How Bonds Fit into a Financial Plan

Key Points – How Bonds Fit into a Financial Plan

Why Should You Own Bonds?
Nothing Is Safer Regarding Fixed Income When It Comes to the Full Faith and Credit of the United States
The Intention Is for Bonds to be a “Stay-Rich” Investment
What Is the Relationship Like Between Bonds and Interest Rates?
The Bond Market Is Bigger Than the Stock Market
14 minutes to read | 35 minutes to listen

Why Should You Own Bonds?

One of the most common questions that our advisors here from clients and prospective clients is, “Why should I own bonds?” Considering how rising interest rates and inflation have been wreaking havoc on bonds, it’s a fair question to ask. Still, no matter the economic condition or how interest rates are doing, bonds can still make sense in your portfolio. Dean Barber and Chris Rett explain why in this Modern Wealth Management Educational Series event.

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Components of a Portfolio

To help better understand how bonds do into your financial plan, let’s first break down the components of a portfolio. Of course, you have stocks and bonds. Then, you can have some alternatives, such as real estate, precious metals and commodities, cryptocurrency, and cash.

Different Ways to Own Stocks

Let’s start with reviewing stocks. You can have large-cap, mega-cap companies that are the biggest of the big when it comes to dividend payers. There are also deep-value stocks, growth stocks, medium-sized stocks, small company stocks, international stocks, and emerging market stocks. Then, you can also have private equity by investing in private companies that aren’t traded on any stock exchange.

“There are all kinds of different ways to own stocks,” Dean said. “Stocks represent ownership in a company. If that company does very, very well and you own their stock, you’re participating in the growth of the company.”

In that regard, you can say that the intention of stocks are to be a “get-rich” investment. Obviously, that is no guarantee and might not happen overnight. And if those stocks that you own don’t do well, you’re bearing the risk of that. Most people can grasp the concept of stocks, but bonds are a little bit of a different story.

What Is a Bond?

A lot of people have heard about bonds for years and years before even starting their own portfolio, but there are many misconceptions about them. To make it short and sweet, a bond is nothing more than a loan. Dean likes to illustrate how a bond works by using an example of the 10-year treasury.

“Let’s say that Chris wants to loan the government money. The 10-year treasury is one of the most popular methods in which the United States Government borrows money,” Dean said. “So, the 10-year treasuries come up for auction and they say they’re going to auction off $X-billion of their 10-year treasury at 2.5%. What the United States Government wants to know is how much money people are going to loan them, knowing that Chris’s investment is going to repaid with the full faith and credit of the United States Government?”

The Full Faith and Credit of the United States

There are a lot of pieces to unpack before answering that question. The full faith and credit of the United States is the gold standard. It’s the safest investment that you can possibly make because it’s backed by the taxing authority of the United States.

“If I had that power and could borrow that money at 2.5%, I would be asking how much I could get,” Dean said. “But I wouldn’t go out and blow it on stupid projects. I would go out and invest that money in a place where I knew I could make more than 2.5%.”

Back to the Question…

So, how much money do you think the people are going to loan the U.S. Government at 2.5% for 10 years, knowing that their investments are going to be repaid with the full faith and credit of the United States? As Chris mentioned, that’s a very safe investment for people to make. Chris would loan the government that money at 2.5% given what where interest rates are at.

Here are where the moving parts start to come into play, though. Let’s say that Chris loaned the government $100,000. The government is going to keep that $100,000 for 10 years. Every year during those 10 years, the government is going to return $2,500 (2.5% of the $100,000) to Chris. Therefore, Chris knows that he will receive $25,000 in interest from the government at the end of those 10 years. And at the end of that 10-year period, Chris is going to get that $100,000 back.

What If the Interest Rate Environment Changes Over That Time?

But what happens if a year from now that the government tries to raise money, but no one wants to buy at 2.5% anymore and only agree to buy at 5%? The interest rate environment has changed (in this hypothetical situation and likely in real life).

Chris can’t just call the government and trade the 2.5% for the 5%. He’s stuck with the 2.5% for that period. So, if Chris tries to sell that $100,000 bond at 2.5%, he could have a hard time finding someone who wants to buy it from him since they can buy from the government at 5%. But here’s why Dean says someone would still buy it from Chris.

“Someone will buy that bond from Chris, but they’re only going to buy it if they can buy It at a big enough discount that they know they’ll average 5% at the end of 10 years. They know they’re only going to get Chris’s 2.5% per year interest, but they’re going to buy it at a 22.5% discount,” Dean said. “They’re going to give Chris $87,500 that he paid $100,000 for a year ago because they know that at the end of that time, they’re going to get the 2.5% interest ($25,000), plus 22.5% discount and what it’s going to mature at. The total return for the new buyer equals 5%.”

The Important Distinction

So, if a person makes that deal with the United States Government and two or three years later they want to sell it but the government is issuing debt at a higher rate at that time, they’ll take a loss if they sell it.

“That’s the important distinction is if they sell it. You can’t call the government and get your money back,” Chris said. “Now, the flip side is if you hold it to maturity the whole 10 years, you get your $100,000 back. But if you want to look at investing in the Federal Government again at that higher rate, you’re going to have to sell that bond at a discount or buy more bonds.”

Bonds Are Intended to be a “Stay-Rich” Investment

Here’s another simple way to look at bonds. While we pointed out earlier that stocks can be a “get-rich” investment, bonds are viewed as a “stay-rich” investment. But when you buy those bonds, you need to understand the terms and conditions of the investment. Chris sees the relationship between stocks and bonds in a portfolio as a perfect marriage.

“When you have one individual who is going to be up and down up emotionally, that person is going to be the stocks. The stock market needs that stable, calming voice in the background in a marriage,” Chris said. “That is the intention of bonds. Now, it’s not always that way, but the intention is for bonds to complement stocks.”

In a time when you’re in a rising interest rate environment and you get your financial statement and your bond is worth 10% less than what you paid for it, you’re probably asking, “What’s going on with my ‘stay-rich’ investment?” Well, that’s temporary because we know that it’s always going to come back up to its par value, which is what it’s going to mature at.

“That’s the basis of fixed income and why it’s different than the growth piece. Bond prices will fluctuate the same as stock prices,” Chris said. “The difference is that you’re getting that income in the meantime. So, you don’t need to sell it even though it may be down. Nothing is going to go up all the time. Whenever there is an exchange, there’s a premium or discount that you’ll need to pay, but the fundamental reasons to get into bonds are for the income and the return of principal.”

Relationship of Interest Rates and Bonds

When Dean and Chris recorded this educational series event on April 20, the 10-year treasury was at 2.8%. Meanwhile, the two-year treasury was at 2.6%. So, it would be much more logical to go with the two-year commitment at 0.2% less.

There have been times in history, though, where the yield curve has inverted, including one very recently. That’s when you loan money to the government for two years and getting paid more than if you did it for 10 years.

“People need to understand the principal behind that risk,” Chris said. “The longer that you have your money invested, interest rates could rise or fall. Part of that is to entice investors to make that longer commitment and therefore paying more money.”

The Teeter-Totter Illustration

The relationship between interest rates and bonds is a lot like a teeter-totter. We’ve spent a long time where interest rates have been on the ground and bonds have been way up in the air on the other end. As the interest rates start to come up, the bond values can come down.

The key to being successful with bonds when interest rates start to rise is gravitating toward the shorter-term bonds. That way, you’re not sacrificing as much in terms of yield but are still getting the safety of the bonds. Even if you can see some changes from day to day, you know that over a two-year period that you’re going to get whatever the yield is and get the money back.

The Bond Market Is Bigger Than the Stock Market

We mentioned earlier all the different types of stock options out there. Well, the bond market has even more options. Remember that all bonds are not created equal. Dean has another example to help explain this.

“Coca-Cola is known worldwide and is a very steady, strong, predictable company,” Dean said. “I want to build two Coca-Cola plants, but I don’t want to spend any of my money. I want to borrow it. So, I’m going to issue a bond. I want to borrow money for 20 years at 4%.”

Corporate Bonds vs. Government Bonds

This Coca-Cola example from Dean is a corporate bond. Corporate bonds aren’t as safe as government issued bonds, but as Dean said, Coca-Cola has a strong reputation. You’ll also notice that the terms from Dean’s Coca-Cola example are longer (20 years) as opposed to a 10-year treasury, but so is the amount he’s paying (4% as opposed to 2.5%).

“While the Federal Government is the safest place to go for bonds, the one risk you take when looking at a company like Coca-Cola is the company defaulting. That hit closer to home a little more than 10 years ago for me with General Motors,” Chris said. “They said, ‘What’s in it for the bond holders?’ Of course, GM was going through a bankruptcy. Suddenly, everyone knows how bonds work.”

Senior-Secured Debt Lenders

General Motors filed for bankruptcy in 2009—right after The Great Depression. Stockholders got hit really hard when GM filed for bankruptcy, while bondholders ended up with around 30 cents on the dollar. However, there were other lenders to GM that got all their money back. Those were senior-secured debt lenders.

“GM was wanting to raise more money and didn’t want to issue more bonds,” Dean said. “They wanted to go out to the private markets to see if they could get private lenders to loan them money. That private lender said, ‘OK General Motors. What’s my collateral? You’re already leveraged and look kind of scary to me.’ When you say senior, that means I’m going to be first in line to get repaid and secured means it’s collateralized. So, there’s a hard asset—real estate, land, etc.—that is backing that loan. Those lenders knew GM needed money, so they probably asked for like 7%. That was an outlet for GM to once again be financially secure.”

It’s All About Diversification in Your Portfolio

When you think about it, it makes sense to be interested in some of that senior-secured debt. Dean is a believer that the senior-secured debt market is a good market. That senior-secured debt might not be as immediately liquid as the bond from Coca-Cola or U.S. treasury bonds. While you might only be able to access it quarterly, you know you’re going to get a higher interest rate and most of the time it floats. So, if interest rates fall, GM is going to pay a lower interest rate. If interest rates rise, they’ll pay a higher interest rate.

“If I’m a current bond buyer, does it make sense for me to buy a 10-year treasury at 2.8%? Or should I try to find someone who is trying to issue debt and I can be a senior-secured debtor?” Dean said. “Maybe it’s at 5%, but I know that as interest rates rise that I’m going to get paid more? So, what would I do? I’m going with senior-secured debt.”

Whether it’s stocks or bonds, there’s always a trade-off. Take Apple as another example. Apple has a long track record, but you don’t want your entire portfolio to be invested in Apple and gamble with it. It’s the same with the senior-secured debt. It does make more sense right now then 10-year treasuries, but diversification is key in bonds and stocks.

Treasury Inflation-Protected Securities (TIPS)

Next, we shift gears toward Treasury Inflation-Protected Securities (TIPS). The idea behind TIPS is that the government will ensure that if inflation does rise, interest will rise with it. So, that has clearly been relevant lately.

The one drawback about bonds is that they don’t usually do a good job of keeping up with inflation because the interest rate is fixed. That’s where TIPS come in handy to address that concern in a rising interest rate environment.

“If we wanted to add TIPS to a portfolio, we would likely buy an ETF that would be a basket of TIPS that were anywhere from one to five years in maturity. Again, we would want to stay toward the middle of the teeter-totter,” Dean said. “But right now, the yield on most of those is about 5%. Do I want that today or that 10-year treasury at 2.8%? I’ll take the TIPS, but I just don’t want to put 100% of my money there.”

It Starts with Building a Plan

If you’re working with a CERTIFIED FINANCIAL PLANNER™ Professional, they are going to sit down with you, do the financial plan first, and then help you understand what your money needs to do based on the resources you have. We start with risk allocation with the diversification between stocks and bonds, but we diversify within the bond sector as well. Here are some of the questions we consistently ask when looking at bonds in someone’s portfolio.

What do we need these bonds to do?
Where can we afford to take a little bit more risk (like we talked about with the senior-secured debts)?
Where do we need income more so than growth potential?
And, of course, where does a client feel comfortable?

The High-Yield Bond Market

When it comes to bonds or any aspect of financial planning, Dean likes to do a quick history lesson to compare and contrast to what we’re experiencing today. Stress testing is vitally important to determining the probability of success of a financial plan.

So, Dean wants to take a quick look at the junk bonds of the 1980s. When junk bonds exploded in the 1980s, it was a product of what Michael Milken had done.

“Junk bonds were basically loans to corporations that maybe didn’t have a great track record or financial condition to repay that debt,” Dean said. “There were a lot of junk bonds that went under and a lot of people lost a lot of money on them. The high-yield bond became synonymous junk bonds. Today, you can look at high-yield bonds and ask if they’re really junk or if they’re decent. How much additional yield will you get to take the risk that one of these companies could default The high-yield bonds are typically going to give you 4-5% better than the 10-year treasury.”

There Are Always Trade-Offs

That brings us back to highlighting that there are always trade-offs in the bond market. Again, the safest thing you can invest in is the U.S. Government. In the next 10 years (with the 10-year treasury), you’ll get 2.8%. Or you can look for bond opportunity with a company that’s in distress or up and coming. Either way, that company needs the money because it’s growing or has made some bad decisions and needs some immediate needs covered. Therefore, that company will likely issue more than the Federal Government.

Private Sector Bonds

There are other fixed income pieces that can give you a higher yield that don’t necessarily carry higher risk. Those are private sector bonds. These are non-publicly traded companies that need to borrow money.

“Banking regulations have changed to such a degree that it’s very difficult for private companies to get the credit or loan they need from the banking industry,” Dean said. “So, they have turned to the private credit markets.”

A Private Sector Bond Example in the KC Area

For example, Russell Stover Candies is a Kansas City-based company that is very well-known and isn’t publicly traded. If Russell Stover wants to borrow money, they have two choices. They can go to the bank, which is going to be limited. Or they can go to the private credit markets where big lenders will work with them on their terms.

“The companies that are doing this need money for a short period. They outline their project and expectations for it,” Dean said. “They have a high degree of confidence that they can repay that money in a short period. That private credit market used to be exclusive to all the private lenders. But in recent years, that has become available to the average investor through interval funds.”

Interval Funds

Interval funds are similar to mutual funds, as outlined in the 1940 Investment Company Act. However, interval funds don’t provide daily liquidity. The liquidity is only provided on a quarterly basis.

“There are private credit funds that we can put money into today that are yielding anywhere from 6-8%. They also have quarterly liquidity and the average duration of the loan is three to five years,” Dean said. “These loans are frequently turning over. It’s another diversifier that we can have with fixed income that can get you a better yield. There might be a little more risk involved, but that could be worth the extra return.”

This is where we rely on mutual fund managers. It’s no different than what a growth stock manager is going to do. You’ll likely find that Russell Stover is worth the risk. Russell Stover just might not have access to the lending that other major corporations have because they’re private. That extra hurdle means a limited supply of lenders, but that means they can charge more in interest.

The Bottom Line

As we wrap things up, if someone says that bonds should be a part of your portfolio, the investor shouldn’t immediately worry just because we’re in a rising interest rate environment. Remember, not all bonds are created equal.

“We can create fixed income components of a portfolio that can go through all kinds of market cycles. Don’t just put 60% in the S&P 500 and 40% in the bond aggregate and call it a day,” Dean said. “That might have worked well in the last 10 years. And remember, we’ve been in a declining interest rate environment since 1984. It goes back to the teeter-totter example.”

One More Look Back at History

So, let’s flash back to 1983. What’s the best investment you could’ve made? If you said, “30-year treasury,” you’re correct. You would have been getting more than a 10% yield. Interest rates started falling and the treasury started appreciating in value. What’s more, there’s no risk involved.

“We live in a different world today,” Dean said. “And I don’t want to get back to where we have 30-year treasuries at more than 10%. That means there is something very funky going on within the economy. None of us want to live in that world again. In pretty much every economic cycle and interest rate cycle, you’ll find fixed income (bonds) that will work. Don’t bury your head in the sand and say that all bonds are the same.”

Using Another Auto Industry Example

Before signing off, Dean thought of one more example to illustrate from the auto industry. Dean has been a Chevy guy for a long time. So, if you would’ve asked him what stock he wanted to own in 2008 between General Motors and Ford, he would’ve wanted to go with GM. But he was quick to admit that Ford was the better stock option at that time.

“You need to look under the hood and understand what you own,” Dean said. “You need to make sure it fits into your own tolerance for risk and overall objectives of what you need your money to do. Fixed income in almost all cases will play some role in a person’s investments.”

What Fixed Income Is Intended to Do

The intention of bonds are to provide a fixed source of income in any market environment. It doesn’t mean that it stays static in value. It just means that it’s going to be way more stable than the stock market over time.

“We rely on the stock market to get rich over time, but there are going to be times when the stock market is down,” Chris said. “Just look at the S&P 500 this year. It’s not off to a great start, so clients and investors need income.”

Dean added, “People need to get a handle on this. They need to understand what’s in their portfolios—how much of it should be fixed income and how much should be equities.”

It’s perfectly understandable to still have questions about how bonds best fit into your financial plan. We encourage you to schedule a complimentary consultation or 20-minute ask anything session with one of our CERTIFIED FINANCIAL PLANNER™ professionals to talk about what sources of fixed income will fit well into your portfolio. We are happy to meet with you in person, by phone, or virtually.

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Investment advisory services offered through Modern Wealth Management, LLC, an SEC Registered Investment Adviser.

The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.