Why Invest in Bonds?

Transcript

Paul Winkler: Welcome. This is the Investor Coaching Show, Paul Winkler talking about the world of money and investing. So, interesting week regarding markets in general. I had explained a concept that I’ve talked about a few times here, but it bears repeating, especially when you’re getting news about this particular event that’s occurring in markets. I want to talk a little bit about bond portfolios,bonds and, and the use of bonds. You know, some people that say on bonds, you just don’t want to touch.

The Ups and Downs of the Market

Are you hearing that recently? And it’s, it’s typically after something has gone down in value, all of a sudden people come out of the woodworks. That’s no good. They, you shouldn’t own that.It’s no good.

Oh, brilliant. Why didn’t you tell me that three weeks before it happened. 

Right.

You know, that’d be really, really nice you always hear about, “Oh, this area, that area of the stock market….”

I saw something this week about value stocks: they’re acting like momentum stocks right now.

And you really ought to get excited about this: It’s like, well, you know what? You probably should have owned some of these stocks three months ago. And I want to know about what’s going to be good next week.

The week after that—three months after that—don’t tell me what did well recently, or what did well in the last three months of the year. And Wall Street’s famous for that because they know you want the next prediction about the future.

So they’re going to give you some kind of prediction, whether they know what’s going to happen or not, it doesn’t really matter. That’s never really mattered much.

And you know, it comes as no surprise that you hear the same thing about stocks you’ll hear about a stock or a company. And people get excited, but there was one study that actually showed that when companies make the media, they make the news, whether it’s for a good reason or a bad reason, the activity in their stocks increases afterwards.

And you know, if it’s good news, people are buying it, and they drive the price up. If it’s bad news, they drive it down. And typically what ends up happening, they drive it up and then it goes down or they drive it down and then it goes back up.

So you’re always on the wrong side of the trade. That is what you find in the research. And same thing with bonds as I was talking about, but you know, back to the value stocks for just a second they’re saying it’s momentum: Oh my goodness, it’s taking off, it’s going up in value.

And it has you look at large us stocks in the S and P 500. Big companies are down. You hear, Oh pretty good news. Well, It’s nothing compared to what has happened in other areas of the market, like small and small value stocks and so on and so forth from the time that the vaccine announcements came out until now.

Stay Away from Bonds?

But bonds, let me just talk a little bit about that because yeah, something you’re hearing people say, “Stay away from bonds.” I always have to point out bonds are not for return. They’re trying to drive you to buy them for returns.

We think if I get good interest rates on my bond money, I can live off the interest, not to touch the principal. Well, if we go back through history and we look at the rate of return of Treasury Bills, for example, short-term government bonds after inflation, the rate of return is about as close to zero, as you can get, there’s no return after inflation.

Now, you might look at the nominal return, which is before inflation and see a positive return and get a false sense of that. You’re going to be secure in retirement, putting money in bonds now, not right now, of course, because interest rates are next to nothing.

But in years past, people did. They got a false sense of security that they would be okay, putting their money in these fixed investments. You know, when they paid 5%, and there were times when they paid 5% (it may seem like a distant memory now), but there were times when those things paid 5%, but that was when inflation was pretty close to that. When inflation was very, very high.

Now, if I put my money in bonds, now I look at and go, well, the interest rate is very, very low and you know, why, why bother?

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Why Bother with Bonds

Well, the reason that you bother is because your returns. What I want and where I want my returns to come from the stock market. That’s what protects me against inflation. You know, if we look at equity markets historically, return for large US Stocks(about a 7% above inflation for small companies), about 9% above inflation. Now, it doesn’t show up all the time. You know, you might have a 35% return, which is way, way above inflation, or you might have a negative 5%, which is obviously below, right? So it’s, it’s going to be back and forth around that. And what I use my bonds for is when you have those negatives. I want to have some place that I can grab money from. So I don’t have to sell my stocks low. And that’s the idea behind it.

Well, what has happened now?

Recently, as you may know, interest rates are low. You know, so if I have an interest rate of, let’s say 2% on a 10 year bond or something like that, and that means that I’m going to give them $1,000, a lender, and they’re going to pay me $20 every year for the use of the money. As long as it’s out there for, if it’s out there for 10 years, I give him a thousand bucks, then 10 years later, I get my thousand dollars back. In the interim between times, I’m going to get 20 bucks a year. And that’s my 2% interest.

How Interest Rates Play into This Discussion

Well, if let’s say, we have a year where interest rates spike some, and you know, that’s where you start to see economic activity happen. You know, if you start to see where people are going back to work, or the number of people that are in the workforce are fewer in number, and all of a sudden companies have to compete for employees based on price. You know, that they have to pay them more. In other words, you can have something that would be of an inflationary nature. In other words, if all of a sudden, let’s say, more people start to go out to eat in restaurants, because maybe they’re not so worried about the spread of a virus or something like that.

Well, now you have fewer people out there in the workforce and you have more restaurants, opening, and more demand for restaurants. So you’ve got to hire people and you might have to pay them more. If you have to pay them more, you might have to charge more for meals. And if you charge more for meals that becomes inflationary.

Then you see not only that, but you know, you’re also going to have manufacturing. People going out to stores, maybe people going out to buy, let’s say audio equipment, or TV equipment, or maybe things for their house, or maybe they’re going to buy cabinetry, or they’re going to buy floor flooring and or those types of things, or just pick anything. I mean, I don’t care, whatever you can look at computers or whatever that you might buy.

If there is an increase in demand for these things, it increases the price obviously. And because you’ve got to pay people to put this stuff together, unless you automate, that takes time. So you have an inflationary pressure and interest rates highly correlate with inflation. So, when interest rates go up or when inflation goes up, interest rates go up. So you have these two things moving together.

So hence that’s why you hear people saying, Well good grief, you could have bonds go down in value. And that is very, very true because if I have, let’s say a 10 year bond at 2%, I say you have a government bond that pays just 2%.

Then, all of a sudden, now the government has to actually pay more to use your money. Maybe they pay 3%. And now they’ve got a new bond that is 10 years to maturity and it pays $30 a year at 3%. Well, all of a sudden that 2% bond doesn’t look so attractive anymore. And because it’s going to pay $10 less per year for 10 years. Well I’m basically, I’m going to get a hundred dollars less. So how do I get somebody to buy the bond off of me while I dropped the price down to somewhere in the neighborhood of $900. Now, it’s not exactly that because there’s time value of money and it complicates it a little bit, but you know, $900.

So, my bond went from $1,000, which is what I paid for it when it was paying 2%. Now there’s a new bond out there that pays $30 per year to use my money and my bond. If I try to sell it to somebody else, well, I sell it to them. And they’re only going to get $20 a year. And hence I have to drop the price to make them want to buy my bond versus the one that pays the higher interest rate.

Right?

When the Economy’s Heating Up

So it’s pretty simple, but this is really why you have this situation. You get the economy heating up and you go, well, what do you do? What’s a person to do? Well, there are a couple things that you do. Number one, this is why you’ve got to keep—typically what I tell people when it comes down—bonds low duration on bonds.

Now you’ve got the interest rate that you’re getting paid, but what’s the duration? What’s the interest rate sensitivity?

Now duration basically means if interest rates… if you’ve got, let’s say you’ve got a duration of 20 and that’s not unusual. You’ll see municipal bond funds and things like that. Or some of these intermediate to long-term bond funds the duration’s out there at 20.

So you get a 1% increase in interest rates. You get a 20% decline in the value of your bottom. Well, what if we have a 2% increase or you start to look at it and go, Whoa, there could be a huge loss in these bonds. So what what’s a person to do? We’ll keep the durations short.

Now, how do I know that? Well, I can actually look it up. I can look up online. I can look at the duration. If I own a bond fund, I can look that up. And you can read the prospectus and find out what you can. Or bring it to somebody that knows about this kind of stuff like in our group.

So Why Bonds?

We can tell you exactly what it is. What your interest rate sensitivity is. And you know, you go, Well, why why would anybody hold a super, super long-term bond with such interest rate risk? Well, the reason comes down to the investment industry. Think about the investment industry. The whole desire is to give you as much return as you possibly can get from every different asset that you own.

You know, there are two ways we can do this.

Number one is we can lend the money for a really long period of time.

And the longer we lend it for, the higher the interest rate. Well, why is it paying such a high interest rate? Well, it’s because of that risk, you’re getting compensated for that risk, that if interest rates go up, your bonds could come crumbling down. Well, a lot of people don’t even notice it. As like in 2008. Good grief. We saw this in a big way. You know, we saw some bond funds down 20%—40% we saw some of them. I suppose, one bond fund was like 90% negative return.

It was just huge loss. And so you can have huge declines in value.

Now, there were two things at play when you had a 90% decline, number one is interest rate, but you can also have the risk of the borrower themselves. And that’s the other thing that I tell people, look at how long the duration is. And I tend to keep stuff really, really short because I’m not trying to be a hero in the bond portfolio. Matter of fact, I don’t really care a whole lot about what the bonds do as far as return goes. I want those to be really, really stable that if the market goes down, stocks go down. I can dip into my bonds, not worry about what’s happening there. And I can grab income.

Now I get a lower interest rate, obviously long run, but because I get rid of some of the sequence of returns risk, and here’s what that is: If I have an investment portfolio, that’s moving up and down and up and down. And when it’s down, if I am forced to sell things, assets at a low price it goes down 10%, and you know, stocks go down 10% or they go down 20% or you get a big downturn. I don’t want to be forced to sell stocks down negative 20% because what do I know? I know about stocks.

I know that historically three out of four years, they’re going to go down. Now, which of those years it’s going to go down. I have no clue. You might have 10 in a row that it’s up. And then two in a row or three in a row that it’s down. So it’s not just off four down, down one; or up three, down one; and then up three again and down one. It’s just not that predictable. Now, you don’t know when it’s going to happen. So what you do is you just go, okay. So I know that they’re going to go down, and I know when they go down, it can be pretty significant. So I’m just going to hang on. And I know that when markets come back, they come back pretty fast and pretty furious.

You know, historically you probably heard me say this before: from the 1940s, until now, on average, it takes about 111 days for stocks to recover from downturns. Just know that that’s going to be the case. And you know, sometimes it’s going to be a little bit longer. It might be a full year. You might have now even a two-year period. Like when we had the downturn in 2008, we had a pretty big upturn in 2009, but to fully recover, it took a little bit longer than that, but you know, it wasn’t forever. Because companies are going to slash their expenses, they’re going to cut their expenditures. They’re gonna cut the dead weight in the company. They’re going to stop buying things.

Why Bond Safety and Stability Is Important

They’re going to get rid of anything that they can to get the earnings to go back up. And it may take a little while to adapt. And that’s just the way things work. But this is why the bond safety and stability is so important in your portfolio.

Now, when you’re younger, you don’t worry about that as much because you know, that extra risk that you get with stocks is actually can be beneficial if you’re putting money in on a regular basis, because if market’s down, you’re buying more shares. Market’s up, you’re buying fewer shares and Dollar Cost Averaging is what we call that.

But when you’re older, you need to make sure you have those in that fixed income investment vehicle, in there holding value. Cause that’s where my income is primarily going to come from when markets are down so that’s one thing.

The Importance of Credit Quality

Duration. Another thing is credit quality. This is huge. You know, when I’m looking at my investment portfolio, and I’m looking at my bonds, I want high credit quality so that I don’t worry about whether they’re going to be able to repay their bills or not.

And that’s one of the other mistakes I see people make because they look for high yield or high returning bonds. And those companies that are paying high yields are high returns are companies that are really quite financially distressed.

Otherwise, why would they want to pay you a higher rate of return? And nobody wants to pay you a higher rate of return on your money if they don’t have to, but they have to, when it comes down to the companies that are a little bit more distressed, as far as you know, maybe the economy goes south.

When the Economy Goes South

So the economy goes south, and all of a sudden they’re having to pay higher yields on your money and their stocks go down. Or your stocks in general may go down and your bonds go down because as the economy gets more distressed, their ability to repay their debt is even less. I mean, I get it. I’m gonna have a hard enough time paying you. A company might have a hard enough time paying their debt during good times, let alone when the economy gets soft.

And then all of a sudden what happens is investors look around and go, Oh, wait a minute. You know, the economy’s getting a little bit soft, and this company that has some financial difficulties in there, they’re up against challenges.

Well, now I’m not sure they’re going to be able to repay their debt at all. So, what can I do since their bonds are outstanding? It’s paying, let’s say 5%. Okay. And you know, I’m going, Oh, well in some of them, that’s how, that’s how low the, the high yield bonds are. You know, they’re you say, high yield.

And some of these things, even though they’re really risky, they’re not paying a very high interest rate that spreads were super, super low. As I’ve talked about here on the show before: between the high yield bonds and the really safe and secure bonds… which is crazy. I mean, it’s just really kind of interesting what has been happening. Why? Because investors have gotten so excited about these high yield bonds that they bid the prices up and bid the interest rates down.

So, the interest rates were really, really low compared to the level of risk being taken well, that unwinds, when interest rates start to go up or risk starts to increase because investors go, There’s more risk on this bond and this outstanding bond, it’s a high yield high or junk bond as they call it a junk issuer. And, Oh, my goodness is this 5% is not enough for the risk I’m taking. I need a higher return than that. What’s a person to do? Drop the price. You’re willing to pay. Don’t pay a thousand dollars. If you buy that off of somebody, you don’t tell them,Hey, I’ll buy it off for you for 700 bucks.

Now you get the difference between what you bought it for—700—and what it matures for a thousand. So you get the $300 plus the interest payments. And if it was 5% of this 50 bucks a year for out (however long), those bonds out there. So see that’s how it works.

In one of the things that you get to think about: you’ve got two different levels of risks that you got to be really, really kind conscious of, that’s the interest rate risk, and that’s that interest rates go up, bond prices go down. Then, you also have the risk because of just that—the credit worthiness of the borrower. And that is something that can change in a heartbeat.

You know, you can literally have overnight Liveris, that’s perceived to go up and the bonds drop in value. So be very conscious of this as an investor, you can’t ignore these types of risks and bonds.

You know, there’s a lot of interesting things going on right now, and only time will tell where all of it lands. Two things that you can pay attention to as an investor, especially as you get older and closer to the time when you’re taking income or when you are taking income.

Paul Winkler, this is the Investor Coaching Show.

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