Bonds and Bond Funds…and Risk

There's an important difference between owning bonds and owning bond funds.

?Bonds 101

A bond has a maturity date. On that maturity date, you will be paid the par value of the bond. Unless the company goes bankrupt, you will get the par value - usually $1,000. So, if you paid $1,000 or less for the bond, you'll get all of your money back... and maybe more.

Though a bond fund is made up of bonds, the fund itself has no maturity. Therefore, there is no date on which you can assume a return of your capital.

If the value of the fund is lower when you want to take your money out, you sell for a loss.

In a rising rate environment, the value of the bonds in the fund will decline - which will reduce the price of the fund.

"But wait - if I own the bond outright, won't its value decline too?" you may ask. Absolutely, it will. But that doesn't matter if you plan on holding it until maturity.

Here's what I mean: Let's say you buy a corporate bond at par that yields 4%. It matures on October 1, 2023.

Every October and April, you will receive interest payments equal to 4% annually. Let's assume that this time next year, interest rates have soared. And your bond that you paid $1,000 for is worth only $900.

You will still receive your interest payments in April and October no matter where the bond is trading. Unless you are going to sell the bond, it doesn't matter what the price is - because on October 1, 2023, you're going to get $1,000 back.

Today, bond investors should buy only bonds they plan on holding until maturity.

Junk

More than $2 trillion is owed by companies with poor credit. They're considered non-investment (or "junk") credits... You can think of these companies as subprime corporate borrowers.

In 2020, the Fed lowered interest rates to almost zero and promised to buy corporate bonds for the first time in history... That gave a false sense of confidence in the bond market. Investors began practically throwing money at companies looking to borrow, including the zombies.

Companies across the board went on borrowing binges...

Stronger companies hoarded the borrowed cash. Meanwhile, the zombies refinanced their debt and pushed their maturities out several years.

All that has done for the zombies, though, is delay the day of reckoning. As the government withdraws its support in the weeks and months ahead... many zombies won't make it.

And yet, investors are downright giddy for junk bonds these days...

Bond prices are stretched to absurd levels... Junk bonds now yield less than 4%, on average.

That's the lowest junk bonds have ever yielded. (Remember, as bond prices rise, yields shrink.)

Junk bonds are supposed to pay you the highest rates because they're the riskiest of all debt.

And it's even worse nowadays when you factor in inflation…

The 'real' interest rate on junk bonds is less than zero today…

The interest rate adjusted for inflation is known as the "real" interest rate. And when you deduct the latest inflation figure – August's 5.3% rate – the real interest rate for junk bonds is negative 1.3%.

That's right... the riskiest bonds in the market now yield less than nothing. If that doesn't scare you, I don't know what will.?

Bill Gross - the "Bond King" is the famed co-founder of fixed-income investment company PIMCO.

In his blog last month, Gross wrote that funds that buy long-term bonds belong in the "investment garbage can." He wasn't even talking about corporate bonds... He was talking about safe 10-year U.S. Treasurys.

As Gross explained…

“I'll come right out and say it: At 1.25% for the 10-year Treasury, they [interest rates] have nowhere to go but up. How quickly is the real question...”

Remember, as interest rates rise, bond prices fall.

If Gross thinks Treasurys are garbage, I wonder what he thinks about junk bonds.

He pointed out that when the Federal Reserve begins to taper its bond buying, demand for Treasurys will plummet... That will lead to higher interest rates and lower bond prices.

Gross' point applies to corporate bonds, too... The interest rate that companies pay on their bonds moves up and down with the interest rate on U.S. Treasurys. So if the prices of Treasury bonds fall, corporate bonds will follow... And they'll fall much harder.

?That's because corporate bonds are much riskier – and therefore, much more volatile – than U.S. Treasurys. A small move in the prices of U.S. Treasurys can lead to big – and sometimes, even extreme – moves in the prices of corporate bonds.

Bond funds are a dangerous place to invest in a rising rate environment because they are practically guaranteed to lose money.

?A Bleak Future

Warren Buffett minced no words in his most recent annual shareholder letter when he told investors that “retirees face a bleak future.”

Buffett was referring to the pitifully low interest rates that dominate fixed income investments (like bonds, savings accounts and traditional annuities).

In September 1981, he writes, investors could buy a 10-year US government bond yielding nearly 16%.

Now, inflation was a lot higher in the 1980s than it is today. But even after adjusting for inflation, the average annual yield for any investor who held that 1981 bond to maturity over the next decade would have been 5.7% per year.

Today, that same 10 year bond yields just 1.4%. But the “official” inflation rate in the United States is 5.3%. This means that, after adjusting for inflation, your net yield today is negative.

Millions of people have moved into bond funds because they are considered less risky than stocks. That's been the case for most of history. Today, they are almost guaranteed to lose money.

Target-date (or Glidepath) funds - are they really less risky?

Target date funds, which are often mutual funds, hold a mix of stocks, bonds, and other investments. Over time, the mix gradually shifts according to the fund’s investment strategy. Typically, the funds shift over time from a mix with a lot of stock investments in the beginning to a mix weighted more toward bonds.

According to a study by Fidelity Investments in 2018, more than half of all 401K accounts have 100% of their assets in TDFs. More than 62% of all 403B accounts are in TDFs, and over a trillion dollars is now in TDFs.?

98% of employers use TDFs, and 90% of them have it as the default option, which?means they automatically put your money there unless you specifically direct them to do otherwise – and almost no one does..?So, if you have a 401K, there is a good chance your money is in a TDF, even though you didn't request it.?So, many retirees' portfolios are heavily weighted towards bond funds.

In addition, it's 'one-size-fits-all' - not taking into account?anything?but your age.?Not income, risk tolerance, savings amount, lifestyle. Just age.?Today, TDFs are a recipe for mediocrity!

Please understand this. The markets are fluid. They are always changing based on demographics of investors, interest rates, monetary policy, inflation and even political pressure.

To think we should be investing using the same strategies whether the risk-free rate (the 10-year Treasury) is 2% or 16% is flat-out ludicrous.?To think we allocate based solely on age is doubly ludicrous.?

This isn’t intended to be a downer; but a call to action. Because there’s plenty you can do about it.

OK…What can you do?

Only a handful of people in the world have the ability to set interest rates and inflation policy, or to manage Social Security back to health. Chances are you’re not one of them. Neither am I.

But we do have the power to use every tool at our disposal to fix these challenges for ourselves.

Limiting our tools to stocks, bonds, and mutual funds is like trying to build a house with a hammer and a screwdriver. It may be possible, but is it efficient? Is it wise? It never ceases to amaze me that millions think these are the ONLY tools.

They aren’t.

There are very efficient tools offered by some of the most solid companies on the planet that can effectively navigate the rough waters ahead.

Many have guarantees.

Most will not ever lose money.

No matter what the market does.

Some will pay you a monthly paycheck even when your principal is exhausted.

For life. If you live to 110.

Try asking your broker to do that with your stocks, bonds and ETFs.

Oh...and built properly, some of them will accumulate tax-advantaged and distribute totally tax-free. So you won’t have to spend your golden years worrying about the foolish shenanigans of the Congress, the Fed and the IRS.

Tax-free distribution.

Tax-favored accumulation.

No market risk.

Immediate access to capital.

And I haven’t mentioned the possibility of long-term care coverage.

And building a legacy for the next generation... delivering 2-4x what was put in…

A Personal Pension

Yes, these are the oft-denigrated products offered by insurance companies. You know, the tools companies built pensions on (remember them) in your grandad’s day.

Created by companies that date back a century.

That aren’t in the news for defrauding customers.

If what you think you know is true turned out not to be true... when would you want to know?

But many ‘hate’ these tools now, for some inexplicable reason. Does it make sense to ‘hate’ a saw because we only are familiar with a hammer?? Does that help you build your house?

Dare we say the A word?...Annuities.

And the other word that will clear a room. Life insurance.

…ok we said it. Are you still reading? There are no other tools that can do what these will, built and applied properly.

?Fact.

No tool is for everyone. And no tool is perfect.

But building your future using half a toolbox is not only unwise and inefficient, it’s very, very risky.

Especially today.

"An open mind leaves a chance for someone to drop a worthwhile thought in it." ~ Mark Twain

Are you open to learning how to build your future with safe, tested tools? ?Contact us for a no-pressure 15-minute call to see if there's a fit. Or schedule a call here

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