Investing in Safe Bonds: Invest Like You're Rich and Take Less Risk
Updated: 5 days ago
Investing in (safe) bonds: that's the strategy that rich people and people who are nearing or at retirement share. By the end of this video, you'll know what types of bonds to buy and what account to buy them in. If you're looking for bond funds and ETFs, we'll detail the three top items to look at when researching bond funds.
We are asked often, but probably not often enough, what are the best bonds to buy? How do you buy them? Where should you buy them? It can be confusing.
First, Bridget Sullivan Mermel and John Scherer discuss why they like US Treasury Strips. Treasury strips don't garner much excitement in the investing world--yet both Bridget and John recommend them a lot. Why? As fee-only advisors, we put our client's best interest at center of our recommendations.
US Treasury strips are inexpensive to buy, and are readily marketable. That means that you can sell them, or if you die, your heirs can sell them easily. Corporate bonds and municipal bonds can be difficult and expensive to buy and sell. That really eats into returns.
The biggest thing they like about US Treasury Strips is that they're backed by the US government. That includes a printing press for money. You know you're going to get paid back.
What about bond funds? We discuss the main items that we look at when picking bond funds. By the end of the episode you'll be able to pick bond investments.
Here's Bridget's firm website: https://www.sullivanmermel.com
John's firm website: https://www.trinfin.com
For advisors around the US: https://www.acplanners.org/home
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Bridget: What are the best bonds to buy? In this episode, we'll talk about what we look for when we're recommending bonds to clients and other people. We'll talk about bonds and bond funds, too. And at the end of this episode, we'll talk about why you hear so much about investing in stocks, but hardly anything about investing in bonds when it's actually more important about how you invest in your bonds.
Hi. I'm Bridget Sullivan Mermel and I own a fee-only financial planning practice in Chicago, Illinois.
John: I'm John Scherer. I run a fee-only financial planning practice in Middleton, Wisconsin. And before we get started on this conversation, Bridget, I'm really looking forward to it, but I want to remind our viewers to hit that subscribe button. That helps other people find us on YouTube. And so if you hit subscribe, let's get on with talking about bonds and how to buy them. Last episode, we talked about, or recently anyway, talked about how much we love bond funds or bond ladders. We also talked about setting up a bond ladder to produce income for retirement or cash flow in retirement. Then the next question is how do you actually do this? What kind of bonds do you buy? And I'm really interested to hear how you approach this with clients.
Bridget: Well, it's going to be a different approach depending on their situation. First of all, I love those Treasury Srips in IRAs, especially if people are retired and we can't create that cash flow. We did a whole episode on how both of us love doing that. So that's my number one is if it's an IRA, then I'm more attracted to Treasury strips. If the person's younger, maybe, or maybe not, but definitely when they're retired, having that safety of being backed by the government and having that cash flow. Even if it's more than what they need, then I'll buy a separate individual bond. I like it because it's safe. And also they're marketable. So for a Treasury strip, you buy them on Schwab. I'm sure the other custodians have them too, or you can buy them through Treasury Direct.
But if you buy them on Schwab and you need to sell one, you can sell it. And it's not excessively expensive to sell or hard to sell. You can either just do it on the website or you might have to make a phone call, maybe. I've had both situations. It seems like they've upgraded the website so I didn't have to do that the last time I had to sell a bond. But it's easy and it's not expensive, and they're marketable. If somebody were to inherit them, again, they can sell them. It's not hard to sell them. We can talk a little bit about corporate bonds or municipal bonds, but they're not at all as easy to sell. Anything else, except for the Treasuries, are not that easy to sell. There is not a ready market. So that's another reason why I like Treasuries.
John: I love the idea. I wanted to sort of pull out one of the things you said in there. It's the idea, and I think we both established this in our practices, is that when we're talking about bonds, safety trump's yield. It’s not like we're not trying to get good returns although that's nice. The important part is that safety aspect of things. At least that's how I look at that. Especially when you're buying a US Treasury bond, a Treasury strip like we do for our bond ladders, CDs that are FDIC insured, certain agencies, agency bonds from the government that are backed by the printing power of the government, it’s important that you know what you're going to get. You know that you're going to have this and that money will be there at the end of the bond term. And that I think is a really significant difference, at least how I look at it compared to corporate bonds.
Sure, maybe we can get better yields on corporate. There are some drawbacks as you just mentioned. But when you go back to 2007-09 and suddenly the stock market is going down and the dividends get cut and now if I'm wondering if the company that I've bought a bond from is going to pay me back, that is not an awesome place to be. We have the safety things. We know that the money is going to be there because the government can literally print money. That is such a big part of the bond side of things for me. I just want to make sure to draw that out a little bit.
Bridget: Yeah. And when I have looked in the past with corporate bonds it looks to me like you're taking the risk. Like you said, you're not sure if you're going to get paid back if the company goes under. You're not sure. You're not an employee…you're pretty far down on the list of who we're going to pay back. You're not all the way at the bottom but you're pretty far down on the list. That is, a corporate bond is. So you're taking more risk, it's hard for them to gauge the risk, and they are not able to get the financing with a bank or somebody else. So again it's higher risk, and you have no upside reward. So if the company does well you don't get any more money. If you like that company, invest in the stock and then go buy a Treasury because you have more upside reward if you invest in the stock because they can keep going up.
And if you buy the company bond all you can do is get whatever they're paying an interest or lose it all. There's no potential to make any more than that. So all you can do is get paid back or lose it. Whereas, if there is a recession coming up, we'll be seeing some people not getting paid back. That doesn't feel good.
John: One thing as we're having this discussion is that it’s super interesting to hear how you think about it, where we're similar and maybe different in some things—and we'll talk about bond funds in a little bit—but one of the keys things is that most of our clients are at or near retirement. This means we're looking at this bond ladder idea—producing cash flow in retirement. One of the things that we're getting some questions about today is interest rates are rising and so the value of bonds is dropping. Those of us that have bond funds are seeing that. We're having negative returns this year.
And I think it's really important to remember for viewers that when you buy an individual bond, like we're talking about here, it's kind of like buying a CD, which people are familiar with. In five years, the company, the government in this case, will give me my $100,000 back and, in the meantime, I'm going to have this interest return, that sort of concept. And so even though with rates rising, my bond might be worth less. When I look at my Schwab statement it says a lower number. In five years, it's worth that number. Just like in five years your CD is worth that number. It might be worth less now.
We don't even look at the returns on that because from that perspective, it's about the cash flow. It's that cash is going to show up in three years, five years, seven years. It can be confusing, sort of disheartening. When the stock market is dropping, I go, “Geez, my bonds are worth less.” Yeah, if you sell them today, as you said, they're marketable. But if you don't sell them, they're still worth exactly what you thought they were going to be worth two or three or four or five years ago. And it's not that easy to think about that. It doesn't feel like that when you see your statements.
Bridget: Right, exactly. So I try to get people to ignore what the ups and downs of an individual bond is and just say, “Look, this is what we're looking for.” We're looking for: it's still going to pay back. It's still going to pay you how much we thought it was going to pay. That's what we're looking for. So let's switch topic to bond funds. I mentioned that I really like Treasuries in IRAs, but there's a lot of other things out there. So let's talk about when we use bond funds and what we look for in bond funds.
John: That's great. Before we start this, Bridget, let's just explain, just to make sure everybody's clear so we don't get the jargon police coming in and busting us. There are individual bonds just like individual stocks. That's what we’ve been talking about. When we talk about a fund, we're talking about a mutual fund or ETF, where a company buys all kinds of bonds, 500,000, or 5000, and we're buying that sliver to invest in the mutual fund.
Bridget: Right. Absolutely. So let's talk about what we do with bond funds. And this is where we might diverge a little bit. With bond funds, I have a couple of favorites and I tend to like those. And they might have some corporate stocks in them or corporate bonds, pardon me, in them. But I feel like the things that I really look for when I'm looking at a bond fund to pick is: what are the expenses? Just like any other stock fund, what are the expenses? Is the expense rate low? And what's the average duration? Okay, now there we got Jargon police for sure. Another thing I'm looking at is the duration on bond funds.
John: And what duration means is basically how long of bonds. Think of it in CD terms. A one year CD versus five year. The duration of the five year is longer. So it's just how long are the bonds. That’s that fancy-pants word. It means how long are the bonds in the fund.
Bridget: Yeah. And I mean, I think that the bond people define duration as “how long does it go?”
Bridget: So I like bond funds that have expense ratios less than, say, 0.5 for sure. So half a percentage point. And I like bond funds that have a duration of around five years or less.
John: It's very similar. We've been seeing even bond funds, especially, we do a lot of index funds. And so the expenses can be even a lot lower than that. But we're exactly the same on that duration. The average length of bond that we want to see in the fund is five years and less. You get above that and there's a lot more volatility, meaning more ups and downs. Remember, we're talking about this being our pantry, being the safe place in the portfolio. So having a shorter duration on bond funds means lower returns over time, but also, when you have times like these, less downside.
I think the only other thing that I'd throw in there, Bridget, as I look at bond funds for people is the quality of the bonds inside. People are maybe familiar with Treasuries or AAA backed by the government and then you got junk bonds on the other end of the spectrum here. The farther down the spectrum you go, the more returns you get. But there's a reason for that. The lower the grade of the company or the bond, that means that maybe they're not going to pay you back or it's not as reliable. So we like high-grade—again, return of principal, not necessarily return on principal. So high grade, AAA, AA, those sorts of things, and low duration. You can find that information out there. And if you do those two things and have a low expense ratio, I think you're setting yourself up for success in bonds.
Bridget: Yeah, and I think people might recall back in the eighties there were a lot of junk bonds. That's what you're talking about with the low ratings. So loaning a company—somebody wanting a junk bond—it’s just like loaning an unreliable friend money.
John: Well, you got a friend like that too? 😊
Bridget: No, my friends are very reliable, actually. 😊 But that comes up a lot. Anyway, you don't expect to get paid back. And what we really want with our bond investments is to get paid back. That's what we're looking for. We want to get paid back. Another type of bond that we've talked about a lot are I bonds. And we just don't want to talk about bonds without talking about how great I bonds are right now. So we'll mention them, although we've got several other videos on the topic. Do you want to give a quick pitch for I bonds?
John: It's one of those things exactly like you said. Look at some of the previous episodes. Right now they're paying an annualized rate of over 9%, backed by the government and tax deferred. If you're not at least thinking about those, there are some drawbacks, but if you're not thinking about those, you're missing the boat. So that's a really great place to look. And again, check out our previous episodes on I bonds.
Bridget: Yeah, okay. But this brings up a great question because you said you just went to some continuing education and were talking to a lot of advisors that were not on ACP or the Alliance of Comprehensive Planners. You were talking about how you're investing, what's hot for you guys, and only one person mentioned I bonds.
John: One. One, out of a few dozen that I personally spoke to.
Bridget: The same as the rest of bonds, actually. Why are bonds not talked about? First of all, the expense ratios are low and you can go buy Treasuries for free. The custodian might charge you a little bit, but it's very inexpensive. So advisors don't make money, as much money on bonds. Although last time I checked, there was a lot more money in the total stock market for bonds than there was in stocks. When I talk to people about bonds, I tell them: this is what rich people do. They buy bonds. They don't need to take the risk of the stock market. They don't want to take the risk of the stock market, but they want to keep up with inflation, make a little bit. Anyways, so that's what we hope for with bonds. Just get it back. And we want it to be safe. It's like our safe space.
John: That's right. I was going to say, I love that idea. There's more money or at least as much in the bond market as the stock market. Some people say, “Boy, the market is really down.” And I say, “Oh yeah, the bond market.” “Well, no, not that market.” And we forget this thing. That's such a great point.
Bridget: Yeah, well, and it's not sexy. You got it…like Treasury strips. I guess the word, the word strip is the biggest thing it has going for it, but it doesn't compare with the tech stocks and how much fun that is. I think that for those two reasons it doesn't engage people's imaginations, and the people in the industry don't make much money off of them. These are the two reasons why advisers don't talk about them too much. And why we do. That's something that in ACP we like talking about: how are we doing this?
John: That's maybe a great place to circle back and remind everybody that both Bridget and I are members of the Alliance of Comprehensive Planners, or ACP. There's a nationwide group of fee-only, tax focused holistic planners that think similar to the way we do. And if you like what you see on our show, check out acplanners.org to find an adviser in your area.
Bridget: And before we go, don't forget to subscribe. See you next time.
John; All right, bye.
At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.