Before we talk about bonds, Schwab has received reports matching up with one of my posts from earlier this summer about how fraudsters are leveraging AI to make it easier to rip you off. The idea is you’re contacted by someone purporting to be a Schwab employee who needs to verify suspicious transactions within your accounts. They have some information about you gleaned from the internet and maybe an authentic-looking website. You’re asked to confirm login credentials, pass along a two-factor code, etc, and you’ve handed over the keys.
To be clear, nobody from Schwab will ever call you in this way. Frankly, they’d likely reach out to me first if there was suspicious activity related to your accounts. So, if you get a phone call or email close to what I’m describing above, hang up. Then either call Schwab yourself after looking up the number online or call us.
And this applies to other brokerage firms. They all have internal policies forbidding employees from asking you for login credentials, so play it safe and assume the call is fraudulent.
Okay, on to this week’s post…
The bond market has been struggling again as interest rates rise. I’m sure you’ve seen evidence of this, and we’ve discussed it in this blog. The reasons are wound together: strengthening global economic growth coupled with persistent inflation here at home, the Iran War and oil prices, massive public borrowing to fund AI development, Fed policy shifting to rate increases, and how investors are interpreting it all.
It’s complicated but that’s nothing new. Still, it’s reasonable to revisit why we own bonds as our “fixed income” investments, review alternatives, and make judgments about how viable they are.
First and to oversimplify, bonds are loans that investors make to a bond issuer like the US government, a state or local government, or a company like Google that borrowed something like $32 billion earlier this year to fund AI expansion. Bonds are issued with a specific maturity date from 30 days to 30 years, and a few last 100 years. Each has a set annual interest rate typically paid every six months and gets sold into the market via a process roughly similar to a stock IPO. Then the bonds are held until maturity by investors or, more commonly, end up being traded back and forth in the secondary market at premiums or discounts depending on various factors. This trading creates a focus on a bond’s yield to maturity which bakes in the premium or discount and moves opposite to the price of the bond. Further, most investors own bonds by owning shares of mutual funds or ETFs which can individually hold thousands of bonds. For better or worse, this tends to obscure the details of the individual bonds held in those portfolios.
Anyway, bond yields have been rising pretty much across the board, which has been impacting prices based on issuer type and average maturity. To cherry-pick some timeframes, a typical short-term (1-3yr) bond ETF is up almost 0.5% this year, while the US Aggregate Bond Index (5-6yr) is down 2.2%. Longer-term bonds (20+yr) are down 6.2%. Over the same time, Treasury Bills maturing every 30 days (considered a cash equivalent) are up about 2.6%. Along the way, typical money market mutual funds at Schwab and Vanguard have paid about 3.5%.
Over a three-year period, the bond funds mentioned above performed about the same, from 13% to 14% cumulative return, except for long-term bonds which only grew a measly 1%. Stretch that timeframe to 5yrs and 10yrs and “cash” outperformed. It’s not until 15yrs and longer that holding bonds, especially the 5-6yr aggregate version mentioned above, has outperformed holding cash.
So, why own bonds at all?
Bonds have to pay regular interest regardless of their market value. Right now, those cash flows go from maybe 4.3% to a little over 5% if we look at bond maturities from one to five years and stick with higher-quality issuers. Bonds go into default if they don’t pay and default is exceptionally rare in the US. Less than 0.2% of highly rated corporate bond issuers default each year, based on long-term averages (and the default rate remained less than 1% during 2008 and 2009).
The most common bonds are those issued by the US Treasury. While there have been times when the Treasury has technically been in default, these happened a long time ago. Since then, US Treasury debt has been considered the global benchmark for “risk free” assets and is considered the most liquid in the world. Somewhere around $1 trillion worth of Treasurys are traded each day. For comparison, the Treasury market is nearly 3x the size of China’s and 4x the size of Japan’s. From a practical standpoint, it’s incredibly fast and cheap to transact in Treasuries. For example, if the market is open on a Tuesday, I can sell a bond and have cash in a client’s bank account by Wednesday via a wire or Thursday via normal bank transfer; liquidity is an underappreciated aspect of your financial plan.
Combine those two reasons, certainty of cash flow and liquidity, and it’s easy to see why bonds are popular with institutions and individuals looking for relative certainty and a fixed income.
Still, bond performance has been frustrating so let’s look at some alternatives (not an exhaustive list). Each brings its own risks, so understanding how to evaluate that is critical.
Bonds vs Bond Funds – As mentioned above, you can buy individual bonds or funds that own bonds, or you can buy both. Frankly, I often do the latter for the first few years of what a client needs and then buy medium-term bond funds to fill out the rest of the client’s fixed income allocation. (I don’t normally buy long-term bonds.) The benefit is that bonds for the first years have set rates and dates, and I can use the early maturities to reinvest or to help fund a client’s spending needs. If managed correctly, there’s little to no market risk with this structure. Then the medium-term bonds can float with the market, hopefully rising in excess of the yield on cash while keeping up with inflation.
Cash – in the form of a money market mutual fund, a “high yield” savings account, or certificate of deposit issued by a bank or credit union. These are great options for money you need to keep safe for a year or two, but it’s not meant for longer-term income. Cash usually pays the least interest because there’s no meaningful market risk, and the risk comes from keeping your money in these vehicles for too long and underperforming the bond market. But as mentioned above, recent history challenges that assumption.
Dividend stocks and preferred stocks – As the names suggest, these aren’t bonds but some folks still put them in the fixed income category. A quick look at two common index funds shows a dividend yield of 3.4% and 6.5% respectively (for comparison, the S&P 500 currently yields about 1%), so these fund categories provide good cash flow along with stock market volatility. Also, these cash flows are not guaranteed in the same way cash flows from bonds are, so that’s another issue. If you can withstand more volatility in exchange for higher cash flow, swapping some of your bonds for these hybrid categories can work.
Direct investment in real estate or via private Real Estate Investment Trusts – Owning a rental property can be a great opportunity for fixed income. Owning shares of REITs can also work. The main issue with these options is liquidity risk. I’m sure you’re aware of how challenging it can be to sell a home depending on your timing; sometimes even just to borrow against it. And there are lots of stories about how getting cash out of a private REIT can feel like trying to squeeze water from a stone. Still, if you’re open to it and find the right property, buying a rental can make good long-term financial sense. That said, mortgage rates are tied to bond yields, and the typical 30yr mortgage rate is about 7.2%. Loans on investment properties are usually half a point or more above that, so selling bonds and buying a rental isn’t necessarily a slam dunk, at least not right now.
Private credit – This is a complex sector, but a fairly straightforward option is lending to risky homeowners via first trust deeds at above-average interest rates. These are usually loans of up to a few years and are tied to the property, so cash flow can be good assuming everything goes to plan. But borrower default means foreclosure and taking over/selling the property to get your money back and sometimes standing in line with other lenders. But you can be compensated for that added risk and complexity by higher rates – just don’t invest too much of your savings into this category.
Fixed annuities – The simplest annuities function like buying a pension payment or buying a medium-term bank CD. Avoid the more complicated versions where performance is tied to a market index. A quick Google search shows lifetime income and five-year deferred annuity contracts with better companies paying around 5.5% to 6%. That sounds good, but accessing a large chunk of cash early usually has a penalty. Those rates are only marginally better than more liquid corporate bonds, but it’s a viable option if you don’t think you’ll need to touch the money and you’re looking for something other than bonds. Still, I tend to avoid these contracts because of the liquidity issue and how complicated they can be.
So, there you have it. Bonds are having a tough time, but I continue to favor them as a fixed income vehicle because they’re easy to buy, sell, and research, and have income guarantees that are tough to beat. Still, some of these other options can work in conjunction with bonds in your portfolio, so optimizing the blend can be a good goal.
Have questions? Ask us. We can help.
