A Better Way to do Bonds
Your portfolio is probably made up of a collection of pooled investments like mutual funds. While these are great vehicles, there is a special case to be made for doing your bond investments a different way as you approach retirement.
It's 30 Minute Money podcast that delivers action oriented smart money ideas and little tiny bite sized pieces. My name is Scott and I'm here with Steve Wershing from Focused Wealth Advisors. Steve, welcome to the
Speaker 2 (00:21):
Show. Scott, always good to
Speaker 1 (00:22):
See you. Always good to see you. You're gonna talk about bonds today. It's just something that, one of the things that, one of the many things I really wanna learn more about
Speaker 2 (00:30):
, don't, don't, don't tease me like that.
Speaker 1 (00:32):
. I'm not , I'm being 100%
Speaker 2 (00:35):
Truthful. I, I, you have to be the first person this month to say that I wanna learn more about bonds, but they're really important.
Speaker 1 (00:42):
Yeah. Well, you have, uh, mutual funds, EFTs and annuities and all those, uh, little buzzwords that I like to, to, that I hear thrown about a lot. Exactly. And I wanna learn more. Okay, well lay it
Speaker 2 (00:53):
Down. So, so let's, let's start at the beginning. The, the, the single most important decision when you're managing a portfolio is how you allocate the money across the different kinds of investments. There are most advisors, track three, what we call asset classes, stocks, bonds, and cash. Um, we do five stocks, bonds, cash, commodities, and real estate. We think that those two other ones lend something meaningful. But the point is that the most important decision is how you spread your money across those different, um, types of assets and how much goes into East beach. Pie slice changes over time. When you're younger and you've got a long time to go, you'll have relatively more in things like stocks. And as you get closer and closer to retirement, you'll start leaning over in the direction of bonds. So you'll have less stock typically, and you'll have more bonds because bonds are income generators and you want to prepare the portfolio to give you an income when you need it to replace a paycheck.
Speaker 2 (01:51):
So that's the, that's the most important decision. Now, the next decision is what you put into each of those pie slices. And typically when you're doing it in an ira, when you're doing it in a 401k, you know, wherever you do it, it's probably in some kind of pooled investment, like a mutual fund. So a mutual fund is just a lot of people getting together, pooling all their money, hiring a manager to make the selection of what goes into that mutual fund. And that way you can, you know, even with a small amount of money, you can get a lot of diversification, you can get professional management, you can get, get it at an effective price, cuz thousands of other people are doing the same thing in that mutual fund. And so those kinds of pooled investments, mutual funds and exchange traded funds and those kinds of things are a great way to populate those pie slices in that portfolio allocation when you get closer to or into retirement.
Speaker 2 (02:43):
However, one of those changes, and it's bonds, and I'll, that's for two reasons. One is that bonds are becoming a more prominent part of your portfolio. Uh, but also because there are some funny little dynamics that go on in mutual funds and it has a particular effect on those income generators when you're gonna switch over to start using that portfolio to generate income, um, to pay for your retirement. Um, there are a number of different things that can compromise, that can, that can create extra risk for you if you have a bond portfolio. Um, I'll just, I'll give you a real simple one because it's, it's real straightforward and easy to understand. Let's say that you've got a significant amount of your, of your retirement savings in a bond fund and the bond market, you know, interest rates spike and the bond market goes crazy and it drops like a rock.
Speaker 2 (03:36):
And a whole bunch of the people who own that bond mutual fund call up the fund and say, I don't like this ride anymore. Take me off, move my money over to the money market fund. The manager by law has to send that money out the next day. And if that manager is, has most of the portfolio invested, that means that that manager will have to sell a bunch of bonds to be able to send the cash out. Now, that may be a terrible time to sell bonds and the manager may know this is a terrible time to sell bonds, but they have no choice. They have to sell those bonds to raise the cash to send it out. What that means is that everybody's who's who's left in the, in the fund gets hurt because some of their portfolios was sold at a really bad time. And even though the manager knew it was a bad time, he had no choice. He had to do it. That affects everybody who's still in the fund. Is
Speaker 1 (04:31):
It, is it, uh, bad for me to ask you, what is a bond?
Speaker 2 (04:34):
Ah, so a bond, a bond is a debt, A bond is an i o U. And so, um, if a company, let's say, so I
Speaker 1 (04:46):
See treasury bonds and I, and, and
Speaker 2 (04:48):
Yeah, so it's a government bond. It's a government bond that's, so that's, that's a, um, that's a debt that you buy from the government. So like, if, if you wanna buy a house, you go to the bank and you get a mortgage and the bank loans you money and you use that to buy, to buy the house, right? Well, the government needs money too, and companies need money. And so they might go out to borrow money from you. And the way that they do that is to sell you bonds so that they, they go out to the marketplace and they say, well, we need to raise several million dollars. And so instead of going to one person and say, would you loan us a few million dollars? And usually they're for much more than that. They might be for hundreds of millions or billions of dollars.
Speaker 2 (05:24):
So they can't realistically go to one person and borrow it. So what they do is they package it up and they sell it in pieces to people. And so you might buy a bond for a thousand dollars or $10,000, but it's part of a big issue where a company or the government needs to raise several million dollars and you're buying a little piece of it. And the the deal is you buy that, you buy that i o u and the, uh, the government or the corporation that you're effectively loaning the money to says, okay, we'll give you this much interest on it. We'll pay you twice a year. And at the end of the term of this bond, it could be five years, 10 years, 15 years, whatever. We'll give you your original principle back. That's what a bond is. Okay? And so stocks, you know, stocks over the course of time, you know what we hope is that they go up, some of them pay some income in the form of dividends, some of them don't. So if you really wanna generate income, then you use those IUs because that's what they're designed to do. They're just interest generators. It's like, it's a little bit like your savings account that just pays you interest. It's, you know, but it's a securitized form of that. Does that make sense? Yeah,
Speaker 1 (06:32):
Oh yeah. Makes total sense. Yeah. Uh, I, but I still, it's still scary to me to think that, um, the government is, is is borrowing money for me and and promising to pay it back
Speaker 2 (06:44):
? Well, it's that, that is still the, the, the most solid promise you can have. Yeah. Um, so I mean, they are the highest quality, the most safe kinds of bonds that you can buy are the, are the treasury bonds. It
Speaker 1 (06:55):
Seems, it just, uh, from my simplistic view of it, it, it seems weird that in that situation where you're, you're buying a debt, um, that it can fluctuate, that it can, you could lose money on it,
Speaker 2 (07:07):
Right? Right. Well see that's, that's sort of what gets at our point here is that, um, if you, if you buy it at full price and you wait and, and you hold it until it matures, so let's say it's a 10 year bond and you hold it for the full 10 years, as long as that company continues to pay its bills, you know, you'll get the original money back. It only goes up and down. It, you might only lose money if you sell it in the meantime. And the reason that they go up and down is because interest rates change. Okay? So if you have, let's say you buy a bond and the bond pays 4% and so they're paying you 4%, that's great. But interest rates in the rest of the economy go up to 5% or higher, right? And let's say that you need to get out of that bond.
Speaker 2 (07:52):
Well, if somebody can go out into the market and buy, you know, have their choice of all kinds of things that pay 5%, they're not gonna want to buy your bond cuz yours pays four, right? So instead of just saying, no, I won't buy it, what they'll say is, well, I'll give you less than the full value so that the interest equals 5%. Does that make sense? Yeah. Right. And so that's why bonds go up and down in value is because they're adjusting to the interest rate changes in the environment. Because when you, if you issue a 10 year bond, that interest payment is consistent over the full 10 years. If you buy a 20 year bond, that interest rate's gonna be the same over the full 20 years. And interest rates can change pretty dramatically even in a year. We've seen that in the market this year.
Speaker 2 (08:35):
Um, government securities we're paying like 1% or thereabouts about a year ago. Now they're paying like four, so short term ones anyway, so things can change, but that's why bonds go up and down in value. But that gets exactly at my point is that if, if interest rates change suddenly and people suddenly get scared of bonds and the prices on bonds drop and they want to get outta the mutual fund, and you are in the mutual fund, there's nothing you can do about that because that's just what happens with the other shareholders in the mutual fund. But if you owned a bond directly, you're not exposed to that risk. So other people can be panicking and selling bonds like crazy. As long as you keep holding your bond, as long as that company keeps paying its bills, you're good. You're good, right? Mm-hmm. . And the great thing about owning the in, you know, if you own a bond mutual fund, we don't know what the price of that mutual fund's gonna be five years or 10 years from now.
Speaker 2 (09:30):
But if you have a bond in your hand, I don't care what it's worth right now, as long as that company continues to pay its bills, it will go to full value when it matures. So that sort of gets at the solution to avoiding all that risk in bond mutual funds for people who are close to retirement, again, during most of your working life, buying pooled investments for all the different AC asset classes is just fine. It's just a, a special risk of retirees because they're gonna be starting to use that interest to live on and they may need to be systematically pulling money out of their portfolio. And so it's those bonds that, it's the, the bond portion of that portfolio that, that really has this sort of peculiar kind of risk attached to it. So the answer is owning individual bonds. Now, owning individual bonds can be complicated.
Speaker 2 (10:23):
They're, they're not as easy to trade as stocks are, and it's still kind of an arcane and inefficient market in some ways. But the way to, the way to do that, the easy way to do that is to build what we call a ladder. And that is that you take a certain amount of money and you determine over what period of time you want those bonds to mature in your portfolio and you just divide up the investment equally, um, for each year that you've got in that timeframe. So, so right now, interest rates are going up, they have been going up fairly quickly, so we wanna keep our ladders pretty short. So most of the ladders that we build for people are like zero to three years, zero to five years. If interest rates go up and they stay up for a long time, we might push that out.
Speaker 2 (11:09):
We might start building ladders that are 10 years out or 15 years out, but right now we're usually like zero to five years. And what that means is if you take a hundred thousand from your portfolio that would have been in bond mutual funds and you wanna build a ladder with it, we'll take 20,000 and buy bonds that will mature in the next year. We'll take 20,000, put it into bonds that will mature between one and two years from now and so on. And so, you know, and evenly distributed over those five years, when the bonds this year come due, we'll buy new five year bonds. And so we're climbing that ladder all the way, you know, we're keeping that five year ladder renewed all the time. And there are a number of different benefits. One of them we just talked about the, from my perspective, one of the bigger ones is you're not subject to all the ups and downs of the market. Yes, you will get a statement and you will see that your bonds have gone up or down in value, but in a lot of ways we don't really care that much because as long as they're good companies that continue to pay their bills, what's what they're worth now doesn't really matter. We know what they're going to be worth when they mature, whether that be one year, two years, three years, four years, or five years from now. Does that make sense? Yeah. Um,
Speaker 1 (12:21):
Speaker 2 (12:23):
And, and I I,
Speaker 1 (12:25):
I'm, you know me, I am not a financial guy, right? That's one of the reasons why I, I love sitting here because I'm just in awe of all of this information that you're giving me. Yeah. But just this, just the intricacies of what you're talking about just fascinates me. Yeah.
Speaker 2 (12:39):
Um, there are some other benefits too. One is that you know, what you own, if you are, if you're in a bond mutual fund, you don't, you, you won't find out what you own until they publish the semi-annual report months from now, right? So at any one period, what, at any one point in time, you don't really know what you own. And sometimes that can be a problem because, you know, bond mutual funds compete with each other and they compete on yield. So sometimes managers make some kind of questionable decisions because they want to get something that's gonna boost the overall yield on the portfolio a little bit. If the bond market goes the wrong way, it can have a disproportionately large effect. There have been, there have been times when, you know, the bond market has had, you know, has gone a little crazy and some, some bond mutual funds, you know, have a dramatic decline in price.
Speaker 2 (13:30):
Well, if you own the bonds themselves, you know what you own. Any day you can look at your account and say, oh, okay, I can say, oh, there's a bond from Microsoft and there's a bond from McDonald's and there's a, yeah, you can know exactly what you own. So there's, there's sort of that, that provides a level of security as well. The other thing is that the income that comes from it is predictable because you can look at each of the bonds in portor of, in the portfolio, and you know what each of them will pay in terms of interest every year. So you can figure out, here's how much income I'm gonna get from this this year. And every year you can make that calculation and figure out exactly how much you're gonna get. So it provides you sort of that predictability as well.
Speaker 2 (14:09):
So there are some decision points. Does that make sense? Does this Yep. Whole thing make sense? So there are some decision points that you need to, you need to make if you're gonna do this. Um, the first is how long do you want the ladder to be? Do you want, you know, bonds over the next five, three years or five years, or 10 years or 15 years? And that really depends on where interest rates are and where you think they're going. So right now we're keeping 'em pretty short because it's the short term bonds that are paying the most. Um, and we don't get rewarded much more for locking up our money longer. So right now, most of our clients, the clients that we have in bond ladders, they're pretty short ladders. But that's one of the decisions that you need to make. One of the other decisions that you can make is what kind of bonds you wanna put in there, because they each have different characteristics.
Speaker 2 (14:54):
So you were talking about treasury bonds before, so you can put together corporate bond ladders, you can put together government securities ladders with treasury bonds and notes. You can put together CD ladders for that matter. Um, you can put, uh, ladders together of treasury inflation protected securities. One of the big issues we have right now is inflation is really taking off. Yeah. And there's a kind of government bond that will give you an interest rate kicker, basically based on how much inflation goes up. And so we, we've got some clients who have tips, portfolio tips, ladders, you know, the treasury and flight, treasury inflation protected securities in a ladder. Um, so that, so one of the things you have to decide is how long the ladder is. One of the things you have to decide is what kind of bonds you want. And I really have to emphasize this is the kind of thing that you don't want to do on your own . This, this is, this is the kind of thing where expert help really, it really pays its way
Speaker 1 (15:53):
I would think so, yeah. I mean, you, you, you've gotta have a lot, have a lot of self-confidence in this to, to be like, I'm gonna jump into this and I'm gonna take care of
Speaker 2 (16:00):
Myself. It's not just, it's not just self-confidence, you know, like I said, bonds trade very differently than stocks. You know, you, you can go on to, you know, your online brokerage account and see what what stocks are priced at at any one period of time. It's a very efficient market that's very competitive. Yeah. You can, you can be pretty confident that you're getting a good price when you see it printed on the screen. Bonds are a different story. Um, bonds are, are are less efficiently priced and, um, it's not as easy to just go online onto an online account at by bonds. Um, you really need, you, you, you know, you really need to have, need to work with somebody who's got access to an institutional bond desk that is in constant contact with all of, all of the bond issuers and all the people who trade bonds.
Speaker 2 (16:49):
But the other big thing is that, again, it's a fairly inefficient market and, um, they don't charge you a commission when you buy a bond. What they do is they mark up the price. And so, and that's reflected in how much interest it pays to you, but you don't really know what the markup is, right? All you know is the price that they wanna charge you for it. But I can tell you that if you're buying a very small amount of bonds, the markup's gonna be pretty big. So it's gonna hurt your, it's gonna hurt the interest rate that you end up collecting because they've marked it up. And so, um, ideally you'd work with, with a, with a desk that does millions and millions of dollars worth of bonds every day because they're doing such a volume that they're gonna get a really good price on it. They're dealing with enough different other bond brokers that they're gonna just get a tiny little markup. Um, and so even if you could do it yourself, you're definitely rewarded by working with a re an income expert who has access to an institutional bond desk where you can put in orders that will be accumulated with, you know, hundreds or thousands of other orders so that you can get much better pricing on it because that'll drive up your, your interest rate. Do you know somebody like that? ?
Speaker 2 (18:08):
Well, that's one of the things that we do for clients is, you know, so when people get close to retirement, I, I talk to 'em about these concerns and typically, as long as the portfolio is big enough, you know, what we, what we do is we take the income portion of their portfolio and we, we peel it off and we build a bond ladder with it, and we go through institutional desks that do huge amounts of volume. So we get really good pricing on it, and I just leave it in their hands. I I, you know, we put it in the system and we say, here's this client, we've got a hundred thousand dollars, we want a five year ladder. Go ahead and build it. And they build it, they build it for me. Yeah. And we, and because they're doing it with, you know, millions of other dollars of, of bonds at the same time, you know, they, they might buy, you know, a million dollars of this particular issue.
Speaker 2 (18:54):
Well, my client's gonna get a little piece of it and then they're gonna allocate the rest of that purchase across the hundreds of other clients that they're buying bonds for that day so we can get really good pricing. Um, and that's, and that's, you know, and, and, and they, and they manage that for us for a really low price. You know, it's, it's, it's, uh, they manage it for us for 0.2%. Um, and because they're getting better pricing, actually, you're probably getting a fair amount of that 0.2% back by getting better pricing. So it's really efficient and you want to work with somebody who has access to that kind of thing. If you're gonna do something like this, because it is a fairly inefficient market and you need to get a good price. If you're gonna get the kind of yield that would be competitive,
Speaker 3 (19:37):
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Speaker 1 (21:04):
So who should be thinking about a bond ladder then?
Speaker 2 (21:06):
Yeah. Well, there are two characteristics really of investor that, that this is good for. One is that they're, um, fairly close to retirement. There's no really good reason for a younger person who's real, who's just accumulating money to have a ladder. This is really something, it's a risk management tool for people who are near or in retirement. The other thing is you have to have a substantial enough account that you can peel off. You know, like the minimum that we do for, for ladders is a hundred thousand dollars. Well, if we do that pie chart and we figure out how much of your portfolio should be in US corporate bonds, that pie slice needs to be at least a hundred thousand dollars. Uh, because we can't build a ladder for less than that, then we end up getting into those price inefficiencies and it's just not a good deal for them. So, you know, typically if you've got, you know, if you've got a half a million dollar portfolio, you've got enough and you're close to retirement, then you've got enough that we can, that portion of your portfolio, you know, will be big enough to build a bond ladder from. So those two things close enough to retirement, big enough portfolio.
Speaker 1 (22:05):
All right, so I guess it's time for your, your 30 minute action items then.
Speaker 2 (22:10):
Yes, it is. So it's a
Speaker 1 (22:11):
Real, you lay 'em
Speaker 2 (22:12):
On me. Here it is. Your 30 minute action list is if you are getting ready for retirement and you're, and you, you're, this might be a good solution for you. Take a look at your portfolio and figure out how much of that portfolio should be in bonds. And if it's over a hundred thousand dollars, then you might want to consider a bond ladder as opposed to bond mutual funds or exchange traded funds.
Speaker 1 (22:34):
Focused wealth advisors. Focus, uh, focusedwealthadvisors.com to find Steve worshiping. And of course, all of our podcasts are available as well at 30Minute.money And, uh, really appreciate you joining us and we look forward to more, uh, tidbits and information on this wonderful podcast. Goodness knows, I'm learning a lot. We'll see you next time.