By Allan Roth
There are many myths about bonds that investors, and even financial advisors, buy into. Here are the top three along with how I bust them with clients and help them better understand bonds so they can make better decisions.
Myth one: Bonds are difficult to understand. I get this one a lot. In fact, some people will say they have given up on understanding bonds. Some will even say they want to avoid bonds because they don't understand them. I respond that bonds are far easier to understand than stocks. This myth only takes only a few minutes to bust.
I explain that a bond is a loan. When you buy a bond, you are lending money to the government or corporations, or both. The example I give is the client lends me $100 for 10 years at a 5% interest rate. That's essentially a bond and the client receives $5 a year interest plus the $100 principal back in a decade.
Then, I ask them to imagine that, right after they lend this to me, interest rates go up by two percentage points so that 7% is now the going rate. They are getting only $5 a year and the market says $7 is the going rate. They are getting $2 a year less than market so the bond (loan) is now worth less than $100. On the flip side, if rates went down to 3%, they are getting an extra $2 a month so the loan is worth more than $100. That's why interest rates and bonds have an inverse relationship. It's so simple!
I then go on and explain default risk -- if I file for bankruptcy, it doesn't matter what happened to interest rates as they will likely get nothing back.
I further explain that if they lend me the $100 for 30 years and rates rose two percentage points, they get that below market return for 20 additional years. So the longer the time until the loan (or bond) matures, the more interest rate risk they are taking.
There are many complex factors that impact stocks -- earnings, the change in earnings, cash flows, the change in cash flows, investor expectations, sectors, style, and...I could go on and on. The only factors that impact bonds are perceived default risk and interest rates. Bond issuers can make things more complex such as issuing bonds at premiums, that are callable (or both), but a simple rule is to avoid these.
Myth two: Bond funds are riskier than owning individual bonds. As the saying goes, if you hold a bond until maturity, you know what you'll get back. But if you own a bond ETF or mutual fund (other than a defined maturity bond fund), you never know what you'll get back.
Let's go back to the imaginary $100 loan from the client and use the example of rates rising from 5% to 7% right after they lent me this money. If this bond was publicly traded, the value of the loan would fall from $100 to $85.95 for a loss of $14.05. It's true that the client would still get $100 back if they held the bond, but this is really an illusion.
I tell the client to "get real" meaning they have to think in inflation-adjusted dollars rather than nominal. Interest rates rose because inflation expectations rose and that means the cash they will receive years later in the form of interest and principal repayment from the bond they held will buy less than anticipated.
Seen another way, a bond fund like the iShares Core U.S. Aggregate Bond ETF $(AGG.NZ)$ is a laddered bond portfolio holding thousands of individual bonds. How could a laddered bond portfolio with thousands of bonds have more risk than a laddered bond portfolio of a few, or even a few dozen, bonds?
Another advantage with bond funds over individual bonds: You can reinvest the interest so you don't build up too much cash, but keep that money invested according to your asset allocation plan.
I admit that, with every rule, there are exceptions. With Treasury inflation-protected securities $(TIPS)$, you can buy directly and, if held until maturity, you know the real inflation-adjusted spending power it will provide. And, if you have a future liability in nominal terms (such as a tax bill or mortgage interest reset in a couple of years), a nominal Treasury note or bond could do the trick.
I recommend against taking on credit risk for any near-term liability. I'm old enough to remember the oft-quoted statement that, "as goes General Motors, so goes America." General Motors stock became worthless and bondholders got back only 10 cents on the dollar. This is why you want high credit quality bonds. Another reminder of what can go wrong with corporate bonds: the Bloomberg Aggregate Bond Index was once called the Lehman Aggregate Bond Index.
Myth three: Bond interest rates are predictable. Most advisors I've spoken to tell me they think they can predict which way interest rates are headed. In part, they say this because the Federal Reserve signals their intent to raise or lower the fed-funds rate. While that is true, it happens to be irrelevant. The fed-funds rate is the shortest of the short-term rates. It's an overnight rate.
Intermediate and long-term rates are driven by the market and markets price in available information. When the Fed signals their intent to lower the fed-funds rate, that information is priced into the bond market. In fact, it was probably priced in before that intent was announced since they are basing it on published economic reports, such as the consumer price index, unemployment rate, and other data.
We need to look back only a few months to see a great example. On Sept. 18 of this year, the Fed reduced rates by 50 basis points. It followed up on Nov. 7, cutting rates by another 25 basis points.
I watched the news proclaiming that mortgage rates would fall and how much that would save borrowers. Well, according to the Fed, the 30-year mortgage rate rose from 6.20% the week of Sept. 12 to 6.84% the week of November 21. The 10-year Treasury yield rose from 3.65% on Sept. 17 to 4.27% on November 25.
Top economists have had a horrible record of predicting the direction of the 10-year Treasury note. Bottom line: Markets aren't dumb, but thinking you can outsmart the market is naive.
In conclusion. Bonds are simple. I've yet to see a client that shouldn't have at least some exposure to bonds. They are the ballast to portfolios. It's true that 2022 was the worst year in the history of the bond market but the 13.11% decline of the AGG ETF fund is far better than the 18% loss in stocks that year. The so-called 2022 bond crash was actually good news, I wrote then, since it dramatically increased future real returns investors receive on their bonds.
I tell clients to keep credit quality high, maturities no more than intermediate range with a duration of less than 10 years, and fees low. It's as simple as that.
Allan Roth is founder of the planning firm Wealth Logic in Colorado Springs, Colorado. He is a licensed CPA and CFP, and has an M.B.A. from Northwestern University (Kellogg), but still claims he can keep investing simple.
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(END) Dow Jones Newswires
December 10, 2024 14:19 ET (19:19 GMT)
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