“Bonds are paying the highest yields in a generation, and interest rates are poised to come down.”[i] This is a compelling time to purchase bonds. Are you waiting for a rate cut? How will this affect your financial holdings? The answers depend initially upon your objectives and your financial situation.
It is tempting to keep cash invested in taxable money market funds paying 5 percent or more, or in tax-exempt money market funds paying around 3.22 percent, which may be a higher-tax equivalent yield depending on your marginal tax bracket.
Why would I want to purchase a longer-term bond or a certificate of deposit (CD) at a lower yield? That is a question many investors face, as short-term rates are at or near 5 percent, and longer-term rates yield less. However, this may be a questionable long-term strategy. With inflation abating, the economy softening, short-term rates may significantly decline. Countervailing forces include a rising national debt, war on many fronts and many unknowns.
Are You a Trader or a Buy and Hold Investor
There are two ways of buying bonds: by the individual bonds or purchase the packaged bond funds and Electronic Traded Funds (ETFs)
Buying individual bonds presents an investor with a financial choice that no other investment offers. The balance is between choosing a buy and hold investment that provides a predictable cash flow, no fees, no taxes, and no transaction costs, versus trying to time the market.
One of the primary features of individual bonds is that they come due at a fixed time.
In addition, high-quality bonds provide a foreseeable CASH FLOW. We believe that bond investors should focus on cash flow as the basis of their financial plan.
Let’s look at an example of a specific high-quality individual bond. (This discussion generally describes individual bonds. Bond funds or ETFs are a different animal).
Consider the following tax-exempt individual municipal bond:
- State of Virginia
- Coupon: 4%
- Price: 100 or par ($1,000 face value priced at par is called 100)
- Example: 10 bonds would cost $10,000 and would pay annual interest of $400 per year, until the bond is called or comes due.
- Rating: Aaa/AAA from Moody’s and Standard & Poor’s
- Annual Interest: Tax-exempt interest free of federal income tax
If your objective is cash flow and you are not a bond trader, you will not care what the value of the bond is during the entire time that the bond is outstanding. You will not care about the value of the bond because you know that, unless there is a default, your bond will pay its face value (100) when it is called or comes due. Bonds are unlike any other assets class; you know that your principal will be returned at face value at its due date. You can have peace of mind by ignoring the ups and downs of the bond market. If you reinvest the interest payments you will have compounding growth.
Should You Buy Individual Bonds or Bond Funds and ETFs?
“A combination of the highest bonds yields in a generation and a desire to cut risk elsewhere in their portfolios has investors pouring record amounts of money into both indexed and actively managed bond funds.”[ii]
Bond funds and bond-holding ETFs are quasi-stock investments because they never come due. Bonds are traded within the investment vehicle to maintain a more or less constant duration. These trades may generate capital gains or losses that are then passed on to the holder of the fund or ETF. There are trading costs and management fees as well that weigh on fund performance.
Timing the market is sure to result in fees, taxes and possible bad timing. When it works, market timing can be spectacular, but for many individuals it is a failed effort. As one of our long-term bond clients wrote: “B, [daughter-in-law] trades a lot [in the stock market]. She tells me by how much she beat the market – but…In the end we come out pretty even.”
Bond funds and ETFs saw large outflows in 2022 and to a lesser extent in 2023. The flow is now reversing, with large inflows during the Summer of 2024. If the Fed starts cutting interest rates, then we can expect the inflows to continue until the pendulum begins to swing again, and the traders take their gains.
The Yield Curve Is Shaped by Market Forces
The yield curve is affected by investor sentiment, which gets translated into prices and yields. Currently, inflation has not been temporary; however, the Fed is committed to bringing it down to 2 percent, while balancing a low unemployment rate. Whether they are totally successful is not important. It is the commitment to change based on the data. In the beginning of 2024, the market expected six rate cuts, but that did not happen. Now investors are hoping for one in September, and maybe more. There are so many factors that affect interest rates, it is impossible to predict their direction or movement.
Let’s say that you are committed to investing some funds in bonds. You look at the rates and see that the taxable money market is yielding 5.1% and Treasury bonds and short-term CDs on July 26, 2024 yield as high at 5.3% and a yield of better than 5% can be found out to 2026. Then the yield drops into the low 4 percent range with the nadir in 2029. From there the interest rates rise to the 30-year long Treasury bond yielding about 4.5 percent.
When short-term bonds have a higher yield than longer-term bonds, this is called an inverted yield curve. Yield curves can also be flat, not varying much from shorter-term maturities to longer-term maturities. You can expect the yield curve to change its shape as interest rates shift because it is the sum of all the bond trades in visual form.
When short-term rates are high, it seems like the safest option to just roll over your investments and stay short. In fact, a preferred investment for many retirees are CDs. They roll them over every six months or a year. The banks retain that cash and keep the funds rolling. From 1981 we had 40-years of declining interest rates.
Below is a chart[iii] showing how the Fed Funds rate was near zero after the financial crisis in 2008 and again during Covid. If you were to rely solely on rolling over short-term investments, this is what you might face. Your entire financial plan ground to a halt.
What Are Your Strategies?
Staying in Short-Term Bond Investments:
- Opportunity Risk: The biggest plus for keeping investments short-term is that you have the opportunity to choose another investment path. Investment advisors like the idea of keeping maturities short-term so that the assets can be easily deployed into other kinds on investments. Is that the reason you are investing short-term? If your objective is to create a secure cash flow then perhaps keeping your cash available for other types of investments could be a misfortune, if your fortune is misdirected into less secure investments.
- Reinvestment Risk: This is the risk that interest rates will drop and you will not be able to roll your investment into a new CD or bond at the same or higher rate. This matters. If you had budgeted a 5 percent cash flow from your investments and now you are getting less, how will you cover your expenses? Alternatively, you could lock in the higher rates at a longer maturity. Not the same flexibility, but perhaps you don’t need that. Which is more important: locking in a satisfactory longer-term interest rate and cash-flow, or having the satisfaction of staying short and liquid?
- Paying Taxes on the Interest: It seems so comfortable. You walk into the bank, and your friendly advisor suggests that you invest in CDs. Your advisor may not tell you that the CDs are taxable, and the rate you see is not necessarily the rate you will retain after taxes. CDs are taxable by both state and federal governments, as are the taxable bonds in mutual funds, ETFs and preferred stock. Ouch! That takes a bite out of the return! What are the alternatives? If you live in a high-tax state, such as California, New Jersey or New York, and are in a lower marginal tax bracket you could purchase federal agency bonds, such as Federal Home Loan Bank, Federal Farm Credit Bank or the Tennessee Valley Authority that issue federally taxable bonds that are state tax-exempt bonds. If you are in a higher marginal tax bracket, you could purchase tax-exempt municipal bonds that are both exempt from federal and possibly state taxes.
- Inflation Risk: Bonds are the only investment that repays you the face value of your investment when the bonds come due. For all other asset classes, the final investment value is unknown. Pundits will say that the principal returned will have lost value due to inflation. They do not mention that when you reinvest the interest in rising rates and principal at the current higher rates, the impact of inflation is ameliorated.
Bond Ladder: In this strategy, the investor buys some short-term bonds, intermediate-term bonds and long-term bonds. When the shortest bond in the ladder comes due, it is replaced with a bond of an equal amount on the long end of the bond ladder. This strategy is designed to smooth out the overall interest rate you earn on your portfolio – to spread the risk of concentration into any one part of the yield curve. This strategy also protects an investor from significant losses if they need to raise cash and long-term bonds are selling at a big discount. In general, as bonds move toward their due date, they move closer to their face value. The strategy of a Bond Ladder is an excellent technique in the current bond market when there is a risk of both recession and future inflation due to our massive government debt.
Custom Bond Ladder: With this strategy bonds are purchased to come due over a period of years, with the amounts of bonds coming due in different years set to match the amounts needed to meet the investor’s financial objectives and needs. For example, bond maturities might be clustered to come due to fund college expenses or to buy a house.
Barbell Portfolio: In this structure, the investor splits the portfolio between long- and short-term bonds (each constituting one part of the barbell.) The short-term bonds might have maturities of two years or less and their price will be close to face value. The long-term bonds will provide a high return for many years in the current bond market. For example, a 4% yield is available on the highest rated tax-free municipal bonds.
If you are a trader, a barbell will enable you to harvest gains if long-term yields decline. If the long-term interest rates rise, the substantial short-term bond position would enable you take advantage of the opportunity.
Tax-Loss Harvesting: Many investors have gains in other investments, and do tax-loss harvesting at the end of the year. They sell devalued bonds and purchase similar bonds with higher interest rate coupons to increase their cash flow. The loss on the bonds might offset a gain on another asset class.
High-Quality Bonds vs. High-Yield (Junk) Bonds: Why buy high-yield? It yields more! No one tells you about the risks to your principal. How do you balance out losing 25 percent of your investment in a high-yield bond versus a little more annual interest, if the bonds go into default? While it might be simple to purchase high-yield bonds, if the economy tanks, then selling will be like ten elephants trying to get through a doorway.
However, some high-quality bonds yield more than others based on their sector. Housing bonds are a very attractive choice right now as states try to increase the housing stock. For example, here is a recent new issue purchase with a sample of maturities. Note the information provided: Name of the issuer, the ratings from Moody’s and Fitch, the date of issue, when the first coupon will be paid, the initial trade date, and the fixed call on January 1, 2033. Housing bonds are generally subject to extraordinary calls, in whole or in part, at any time.
In describing the individual maturities, you are provided with the Maturity or Due Date, the Amount or number of bonds available, the Fixed Coupon or interest payable every six months, the sale Price of 100 ($1,000) per bond, The CUSIP, or the finger print of the bond, and the Tax-Exempt Yield (TEY) equivalent in the 37 percent marginal tax bracket. If you were to purchase the 2054 maturity with a 4.80% coupon, your tax-exempt yield equivalent in the highest tax bracket is 7.619%, with minimal risk.
High Coupon vs. Low Coupon Bonds: The coupon is the fixed interest rate the bond is paying. If market fluctuations drive the price higher than the face value, we say that the bond is selling at a premium. The premium value declines over the life of the bond as it approaches its due date. This premium cannot be taken as a loss, and is amortized over the life of the bond.
If interest rates rise, then the value of the bond may decline below its face value. If so, this bond is said to be selling at a discount. You can purchase discounted bonds in your retirement accounts and reap great potential rewards. Below is a taxable bond issued by Fort Bend Texas Schools that was selling at a cost of 85.058 or $850.58 per bond. It will come due at face value (100) in 2048. However, it has a call provision that enables the issuer to redeem the bonds in 2027 at 100. If the bond is redeemed at 100 then, the yield would be 9.9 percent. If the bond is not called, its yield to maturity would be 5.288 percent.
There are different, complex rules for discounted bonds held in taxable accounts. The bond buyer must proceed with caution.
Conclusion
Within the context of your objectives and your financial situation, bonds can play an important role: stabilize your financial life: help you achieve your financial goals by protecting your principal, reduce fees, expenses and taxes, and provide growth through compounding interest. The power of bond investing is revealed in the long-term perspective, not quarter by quarter. It is like a rolling snow ball – starts small but continues to expand in size as it accumulates more snow. It is the strength of interest being paid on interest, and the reinvestment of the principal.
Hildy Richelson and Stan Richelson are the authors of BONDS: The Unbeaten Path to Secure Investment Growth, 2nd Edition, John Wiley, 2011. They also provide fee-only, bond investing services to clients worldwide.
© Hildy Richelson and Stan Richelson August 5, 2024
[i] Jack Pitcher. “Bond Funds Draw in Record Amounts,” The Wall Street Journal, July 30,2024. P. 1.
[ii] Pitcher, P.1.
[iii] Jane E. Ihrig, Gretchen Weinback, Scott A. Wolla. How the Fed Has Responded to the COVID-19 Pandemic, St Louis Federal Reserve, August 12, 2020