybe you buy real estate. You can purchase a home and you get rent. It works similar to high quality intermediate term bonds. Now I’m going, not short, but I want to go high quality. What is a TIP and what is preferred?
Brian: Hopefully my passion will come through. I’m feeling like not James Bond, but a bond geek here a little bit. A TIP stands for Treasury inflation protected securities. What those are, those are bonds issued by the US government. They’re still really safe, except that they have an inflation adjustment component. If inflation goes higher, like we’ve seen recently, the value of that bond resets. They give you a little bit of protection against inflation. Could make some sense in a potential environment where we are seeing prices go higher. Preferred securities are a hybrid asset class. You’ve got stocks like we talked about, you’ve got bonds. Preferreds are in the middle. They’re another way for companies to raise capital. It’s a little bit more of a niche market. The reason some people like them is they provide higher returns. We talked about treasuries at 1.5%. I don’t know. You might be able to get three times that. You might be able to get 4 or 5 % from preferred right now. The issue, of course, is that preferreds are a good deal riskier than an ordinary corporate bond would be.
Joe: Let’s switch gears a little bit. Let’s go to ask the experts.
Brian: Coming in from Bill in Alpine, “Since interest rates are low and there is a housing shortage in our area. Is it better to invest your money in rental properties?” The answer, just like whether or not you should invest in bonds, is probably it depends. Right, Joe?
Joe: A lot of people love to purchase rentals. Because stocks are unknown. It’s in a brokerage account. I see it go down, but you know what I can drive by my house and I can see my rental property. Some people have a lot of comfort with that. You have to look at a couple of things. What’s the market value of the home that you’re purchasing versus the rents that you’re receiving? Then you can look at that and say, what’s my cash on cash return. In Southern California where we’re filming this. The cash on cash is quite low because the property values in Southern California are a little bit higher than other areas of the country. If you go to Minnesota, where I’m from, the market value of homes are a little bit lower, but the rents are relatively the same. You could probably get a higher cash on cash return in other areas of the country versus just looking in your backyard. There’s a lot of different things that you want to consider with rental properties. They are a phenomenal asset class, but there’s also a ton of work involved there.
Brian: Kimberly is asking; “I’m afraid stock prices are artificially high because people are putting their money in stocks rather than bonds. So does that make it a good time to convert stocks to other investments like gold or annuities?” I think that’s really an apples and oranges thing. Gold and annuities are both very different investments from each other, as well as very different from stocks. Joe?
Joe: No, you’re timing the market. You’re trying to get into alternatives. I think you need to look at what your portfolio needs to be right now. If you’re thinking stocks are high, let me sell or stocks are low, let me buy. You have to have a systematic way to do that. That is called rebalancing. I think a lot of us get emotional when we look at our overall portfolio, when we read or or hear the headlines that stocks are at all time highs. Maybe it’s time for me to sell out and buy gold. I would be very, very careful with that strategy.
What did we learn today? Well, bonds are boring is what we learned. Hopefully that’s perfect because bonds should be boring. They are there to protect you when the overall market is very exciting. You need a little bit of diversification in your overall strategy. We also learned; why invest in bonds? We’re looking at the risk in return of different offerings that bonds have. We also talked about alternative investment sources. Go to our website, folks. Why invest bonds in a zero interest rate environment? Well get our special offer today. It’s at YourMoneyYourWealth.com. Click on the special offer. We’re giving you the news to make proper investment moves. I want to thank Brian Perry. He’s our EVP, director of research.
He’s a Bond man, Brian, and I’m Joe Anderson. We’ll be back next week, of course, with Big Al back from vacation. Hopefully you enjoyed the show. We’ll see you next week folks.
