Chapter 9
IN THIS CHAPTER
Making sense of the various types of bonds
Using bonds in a portfolio
Choosing the best bonds for your situation
When you invest, it’s fun and rewarding to see your investments grow over the years. Riskier investments like stocks and real estate can produce generous long-term returns, well in excess of the rate of inflation. But lending investments like bonds make sense for a portion of your money if
Mind you, all these conditions need not apply for you to put some of your money into bonds. Also, this list isn’t meant to be an exhaustive list of reasons to invest some money in bonds.
In this chapter, I discuss how and why to use bonds in your investment portfolio, explain the different types of bonds as well as alternatives to bonds, and describe the best ways to invest in bonds.
Bonds are middle-ground investments. They generally offer higher yields than bank accounts and less volatility than the stock market. That’s why bonds appeal to safety-minded investors as well as to otherwise-aggressive investors who seek diversification or investments for short-term financial goals.
Bonds differ from one another according to several factors: the entities that issue the bonds (which has important associated tax implications), credit quality, and time to maturity. After you have a handle on these issues, you’re ready to consider investing in bond mutual funds, exchange-traded bond funds, and perhaps even some individual bonds (although I caution you especially against jumping into individual bonds, which can be minefields for inexperienced investors).
Unfortunately, due to shady marketing practices by some investing companies and bond salespeople, you can have your work cut out for you while trying to get a handle on what many bonds really are and how they differ from their peers. I walk you through how bonds differ from one another in this section.
A major dimension in which bonds differ is the organizations that issued the bonds. The issuer of a bond is actually borrowing money from the folks who buy the bonds when they’re originally sold.
The following list covers the major options for who issues bonds (in order of popularity) and tells you when each option may make sense for you:
Treasury bonds: Treasuries are issued by the U.S. government. Treasuries pay interest that’s state-tax-free but federally taxable. Thus, they make sense if you want to avoid a high state income tax bracket but not a high federal income tax bracket. However, most people in a high state income tax bracket also happen to be in a high federal income tax bracket. Such investors may be better off in municipal bonds (explained next), which are both free of federal and state income tax (in their state of issuance). The best use of Treasuries is in place of bank certificate of deposits (CDs), as both types of investments have government backing. Treasuries that mature in the same length of time as a CD may pay the same interest rate or a better one.
Bank CD interest is fully taxable, whereas a Treasury’s interest is state-tax-free.
International bonds: You can buy bonds issued by foreign countries. These international bonds are riskier because their interest payments can be offset by currency price changes. The prices of foreign bonds tend not to move in tandem with U.S. bonds. Foreign bond values benefit from, and thus protect against, a declining U.S. dollar; therefore, they offer some diversification value. Although the declining dollar during most of the 2000s boosted the return of foreign bonds, the U.S. dollar appreciated versus most currencies during the 1980s and 1990s, which lowered a U.S. investor’s return on foreign bonds.
Foreign bonds aren’t vital holdings for a diversified portfolio. They’re generally more expensive to purchase and hold than comparable domestic bonds.
Closely tied to what organizations are actually issuing the bonds, bonds also differ in the creditworthiness of their issuers. Credit rating agencies such as Moody’s, Standard & Poor’s, and Fitch rate the credit quality and likelihood of default of bonds.
The credit rating of a bond depends on the issuer’s ability to pay back its debt. Bond credit ratings are usually done on some sort of a letter-grade scale. AAA usually is the highest rating, and ratings descend through AA and A, followed by BBB, BB, B, CCC, CC, C, and so on.
To minimize investing in bonds that default, purchase highly rated bonds. Now, you might ask why investors would knowingly buy a bond with a low credit rating. They may purchase one of these bonds because the issuer pays a higher interest rate on lower-quality bonds to attract investors. The lower a bond’s credit rating and quality, the higher the yield you can and should expect from such a bond.
Bonds are generally classified by the length of time until maturity. Maturity simply means the time at which the bond promises to pay back your principal if you hold the bond. Maturity could be next year, in 7 years, in 15 years, and so on.
Bonds classifications are as follows:
Long-term bonds mature in more than 10 years and generally up to 30 years.
A small number of companies (such as Coca-Cola, Disney, and IBM) issue 100-year bonds. I don’t recommend buying such bonds, however, especially those issued during a period of low interest rates, because they get hammered if long-term interest rates spike higher.
You should care how long a bond takes to mature because maturity gives you some sense of how volatile a bond may be if overall market interest rates change. If interest rates fall, bond prices rise; if interest rates rise, bond prices fall. Longer-term bonds generally drop more in price when the overall level of interest rates rises.
If you hold a bond until it matures, you get your principal back unless the issuer defaults. In the meantime, however, if interest rates rise, bond prices fall. The reason is simple: If the bond that you hold is issued at, say, 4 percent, and interest rates on similar bonds rise to 5 percent, no one (except someone who doesn’t know any better) will want to purchase your 4 percent bond. The value of your bond has to decrease enough so that it effectively yields 5 percent.
Most of the time, long-term bonds pay higher yields than short-term bonds do. You can look at a chart of the current yield of similar bonds plotted against when they mature — a chart known as a yield curve. At most times, this curve slopes upward. Investors generally demand a higher rate of interest for taking the risk of holding longer-term bonds.
Investing in bonds is a time-honored way to earn a better rate of return on money that you don’t plan to use within the next couple of years or more. Like stocks, bonds can generally be sold any day that the financial markets are open.
In this section, I discuss how to use bonds as an investment and explain how bonds compare with other lending investments.
Because their value fluctuates, you’re more likely to lose money if you’re forced to sell your bonds sooner rather than later. In the short term, if the bond market happens to fall and you need to sell, you could lose money. In the long term, as is the case with stocks, you’re far less likely to lose money.
Following are some common situations in which investing in bonds can make sense:
Don’t put too much of your long-term investment money in bonds, either. Bonds are generally inferior investments for making your money grow. Growth-oriented investments — such as stocks, real estate, and your own business — hold the greatest potential to build real wealth.
As I explain in Chapter 1, lending investments are those in which you lend your money to an organization, such as a bank, company, or government, that typically pays you a set or fixed rate of interest. Ownership investments, by contrast, provide partial ownership of a company or some other asset, such as real estate, that has the ability to generate revenue and potential profits.
Lending investments aren’t the best choice if you really want to make your money grow, but even the most aggressive investors should consider placing some of their money in lending investments.
In this chapter, I focus on bonds, but I’d be remiss if I failed to point out that lending investments are everywhere: banks, credit unions, brokerage firms, insurance companies, and mutual fund companies. Lending investments that you may have heard of include bank accounts (savings and CDs), Treasury bills and other bonds, bond mutual funds and exchange-traded bond funds, mortgages, and guaranteed-investment contracts (GICs).
Bonds, money market funds, and bank savings vehicles are hardly the only lending investments. A variety of other companies are more than willing to have you lend them your money and pay you a relatively fixed rate of interest. In most cases, though, you’re better off staying away from the investments described in the following sections.
Too many investors get sucked into lending investments that offer higher yields and are pitched as supposedly better alternatives to bonds. Remember: Risk and return go hand in hand, so higher yields mean greater risk, and vice versa.
One of the allures of nonbond lending investments, such as private mortgages, GICs, and CDs, is that they don’t fluctuate in value — at least not that you can see. Such investments appear to be safer and less volatile. You can’t watch your principal fluctuate in value because you can’t look up the value daily, the way you can with bonds and stocks.
But the principal values of your mortgage, GIC, and CD investments really do fluctuate; you just don’t see the fluctuations! Just as the market value of a bond drops when interest rates rise, so does the market value of these investments — and for the same reasons. At higher interest rates, investors expect a discounted price on a fixed-interest-rate investment because they always have the alternative of purchasing a new mortgage, GIC, or CD at the higher prevailing rates. Some of these investments are actually bought and sold, and behave just like bonds, among investors in what’s known as a secondary market.
In the sections that follow, I explain common lending investments that are often pitched as bond alternatives with supposedly more stable prices. You can find information on CDs in Chapter 6.
Through your retirement plan at work, you may be pitched to invest in guaranteed-investment contracts (GICs). The allure of GICs, which are sold and backed by insurance companies, is that your account value doesn’t appear to fluctuate. (Other insurer-backed investments sold to the public through brokers are similar.) Like one-year bank CDs, GICs generally quote you an interest rate for the next year. Some GICs lock in the rate for longer periods, whereas others may change the interest rate several times per year.
Keep in mind that the insurance company that issues the GIC does invest your money, mostly in bonds and maybe a bit in stocks. Like other bonds and stocks, these investments fluctuate in value; you just don’t see the fluctuation.
Typically once a year, you receive a new statement showing that your GIC is worth more, thanks to the newly added interest. This statement makes otherwise-nervous investors who can’t stand volatile investments feel safe and sound.
The yield on a GIC is usually comparable to those available on short-term, high-quality bonds, yet the insurer invests in long-term bonds and some stocks. The difference between what these investments generate for the insurer and what the GIC pays you in interest goes to the insurer.
The insurer’s take can be significant and is generally hidden. Mutual funds are required to report the management fees that they collect and subtract before paying your return, but GIC insurers have no such obligations. By having a return guaranteed in advance (with no chance for loss), you pay heavily — an effective fee of more than 2 percent per year — for peace of mind in the form of lower long-term returns.
To invest in mortgages directly, you can loan your money to people who need money to buy or refinance real estate. Such loans are known as private mortgages, or second mortgages if your loan is second in line behind someone’s primary mortgage.
You may be pitched to invest in a private mortgage by folks you know in real estate-related businesses. Mortgage and real estate brokers often arrange mortgage investments, and you must tread carefully, because these people have a vested interest in seeing the deal done. Otherwise, the mortgage broker doesn’t get paid for closing the loan, and the real estate broker doesn’t get a commission for selling a property.
Private mortgage investments appeal to investors who don’t like the volatility of the stock and bond markets and who aren’t satisfied with the seemingly low returns on bonds or other common lending investments. Private mortgages appear to offer the best of both worlds — stock-market-like returns without the volatility that comes with stocks.
One broker who also happens to write about real estate wrote a newspaper column describing mortgages as the “perfect real estate investment” and added that mortgages are a “high-yield, low-risk investment.” If that wasn’t enough to get you to whip out your checkbook, the writer/broker further gushed that mortgages are great investments because you have “little or no management, no physical labor.”
You may know by now that a low-risk, high-yield investment doesn’t exist. Earning a relatively high interest rate goes hand in hand with accepting relatively high risk. The risk is that the borrower can default — which leaves you holding the bag. (In the mid- to late 2000s, mortgage defaults skyrocketed.) More specifically, you can get stuck with a property that you may need to foreclose on, and if you don’t hold the first mortgage, you’re not first in line with a claim on the property.
The fact that private mortgages are high-risk should be obvious when you consider why the borrower elects to obtain needed funds privately rather than through a bank. Put yourself in the borrower’s shoes. As a property buyer or owner, if you can obtain a mortgage through a conventional lender, such as a bank, wouldn’t you do so? After all, banks generally give better interest rates. If a mortgage broker offers you a deal where you can, for example, borrow money at 10 percent when the going bank rate is, say, 6 percent, the deal must carry a fair amount of risk.
Also recognize that your mortgage investment carries interest-rate risk: If you need to “sell” it early, you’ll have to discount it, perhaps substantially if interest rates have increased since you purchased it. Try not to lend so much money on one mortgage that it represents more than 5 percent of your total investments.
If you’re willing to lend your money to borrowers who carry a relatively high risk of defaulting, consider investing in high-yield (junk) bond mutual funds or exchange-traded funds instead (see Chapter 10). With these funds, you can at least diversify your money across many borrowers, and you benefit from the professional review and due diligence of the fund management team. You can also consider lending money to family members.
You can invest in bonds in one of two major ways: You can invest in a professionally selected and managed portfolio of bonds via a bond mutual fund or exchange-traded fund (ETF), or you can purchase individual bonds.
In this section, I help you make the decision of how to invest in bonds. If you want to take the individual-bond route, I cover that path here, including the purchasing process for various types of bonds such as Treasuries, which are different in that you can buy them directly from the government. If you fall on the side of mutual funds and ETFs, see Chapter 10 for all the details.
Unless the bonds you’re considering purchasing are easy to analyze and homogeneous (such as Treasury bonds), you’re generally better off investing in bonds through a mutual fund or ETF. Here’s why:
If you want to purchase Treasury bonds, buying them through the Federal Reserve’s Treasury Direct program online is generally the lowest-cost method. The Federal Reserve doesn’t charge for buying Treasuries through these online accounts. Contact a Federal Reserve branch near you (check the government section of your local phone directory), and ask for information about how to purchase Treasury bonds through the Treasury Direct program. Or you can call 800-722-2678 or visit the U.S. Department of the Treasury’s website (www.treasurydirect.gov
).
You may also purchase and hold Treasury bonds through brokerage firms and mutual funds. Brokers typically charge a flat fee for buying a Treasury bond. Buying Treasuries through a brokerage account makes sense if you hold other securities through the brokerage account and you like the ability to quickly sell a Treasury bond that you hold. Selling Treasury bonds held through the Federal Reserve is a hassle, as you must transfer the bonds out to a broker to do the selling for you.
The advantage of a fund that invests in Treasuries is that it typically holds Treasuries of differing maturities, thus offering diversification. You can generally buy and sell no-load (commission-free) Treasury bond funds easily and without fees. Funds, however, do charge an ongoing management fee. (See Chapter 10 for my recommendations of Treasury mutual funds with good track records and low management fees.)
Purchasing other types of individual bonds, such as corporate and mortgage bonds, is a much more treacherous and time-consuming undertaking than buying Treasuries. Here’s my advice for doing it right and minimizing the chance of mistakes:
Perhaps you’ve already bought some bonds or inherited them. If you already own individual bonds, and they fit your financial objectives and tax situation, you can hold them until maturity, because you already paid a commission when you purchased them. Selling the bonds before their maturity would just create an additional fee. (When the bonds mature, the broker who sold them to you will probably be more than happy to sell you some more. That’s the time to check out good bond funds — see Chapter 10.)