Understanding Bonds

Following our?Upticks ?episode titled?Understanding Stocks ,?I joined Falcon Wealth Advisors ?Founder and Wealth Advisor Jake Falcon, CRPC? to discuss what investors need to know about bonds, how we use them to diversify our clients’ portfolios, our bond-buying strategies and much more. A summary of our conversation is below.

Jake:?The simplest way to define a bond is to think of it as a loan. Just how a stock is an ownership stake in a company, if you own a bond, you’re loaning money to a company or government. What typically happens when you buy a bond is that you loan an amount of money to a company or government and they agree to pay you interest on that loan for a predetermined length of time. At the end of that time, you can expect to get back the full amount of money—called the principal—that you loaned them (assuming the company or government doesn’t go out of business or default on its debt).

Cory:?That’s well said, Jake. There are several different types of bonds:

• Investment Grade Corporate bonds: Bondholders loan money to a company, which the company uses for its business
• Government bonds: Bondholders loan money to national governments, which they use for any number of reasons
• Municipal bonds: Bondholders loan money to municipalities, which they often use to pay for roads, sewer systems and other projects
• High-yield bonds: These are also called junk bonds and we don’t typically purchase them for clients at?Falcon Wealth Advisors . A junk bond is normally issued by a company or entity that doesn’t have the best credit history.?These bonds don’t have as high of a credit rating as the aforementioned investment grade corporate bonds.

Jake:?There is a bond market, just as there is a stock market, and there are a number of intricacies associated with the bond market. That’s one reason I think it’s worthwhile to work with a fiduciary wealth advisor if you want to invest in bonds. And on that note, let’s talk about the reasons we invest?Falcon Wealth Advisors ?clients in bonds. The investment-grade bonds we invest in are considered safer investments than stocks. What’s the tradeoff? Bonds don’t typically offer as high of returns in the long term. When we invest in bonds, we accept less risk and a predictable cash flow in exchange for lower potential returns.

Bonds are an important part of a diversified portfolio because they lower the amount of risk you take on and they usually generate regular income. Most of our clients are in the high net-worth sector and they don’t need to invest in risky assets in the hope that they’ll triple their money. Instead, what most of our clients are looking for is protection from risk, steady growth and predictable income in retirement. We like bonds because they?counter some of the risk ?you encounter in the stock market.

Cory, can you talk about how we buy bonds for clients?

Cory:?As regular readers know, we buy individual bonds for our clients—we’re not pooling their money in?investment products . The bond market is huge, in fact it’s much bigger than the stock market. And at?Falcon Wealth Advisors , we have access to the entire bond universe, not just what is offered by Charles Schwab, the custodian of our clients’ accounts. This allows our investment team to use Bloomberg to research bonds from all over the country and world.

Jake:?As fiduciaries, we are required to act in the best interests of our clients. That means we’re not charging markups on the bonds we purchase for clients. The same can’t be said for many advisors, and some of them may earn greater commissions from a stock than a bond, for example. This has the obvious potential to create a conflict of interest. At?Falcon Wealth Advisors , we earn the same amount of money whether we’re investing clients in individual stocks or bonds. I’m happy we’re able to solely focus on making the most prudent decisions for our clients and their financial plans.

We feel the most prudent way to manage a bond portfolio is to execute a strategy called “laddering.” As an example, if you have $500,000 allocated in your portfolio for bonds, we could buy $100,000 of bonds that mature after one year, $100,000 of bonds that mature after two years, and $100,000 of bonds that mature after three, four and five years each, for a total of $500,000.

It’s likely these bonds will offer different interest rates, but as an old colleague told me years ago, “When you buy the ladder, rates don’t matter.” In this era of rising interest rates, when you ladder maturities, you’re able to regularly reinvest the principal from maturing bonds in new bonds that are likely paying even higher interest. And if rates decline, the good news is the bonds you have invested in that don’t mature for several years will likely offer higher yields than the bonds you can buy today.

For most?Falcon Wealth Advisors ?clients, we are using a 10-year bond ladder. Why have we lengthened that ladder in recent months?

Cory:?In 2022, we lengthened the bond ladder as we saw interest rates rise. With bonds yielding higher interest rates than they did a few years ago, long-term bonds that don’t mature for 8, 9, 10 years are more attractive than they were in previous years. We’re pleased if we can earn 4-6% on these bonds, because those rates are meaningfully higher than they were a couple years ago.

Jake:?Yes, we’re aiming to lock in attractive returns for our clients. While we can’t predict what interest rates will do next, locking in a return of 4-6% serves our high net-worth clients well. It allows them to?generate income ?while mitigating risk.

Let’s talk about bond allocation. As we have discussed previously, any money that you will need in the next 5-10 years should be invested in bonds and cash. This gives you a predictable cash flow from investments that aren’t considered as volatile as pure equity positions. And it means you don’t have to sweat the stock market’s day-to-day performance, as any money you have invested in it won’t be used for several years.

While bonds are considered a safer investment than stocks, they don’t come without risk, right Cory?

Cory:?Correct. There are several?risks associated with bonds :

• Interest rate risk, which is the potential for a bond’s value to decline because new bonds being offered are paying higher interest rates
• Reinvestment risk, which involves having to reinvest the bond principal in a bond that is paying less interest
• Default risk, which happens when the bond issuer isn’t able to pay you the interest it promised and/or return your principal to you when the bond matures. This is more likely to happen with a junk bond than the investment grade bonds we buy for clients
• Inflation risk, which is the risk that inflation will erode the value of a fixed price bond

Jake:?There are agencies that rate a company’s likelihood to default and our investment management team pays close attention to these ratings as we purchase bonds for clients. I believe this is one reason it’s important to work with a fiduciary wealth advisor if you want to buy individual bonds. For example, a corporate bond may be paying 10% interest, which will understandably look attractive to an individual investor. But that high yield may be because the bond is at a higher risk of defaulting. These are the kinds of situations our team can navigate for you.

Inflation risk is the reason we don’t encourage clients to invest all their money in?bonds . Let’s say a client’s target rate of return is 6% and we can earn that return on a bond. It’s tempting to think, “I should just invest all my money in bonds.” But if inflation kicks up, it’s possible a portfolio comprised only of bonds won’t be able to keep up. For example, if you invest $10,000 in a 10-year bond, it’s possible that $10,000 won’t have the same buying power in 10 years as it does today.

Meanwhile, as we’ve discussed, stocks offer higher growth potential. Which is why if you’re retired or nearing?retirement, ?it’s so critical to have a diversified portfolio featuring both stocks and bonds.

One final note: we don’t panic when a bond’s value goes down. As many investors learned this year, when?interest rates rise, ?bond values go down, and vice versa. But as long as the bond issuer is still solvent and paying the interest they promised, the value of a bond doesn’t directly impact our clients. They will still get their full principal back when the bond matures, regardless of its value at that time.

Cory:?While many investors would consider 2022 a difficult year, I think those invested in bonds should be pleased they can generate more income from them than in previous years.

Jake:?Indeed. Thanks for joining me, Cory. I hope readers can see all that goes into managing a bond portfolio. At?Falcon Wealth Advisors , we buy individual bonds for our clients—we don’t pool your money in bond funds, where the decisions of other investors can negatively impact your portfolio. If you would like to talk about how bonds should fit into your portfolio, please contact Falcon Wealth Advisors today. You can email us directly at?[email protected] ?and?[email protected] .

Clients choose to work with us to enhance their financial literacy and explain exactly what?their?financial plan means to?them.

Hightower Advisors, LLC is an SEC registered investment adviser. Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.