Exploring the Drawer of Bonds
Bonds are not useful for growing your Money Machine. So why does your file cabinet have a bond drawer? As you will remember in the article ‘Library of Investments: The File Cabinet’ — the three drawers are stocks, bonds and real estate investment choices.
First, because in the allocation of your cash, you may choose to safely tuck some money in Treasuries—U.S government-assured, fixed-rate-of-return securities. This is a means of guaranteeing the return of your money on a certain date and for a known interest rate. You may choose to secure 20 percent of your portfolio this way if you’re conservative.
And second, because bonds may become important later in your life, when you reach a stage where you want to receive a fixed amount of income that’s regularly paid to you.
But the bond market is not the place to be if you want to repeatedly double your money so that you can reach your Money Machine goal. Under most economic circumstances, bond rates hardly keep you
ahead of inflation. The interest they pay is too low, and it takes too long for your money to grow. However, you can safely stash some money in Treasuries and you’ll want to know enough about bonds so that you can decide wisely should a broker or adviser ever encourage you to include them in your portfolio.
What is a bond? For our purposes, a bond is any security that pays you interest for a specified period and then repays you the face value of the security. When you buy stock, you become a part owner of the company. When you buy a bond, you become a lender; the company, bank, or government agency issuing the bond is borrowing money from you for a certain length of time and agreeing to pay you a certain amount of interest for it.
Examples of bonds include certificates of deposit (CDs), government savings bonds, corporate bonds, municipal bonds, and Treasury notes. The difference between them is their time span and their interest rates—some pay higher interest than others.
For example, let’s take a look at CDs, which are jokingly called “certificates of depreciation” these days. When you take the (usually very low) interest rate and subtract inflation, the real rate of return is sometimes negative. In other words, the value of your investment is shrinking over time rather than growing. And remember the Rule of 72, which governs the process of doubling your money: 72 divided by negative-something does not work very well! In 1975, which boasted the highest average annual CD rate—15.79 percent—after subtracting inflation and taxes, the real rate of return was –2.43 percent.
So be wary of bonds as an investment, especially during the years when you’re working to grow your Money Machine. They won’t serve you well.
For much of the twentieth century, investors looked to municipal bonds to provide income for their futures. These bonds are issued by states, cities, counties, and other local governments as a way to borrow money in order to build projects and to provide for other government needs. Because they are government issued, municipals had some special advantages. Bonds provided tax-free income, and if they were issued as bearer bonds—bonds that are not shown on the investor’s tax return—they could easily be given to someone else without incurring any tax liability. For years, when inflation rates were low, these bonds worked very nicely because they yielded a semiannual income you could count on to pay daily expenses. For many investors, municipal bonds provided a predictable stream of tax-free income.
In the mid-1970s, municipal bond interest rates reached all-time highs; then, in the early 1990s, they reached historical lows. People found that the prices of their bonds varied widely. Also, as part of the tax reform of the early 1980s, all bonds were required to be issued as registered bonds: The bond trustee must record the investor’s name and address, and municipal bond income is reportable on tax returns. (Even when the muni interest itself continued to be tax free, investors were indirectly hurt because their overall income increased and, thus, pushed them into a higher tax bracket.) So municipal bonds lost some of the features that had previously made them such an attractive investment.
I cut my teeth in the investment banking world by structuring bond transactions for municipal projects. I was responsible for packaging multimillion-dollar bond programs; the bonds were then sold to individual investors.
Soon after I entered the bond market in 1975, I saw municipal bond interest rates reach more than 15 percent, and they were tax free. Today, they are down to the 2–4 percent range, which is the low end of where they’ve been historically. One key to understanding bonds is that when interest rates rise, the price of an existing bond falls. How does this work? Well, suppose you have a bond that pays 4 percent interest, and you want to sell it to me, but the prevailing interest rate is 6 percent. Therefore, I am going to buy your 5 percent bond only if you sell it to me below your cost to compensate for the bond’s lower interest rate. Today, interest rates have more room to rise than to fall, and every rise in interest rates means a loss in value for bonds. This means you’re likely to lose money in a bond investment in today’sinterest-rate environment.
Have you noticed that mortgage interest rates are historically low? This gives you a clue. They mirror the bond market. If rates were historically high but were heading downward, your bond’s price would rise. It was certainly not such a bad idea to buy municipal bonds when their interest rates were 15 percent, which was a historical high. Chances were that interest rates would fall and the price of your bond would rise. Today, the opposite situation exists.
When I created my own municipal bond company, I traded large blocks of bonds. We helped the city of Chicago, for example, to create bonds that provided money to build new schools and airport and sports facilities. We owned those bonds; we then sold them to bond funds. We owned about $8 million in California state bonds when, in 1994, the chairman of the Federal Reserve Bank unexpectedly hiked the Fed Funds interest rate. I hate to tell you what happened to the price of our bonds. Trust me, it wasn’t a pretty picture. It was a challenging situation, but we got through it and went on to more fruitful opportunities.
To help me with situations like these, I sought the counsel of a wise and wonderful older man named Wayne, who had spent forty-seven years in the municipal bond business. He had retired from Merrill Lynch, and during his career, he had once been in charge of its West Coast bond trading department. Wayne was one of those special men who encouraged me to be more than I thought I could be, and who sometimes really leveled with me when I most needed to hear the truth.
We were sitting in my office one day chatting about the bond business, and our conclusion made us laugh: We surmised that we couldn’t understand why people would want to own bonds! Even if you get a good tax-free rate of 10 percent for a municipal bond, when interest rates go down, the municipality may buy back your bond, so that it can refinance its debt at a lower rate. (This is known as “calling in” a bond.) And if you buy a bond with a 5 percent rate and interest rates go up, you’re stuck with a low rate and a bond whose value is sorely diminished.
Then you Have to Ask Are Bonds Safe?
Some people, however, still believe that bonds are safer and more secure than stocks. Sadie, the writer I’d met at the Ranch, called me one day, somewhat troubled about one of her investments. She had successfully grown about $35,000 in mutual funds. But her broker had suddenly advised her to dump two of her mutual funds and to get into the bond market. The brokerage ﬁrm seemed to think it was the right time to make such a move. This didn’t feel comfortable to Sadie. Both of her mutual funds had outperformed the stock market, but her broker persuaded her to drop them and switch her investments to a bond fund that dramatically underperformed the stock market.
Along the way, her broker had not provided Sadie with any knowledge about bonds or how they work; she was not educated about her choices. Hooked by his advice, she took a dive. Sadie sadly watched the price of her bonds plummet. Once again, a woman was following her White Knight instead of controlling her own financial future. At least this time, she paid attention to that uncomfortable feeling in the pit of her stomach and questioned the advice she’d been receiving. Sadie asked me to examine her portfolio and to help her sort through her various investments. We’ll get back to Sadie and her bond dilemma later.
There are periods when it is better to own bonds than stocks— usually relatively short intervals when the performance of the stock market and trends in interest rates are such that bonds outperform stocks. Unfortunately, it’s virtually impossible to recognize such intervals in advance.
Some people claim they can “time” the markets—or move their investments from cash to stocks to bonds according to changes in market activity so as to get the best possible results. But when I worked on Wall Street, I found that, many times, the forecasts of the “experts” were exactly the opposite of what actually happened. If the weatherman on the six o’clock news incorrectly predicts a sunny day and you go out without an umbrella, the worst thing that happens is a horrible hair day. But if you base an investment move on someone’s erroneous forecast of interest-rate changes or economic upheaval, you can lose big time. If you are out of the stock market for only a few days in some years, you can miss major gains for the year.
No one knows what the stock market is going to do. If they did, they would all go home because they would have collected their riches. The truth is, most people in the securities business don’t have a clue. But making predictions about market timing is a fine way to move customers’ money and is frequently a means to generate commissions. The brokers may beneﬁt, but you don’t.
This is what happened to Sadie. Her bonds declined in value while the stock market rose to glorious new heights, all because a particular brokerage ﬁrm had a theory about “market trends.” Or maybe it was just a particular broker who had the theory. No matter. Sadie is the one who had to live with the results.
The sound wealth-building strategy is to stay with the proven and historically predictable long-term returns of the stock market and not be persuaded to move hither and yon.
Bonds are useful only when you want to establish a fixed amount of interest that is paid to you annually so you can secure your investment. Even then, they are a “safe” investment only when you buy an individual bond (for example, a bond from an issue for your local school district or a Treasury note) and hold it until its stated maturity, for example, through ten years to repayment. This way, you will get back all of your money. Even if the bond is “called in,” you’ll still be repaid the full amount of your investment. This is how bonds earned a reputation for safety.
Trading into and out of bonds, or using bond funds, is a different approach, and not a secure one. When you take this approach, you are subject to market risk, and changes in interest rates will affect the daily value of your bond. You are not assured that you will get all your money back.
I will say this again: Do not use the bond drawer to build your Money Machine. By browsing through what the stock drawer has to offer, you’ll make your financial life a lot easier.