Investing in Bonds #1: How to Invest in Bonds + Pros & Cons
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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm kicking off our four-part series on investing in bonds. Contrary to what most people think, the bond market is actually more complex than the stock market, but don't worry, I'm here to translate everything for you into plain English. In today's episode, you'll learn three big things about bonds. Number one, a short history lesson on savings bonds.

Number two, a breakdown of individual bonds versus bond funds. And number three, how I think most people should invest in this asset class. So if you're a retirement saver who wants to better understand the world of bonds and how they work, you're going to love today's episode and this four-part series. For all the links and resources, head over to youstaywealthy.com forward slash 85.

Okay, first things first, I feel like we should address the traditional savings bonds that many of you have probably had an experience with growing up. So just a little short history lesson for those that are interested.

Savings bonds were first signed into legislation by Franklin Roosevelt in 1941 to help Americans save money during the Great Depression. At least that's how it was positioned to the public because as you might know, savings bonds were issued and used to also help the government raise funds during World War II. And here's how it worked. When you buy a savings bond or any bond for that matter, you're essentially loaning your money to that

organization and in this case with savings bonds that would be the us government the us government then uses your money for whatever they want in this case funding world war ii and then in return agrees to pay you back at a later date with some interest

People, the public, they liked these safe long-term investments that were backed by the U.S. government. And in the 1990s, they gained even more popularity because Congress created tax exemptions for bonds used to pay for tuition, very similar to a 529 educational savings account that is tax exempt when used for higher education.

So savings bonds still exist today and operate very similarly, but there are some caveats. So just a few fun facts for you guys. Number one, as of January 1st, 2012, so about eight years ago, paper savings bonds are no longer sold at financial institutions. You can no longer get one of those paper savings bonds. The only way to buy them is to buy them directly and electronically through Treasury Direct. So I'll link to Treasury Direct in the show notes if you want to check it out, or you can just go and Google it.

Number two, you might already know this, interest income is exempt from state and local income taxes. And then number three, the rate of return is set by the U.S. government and it changes frequently and it can take up to 20 or 30 years for the bonds to fully mature and double their original value.

So for comparison, an investment with a 10% rate of return, which historically is what the US stock market has given you over the last 100 years. So an investment with a 10% rate of return will double every 7.2 years. This is known as the rule of 72. These savings bonds have a much lower rate of return. So it's taking 20 or 30 years for them to double their original value.

In short, I personally believe there are better options out there than traditional savings bonds for most people, even something as simple as an FDIC-insured bank CD.

Also, you can likely better control your risk by buying U.S. government treasury bonds at auction or even in the secondary market. You don't necessarily need to lock your money into a savings bond, which cannot be bought and sold between private parties. You don't need to do that in order to get an investment that's backed by the full faith and credit of the U.S. government. You can buy U.S. government treasury bonds at auction or again, even in the secondary market.

Okay, for those of you that are still awake, let's move into the real topic for today and the rest of this month, which is investing in the bonds that most of us interact with on a daily basis. You know, your corporate bonds, municipal bonds, and yes, even plain vanilla U.S. Treasury bonds and tips.

Similar to stocks, there are two ways you can invest in bonds. You can buy individual bonds or you can buy a fund that buys and holds the bonds for you. Again, like stocks, the fund you use could either be a mutual fund or an exchange traded fund, also known as an ETF. Now, I'm not going to get into mutual funds versus ETFs again here since I touched on it quite a bit in last month's series.

So for the sake of just keeping things simple, we're going to group ETFs and mutual funds into the same category, at least for this episode, and refer to them all as funds. The one thing I will remind you of is William Bernstein's research where he makes a strong argument for why you probably shouldn't use ETFs when investing in bonds. And I'll link to his research in the show notes. But for now, I'll just highlight a few bullet points.

First, unlike mutual funds, ETFs trade intraday. In other words, you can buy and sell ETFs throughout the day while the market is open. And this isn't much of an issue with stocks because stocks are highly liquid. But because bonds are issued at different times of the year and with different coupons and maturity dates, bonds can be highly illiquid.

For example, one single corporation like General Electric or Ford Motor Company, they could have hundreds or even thousands of bonds floating around out there in the secondary markets because again, different issue dates, different maturities, different coupons, there can be a lot of them. So again, bonds can be highly illiquid according to Bernstein's research and these illiquidity issues can become even bigger during catastrophic times.

So if you add illiquidity with the challenges of intraday trading in an ETF format, in some situations you can then end up paying a lot more for your bonds due to these inefficiencies.

As you all know by now, the more you pay for an investment, the less of a return you can expect. That's just how it works. Finally, since mutual funds don't trade like ETFs, remember mutual funds trade at the end of the day. They can only be bought and sold at the close of the market each day. They don't have the same intraday trading issues that ETFs have.

So I don't say all this to send you racing to go sell all of your bond ETFs, but just to share it with you and acknowledge that this research does exist and that ETFs and mutual funds are not always identical when looking at different asset classes, asset classes being stocks or bonds or real estate investment trusts or gold or whatever asset class you're investing in. ETFs and mutual funds aren't always the same when we're looking at these different asset classes.

And I want to be completely fair and objective here. Bernstein goes as far as saying that you should only buy municipal bond mutual funds and corporate bond mutual funds to the extent that you need or want to own those two asset classes.

When it comes to U.S. government bonds and tips, which he claims that these should be investors' largest bond holding, he suggests and thinks that these should be bought individually at auction, not through a mutual fund. He also makes the case that individual bank CDs should be in the mix as well.

So again, in short, Bernstein only thinks you should use mutual funds for bonds if you're buying municipal bonds or corporate bonds. But when it comes to U.S. government bonds or tips, he thinks you should be buying them at auction and also sprinkle in some individual bank CDs as well.

While he might have a point here, you do have to factor in the time it takes to build and manage an individual bond portfolio. And if you're not doing it and you've outsourced this task to a financial advisor, know that it will take he or she a lot more time to build and manage an individual bond portfolio with some bank CDs sprinkled in there. Uh,

their time, as you know, isn't free. So to manage a custom individual bond portfolio for all of their clients means they would have to charge a lot more for their services. Unlike a stock, bonds are maturing at different times and at different amounts. Credit ratings are changing. Also, interest is paid throughout the year on these bonds, and that interest must be manually reinvested. You can't automatically reinvest the interest on an individual bond or

like you can with a stock. So in a lot of cases, it can be a really time consuming process. And I'll share more about that in a minute.

Also, contrary to what Bernstein says, there is some pretty compelling academic research out there that takes the whole opposite side, which is that bond mutual funds actually do make the most sense for investors, that individual bonds are actually not what they're all cracked up to be. So I'll be sure to share more about that research with you later this month. But for now, let's dive a little deeper into these two ways that you can invest in bonds and the pros and cons of each.

So let's start with individual bonds. Let's start with the pros and cons of buying individual bonds. The first pro is that in some situations, you can better control your costs. And if you manage it properly, it's possible to achieve lower fees buying individual bonds than by investing in funds.

Now, there are some caveats here given the complexity of bond trading, but let's just assume you have the complexity figured out. And in that case, you would be able to better control your costs buying individual bonds. The second pro is you have more control over the risk you're taking. With bonds, risk is typically tied to the credit quality of the issuer and the maturity date.

You can pinpoint the exact amount of risk you want to take by piecing together your own individual bond portfolio or bond ladder. You can also influence your risk by choosing how many bonds you hold. So when you're piecing together these individual bonds and building your own portfolio, you have more control over the risk you're taking. The third pro is more predictability.

Unlike stocks, in the bond world, your rate of return is basic math. To calculate the annual rate of return on a bond, you simply divide the interest paid each year by the purchase price of the bond. Now, there are some other formulas you can use to better forecast how that bond will perform. I'll let you dig into the nerdy details if you want to learn more, but that's the basic calculation for determining the annual rate of return on a bond. Simply divide the interest paid each year by the purchase price of the bond.

As long as you hold that bond of maturity and the issuer doesn't disappear off the face of the earth, you know what your return will be. So the third pro, more predictability. Lastly, the last pro is enjoyment. Most clients hire me not because they aren't smart enough to be managing their investments on their own, but because they don't enjoy doing it. They want to enjoy retirement, outsource this tedious task to a professional.

But if managing your own investments is how you like to spend your time, and I know that's the case for a lot of the Stay Wealthy community that I've talked to, then there's nothing better for an investment nerd than getting your hands dirty, buying individual bonds, buying and trading and selling individual bonds. So if you enjoy this stuff, then I would throw that in the pro column that this could be enjoyable to really get your hands in there and learn more about trading individual bonds.

Okay, let's move into the cons of individual bonds. The first con is while you might be able to control your costs in some situations, it's not always easy to figure out exactly what the cost is.

And that's because the price of a bond is usually baked into the purchase price and yield. So a broker, whether it's a big brokerage firm like Morgan Stanley or Merrill Lynch or Wells Fargo, or even a discount firm like Schwab or Fidelity, they make money by selling a bond to you at a higher price than what they paid for it. You know, no different than like a car dealership, right? They have to make a little bit of a profit.

The bond market isn't always a level playing field, especially for mom and pop investors like you and me. In fact, a 2015 study, which I'll link to in the show notes, estimates that individual investors pay on average about 0.77% to buy corporate bonds, individual corporate bonds.

So while you might be able to control your costs in some situations, it's not always easy to figure out what the cost is that you're paying for that bond. Again, because it's baked into the purchase price and the yield that the broker is showing you.

So that's the first con. The second is you often end up with cash on the sidelines when investing in individual bonds. As you might know, individual bonds typically pay interest twice a year. When those interest payments are made to you, they're often too small to reinvest back into another bond.

It's also not, and this is the bigger part, it's also not something that's easily automated. In other words, interest gets paid to your account and then you have to manually log in and decide where and how to invest it. And more often than not, because it's not automated and we all are busy, those interest payments end up sitting in cash. And as you know, cash is a drag on your portfolio. So investing in individual bonds, investors end up with extra cash on the sidelines. It's not put to work.

The third con is time. So as mentioned a few minutes ago, trading individual bonds and managing your individual bond portfolio can be time consuming, similar to managing individual stocks. Trading bonds can be even a little bit more nuanced than that, especially when you're trying to mitigate fees and costs and really understand what's going on. So it is time consuming. I would throw that in the con column. Lastly, the fourth con is

is diversification and risk. So given some of the challenges of trading individual bonds, it can be tricky to build a healthy diversified bond portfolio. And it gets even trickier when you're trying to buy global bonds, since that would require the hedging of currencies through something that's called swap transactions. So for all these reasons, many individual bond investors end up with a fairly concentrated portfolio of bonds that

because of the time and effort that it takes to build this bond portfolio and trade them properly. So you end up with a little bit more risk.

So, those are the pros and cons of individual bonds. Let's move into the pros and cons of buying bond funds. So, the first pro is better pricing. Yes, you heard me right, better pricing. So, the bond funds that we all know by name, they manage billions of dollars. So, who do you think is going to get better pricing when they go to buy or cash in a bond? Do you think mom and pop investors like you and me who are buying and selling $50,000 here, $100,000 there?

Or the institutional fund manager who has a $2 billion buy order. Schwab, a custodian that also brokers bonds, they're on the record acknowledging that bond funds and their institutional managers do in fact get better pricing on individual bonds than investors like you and me. And it makes sense, right? Like they have large orders to place, so they're going to get better pricing.

The second pro is diversification and risk. So with one single purchase order, you can immediately be diversified across the globe in your bond portfolio. It's hard to match this kind of diversification as an individual buying one bond at a time while also dealing with bonds that are maturing and in need of a new purchase.

Along with gaining access to a wide variety of bonds in different markets, you're also protecting yourself against a company's credit rating getting downgraded or a bond issuer just disappearing off the face of the earth. It's not a huge deal if the fund owns 2,000 other bonds if one of them goes out of business. But if it's one of five bonds you own, then that's a little bit different of a story. So the second pro, more diversification, better control over risk there.

The third is saving time, right? You're probably starting to realize that you can almost have your cake and eat it too with bond funds. You're getting better pricing, more diversification, you're reducing risk, and you're also saving time. So it's a pretty sweet deal. The fourth pro is professional management. So as mentioned at the top of the show, the bond market is quite complex and the relationship to interest rates adds to that complexity.

In some cases, or maybe in a lot of cases, having a professional fund manager to navigate the daily, monthly, and annual moves in the bond market and the interest rate environment, that person can add significant value and reduce risk and even improve returns. So I think one of the last pros here is professional management, having somebody navigate this complex environment for you.

Okay, so let's move into the cons of bond funds because yes, there are some. So yes, you get professional management when you buy a bond fund, but that comes with management fees. I've already shared that expense ratios on these low cost index bond funds, they're getting close to 0%. But like stock mutual funds, like I shared last month, there's still a very good number of high cost bond funds out there to watch out for.

Also, remember that you're not only paying the management fee on the fund, but you're also absorbing the cost that the fund manager incurs to buy and sell individual bonds on your behalf in the portfolio. It's not all that different than the bid-ask spread on a stock. It's this hidden layer of extra fees that some investors forget about. So, you know, the expense ratio on your bond fund might be close to 0%, but the individual bonds being purchased

still incur costs that you're absorbing. Again, fortunately, those fund managers are often getting better pricing than you and I as individuals would likely get, as mentioned by Schwab in that report, which I'll link to in the show notes if you're interested. So the first con is, yes, you get professional management, but that does come with an extra layer of fees that you have to be conscious of.

The second is bond funds are not as predictable. Unlike your simple individual bond where you can calculate the interest income and calculate the exact return when it's held to maturity, your bond fund and the hundreds or even thousands of bonds that it owns are

it's going to fluctuate on a regular basis. The dividend can go up and down, which makes the income piece more unpredictable, and your principal will also change each day when the fund's net asset value is calculated.

So this can make planning for your future liabilities a little trickier if you don't have a comprehensive plan in place to create this income stream. So bond funds, because they are so diversified and there are so many bonds involved, are not as predictable as buying that one single bond or just a small handful of bonds.

The third con is less control over risk and taxes. So while you're able to see a bond funds target duration and average maturity, those targets can move around on a daily or monthly basis because of the quantity of bonds being managed in that portfolio.

Similar to stock funds, sometimes when you look under the hood of these funds, you find out that the fund is taking a lot more risk than what was outlined on the sales page of their website. To some, this might be perceived as having less control over the risk they're taking. Also, similar to stock mutual funds, you have less control over capital gains taxes when investing in bond funds in a taxable account.

The last con, lastly, bond funds are boring. If you love investments and trading and you love doing this in your free time, buying a few low-cost bond funds through Vanguard or Fidelity or Schwab, that just might not be exciting enough for you. So I think it's something to consider. If this is something that you're doing on your own and you really love this stuff, buying some bond funds is pretty boring.

So to recap, I'm realizing that I often leave you guys hanging on this podcast with these, it depends type of answers. And in a lot of cases, it depends truly is the right answer. It's not all that different than me meeting a doctor at a party and asking him or her what medication I should be taking. He or she would probably say, it depends. Let me ask you some questions. Let me learn a little bit more about you first.

In the case of today's topic, I do struggle to see why most investors would opt for managing individual bonds. And I have to preface this that it's not a recommendation, but I just personally think that if it's done prudently, the pros of using a low-cost bond fund outweigh the pros of trying to build an individual bond portfolio.

And that's what we'll dig into next week. What to look for when investing in bond funds, how returns are actually generated in the bond market, where there are opportunities to improve your returns, and of course, how to avoid some of the major pitfalls.

So for all the links and resources from today's episode, head over to youstaywealthy.com forward slash 85, and then look out for next week's episode, where we'll dive into bond funds, where returns are generated, how you can avoid those pitfalls and everything I just mentioned. Thank you guys as always for following along. I hope this is helpful and I look forward to part two next week.

This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.