The 4 Types of Bonds and Which One is BEST for Your Portfolio

Which type of bond is best for your portfolio? In this episode of Friends Talk Financial Planning, John Scherer and Bridget Sullivan Mermel discuss the best bonds for your financial situation. Treasury bonds, Municipal bonds, I bonds, and Corporate bonds have their advantages and disadvantages. Don’t miss this opportunity to determine which type of bond might serve you and your situation best!

Check out our What Bonds to Buy video: https://www.youtube.com/watch?v=taoB4XXBf5o

Resources:

- Alliance of Comprehensive Planners: https://www.acplanners.org

- John's firm website: https://www.trinfin.com

- Find us on Facebook: https://www.facebook.com/friendstalkfinancialplanning

TRANSCRIPT:

John: Hi, I'm John Scherer, and I run a fee-only financial planning practice in Middleton, Wisconsin.

Bridget: And I’m Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois. And before we go on to talk about different types of bonds, please hit subscribe. All right, John, I want to talk about bonds. When I started in the industry, I thought I knew a lot about bonds, but actually there's knowledge and then there's practice.

And there was a gap between those two things for me, because I had learned a lot about it in school. But then when I actually got into advising people about it, there was a difference. And actually, I got a lot of information from ACP or the Alliance of Comprehensive Planners about how to do it in practice. So what I thought we'd do today is talk about all the different kinds of bonds and just talk about how we use them or don't use them.

John: I think that's great.

Bridget: Yeah. So the first thing we want to talk about is Treasuries. These are backed by the U.S. Government. And there're two flavors that I want to focus on. One is T bills, and one is known as Treasury strips. Why don't you explain what the difference is?

John: One of the things that you made me think about as we're talking about government bonds or treasury bonds is why are they useful? In general, they pay a lower interest rate than some other things you can buy. But as you said, they're backed by the government. What does that mean? That means that the government says, listen, Mrs. Investor, if you give us $100,000, we'll pay you interest, and then we'll give you your $100,000 back at the end of the period. It's sort of like a CD type of a thing. Well, the government can print money.

They can make good on that promise. That's why you might loan money to the government, let them borrow it from you. A Treasury bill is a short-term bond that the government issues. A Treasury bond, a T bond, is a little bit longer than that. We use strips for retirement income, I know you do as well, but what that means is when you buy a bond, think about it like a CD. I buy a CD. It pays interest on a quarterly basis, semiannual, depending on the terms. But it pays you interest over time, then they give your money back with a strip.

And that's the way a bond works as well. But with a strip, they say, listen, we're not going to pay you interest every quarter or every six months, but you can buy the bond at a discount that builds in that same amount of interest. So theoretically, I could put $100,000 in. If I'm getting 4% interest on a Treasury bill, I get $4,000 a year in interest. They just pay me that, then they give me the $100,000 back at the end of the term.

With a strip, they kind of bake that quarterly payment in, saying something like, “Oh, if you buy this bond from this stripped trust treasury bill for $92,000 or something like this, then it grows. You don't get payments every quarter, but at the end of the term you get $100,000.” So the growth is kind of baked in. And that makes it really easy when we're talking about funding retirement income and those sorts of things. So that's the difference between those, as I see it.

Bridget: Yeah, I agree. So, there's a couple things I want to pull out with what you're talking about. The first is strips versus Treasuries. There's not that much difference except for when they pay.

John: Yep, how you get your money out.

Bridget: The other thing is that they can go for a long time. So you can buy them for 5 years, 10 years, 15 years, 30 years. I think they go up to 30 years. And with shorter terms, you can buy T bills or notes, but we often use CDs in that situation because, again, they're also backed by the government, and they might pay a little higher interest.  

And we see the difference between FDIC insurance and Treasuries as 6 or 1/2 dozen, pretty much the same. So usually when we're buying, we’ll buy CDs for the first five years, and then after that we’ll buy Treasuries because we like the safety of it all. But that decision is totally based on what interest rates they are paying because underlying they're both safe.

John: As we'll get on to some of the other types of bonds, one of the big factors in this is the risk that you take. And by risk, what I mean is if I'm going to loan the government $100,000, I've got a pretty high likelihood they're going to pay me back at the end of the term. When I buy a CD and it's FDIC insured, say I buy a CD from fill in the bank, if they go out of business I could lose my money, except for FDIC insurance. I mean it's a pretty certain thing.

As we get into other types of bonds, you're relying on that organization that issues the bond, whether it's a local government or it's a company to pay you back. And again, most of the time it works out, I don't know, 99% of the time. But you know, when companies go bankrupt there's some risk and that's what we need to think about. For these treasuries and CDs, FDIC insured things, the risk of them not paying you back is probably not zero but really close to zero.

Bridget: Well, it's considered zero. And so, the other thing I want to talk about is TIPS, Treasury Inflation Protected Securities. And it seems like these could be useful if you're specifically concerned about inflation but that when you're looking at it from a completely intellectual level they generally don't pay off better unless you figured out when exactly the timing is that it's going to pay off more. Is that your attitude about it, or do you have a different attitude about TIPS?

John: No, I agree with that. It's tied to inflation, so it does maintain purchasing power, but you pay for that. It's almost like an insurance sort of component. It’s not strictly insurance but you’re giving up some potential return having this inflation protection. That’s not wrong, and we'll use tips for the right clients with things but it's not a free lunch necessarily. You just need to know what the tradeoffs are.

Bridget: Right. Then there's also bonds that are not 100% guaranteed that are issued by the government that are for different things. Do you know much about those?

John: I'm not familiar, I'm not sure I know what you're talking about.

Bridget: Like the agencies of the government that are not necessarily U.S. government, the types of agencies like Sally Mac or Freddie Mac that are pretty much covered by the government, but it's not necessarily the printing money element that you were talking about before. So there’s slightly more risk. That's what I'm saying.

John: Yeah. We have some Tennessee Valley Authority bonds that we buy. Basically, before the credit crisis, Fannie Mae and Freddie Mac were not guaranteed, but we thought they were. And then as I understand it, the government came out and officially said, “No, no, we're backing these up,” so to me, that's like FDIC insurance.

Bridget: Okay, cool. All right, now let's move on to Munis. All right, so someone is backing these. What are your thoughts about Munis? If you're in the highest tax bracket, they should save you some federal income tax. I will say that. But most people get sold these, and they're not in the highest tax bracket. They're just in a regular old tax bracket, 24%, 22%, or even 12%. And they just don't like paying tax. In that situation, I'm curious about your take.

I generally don't like Munis. And my reasoning is you can't figure out what the risk is, because I live in Illinois and I could not for the life of me try to figure out how to figure out what the risk is. How much interest they're paying is based on the perceived risk. And with the federal government, the market does a good job of calculating that. But with these Munis, I just don't think the information is even available. What are your thoughts?

John: Yeah, and I'll call it the jargon police on you, Bridget. Munis are Municipal bonds, issued by the government but municipal governments, not federal or state governments. And there’re tax advantages to them. As you mentioned, in a high tax bracket, there's tax free income on those. Man, it's exactly what you said, though. If taxes are a huge factor in your financial situation, Munis can make some sense.

But how do you evaluate the underlying risk? Counties issue municipal bonds, and counties have gone bankrupt. What happens then? I can't remember how long ago it is now, but Orange County out in California went bankrupt. Well, what risk are you taking with that? And you give up some return most of the time compared to buying a Treasury bill or a Treasury bond. Buying a Municipal bond, you're going to get a lower interest rate. Why?

Because of the tax advantage, it’s all sort of baked in there. So it can be a good tool, but sometimes you think, “Oh, a tax deferral. Awesome!” And as just described, if you're in the top tax bracket, it makes a bunch of sense. If you're in one of those middle or lower tax brackets, you're getting a lower return in most cases and taking some perhaps unknown risk or unquantifiable risk, why do that? It just doesn't seem to fit the plan, usually.

Bridget: Yeah. Okay, so then we already talked a little bit about CDs being interchangeable in my mind with Treasuries. For zero to five years, I'll just look at what is paying higher interest and go with that. Is that your approach?

John: Yeah. I mean, again, with FDIC insurance, it just becomes an interest rate. It’s pretty simple math.

Bridget: And where are you now on I bonds? So with I bonds, you don't pay tax on the interest until you take the money out, and you can put $10,000 a year in. And it generally has an attractive return, especially if inflation is high. So it's meant to protect against one thing that some people are particularly worried about, which is inflation. Now inflation is still a concern for a lot of people, but it isn't that high, are you recommending I bonds much? Where are you with it?

John: It sort of depends on the person and where your situation is. But for people who don't need the money and are concerned about inflation, they can work really well. A couple years back I bonds were a screaming deal relative to everything else in the marketplace. That’s not the case today, but you can only buy $10,000 a year worth.

And so, to have some of those in here, if we see inflation again in the next five to ten years, a person might be happy to have a bunch of money set aside in I bonds. And so, for those reasons, when people have extra money that can be a place that's not going to make or break a person’s retirement income but at the same time it can be a nice tool in the toolbox when inflation comes around again. So we're sort of largely neutral. But I'm not in a big hurry to sell those things.

Bridget: I totally agree. If you're saving in all these other pockets and then you think, “I need some money that's safe,” this can be a good spot. And this will hopefully pay a little more than a money market but it’s accessible. So when you need it, it takes maybe a day or two to get the money in my experience. And so that's awesome. That’s like a savings account that's earning a little more, which is great. And it’s tied to inflation.

John: Yeah.

Bridget: And then the last thing is corporate bonds. So this was a surprise to me when I started in the industry, because corporate bonds typically pay more than the Treasuries and more than Munis. But I was really influenced by Burt Whitehead's thinking on this, which is that, similar to Munis, it's hard to judge the actual risk of the individual corporations, and you might not get paid back. And if you really like the company, why not just invest in their stock and actually have some upside?

Because there's no upside to corporate bonds. Is getting paid back an upside? Is getting paid the interest that you're supposed to get an upside? That's not an upside. Invest in Treasuries, and then when you're trying for growth, invest in the stock market. That was an approach that I've adopted, but that I didn't know about when I just had book learning.

John: I don't know that I have too much to add to that, because that's exactly our take on things. And we use the farmer analogy with our investments. We've talked about that before. Make money in stocks. That's where the farmers make money out in their fields when they grow their crops.

And then when you need things that are safe and reliable, you put those down in your pantry. You can pickles and applesauce and put them in your pantry. That stuff doesn't grow. So with bonds, we're not looking for growth; we're looking for the money to be there when we need to eat it sort of a thing. That mentality of don't try to get growth in your pantry, so to speak.

Bridget: Very good. With that, it seems like a great time to wrap it up. I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois.

John: And I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. Both Bridget and I are taking on clients. We'd love to hear from you. But we're also both members of the Alliance Comprehensive Planners. If you like what you hear on our show and would like to find an advisor in your area who thinks like we do, check out acplanners.org.

Bridget: And don't forget to subscribe.

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.