What You Need to Know About Bonds

Investing in bonds can be an important part of your overall portfolio.  But many investors find them confusing.  Today, Richard Oring and Jag break down what you need to know.

Stocks are pretty straightforward - if you buy a stock, you own a percentage of a company. Bonds, on the other hand, mean you are buying part of a company's debt. Rich explains.

While bonds aren't for everyone, they do have some advantages, including diversification, capital preservation, and income generation.

There are many types of bonds, including corporate bonds, municipal bonds, and treasury securities.  Typically, they are offered in $1,000 increments.

Rich explains the different terms related to bonds, including coupon rate, maturity, yield to maturity, callable, yield to call, yield to worst, duration, discount, and premium.

We also cover the different risks involved with bonds - interest rate risk, reinvestment risk, default risk, and more.

Mentioned in this epsiode: https://treasurydirect.gov/

To talk to Rich about bonds or anything related to your financial future, reach him at (609) 924-2049, extension 126,  go online to https://ncfg.com/, or send Rich an email.  ROring@ncfg.com.

Transcript

Jag: Welcome back in to Financial Matters with Richard Oring. I am John Jag Gay. Rich. It's just us today. First time in awhile. 

Rich: I know. We've been having guests. We're going to have to figure this out. How to do this again. Just the two of us. 

Jag: Just like riding a bike. I am going to tell you upfront though. I'm going to rely on you pretty heavily today because we're talking about bonds today. And this is an area that I think, like many of our listeners, I have a hard time getting my head around. So I hope you can kind of give me the basics and walk me through it. Where should we start with what we need to know about bonds?

Rich: Let's start off with just the basic, what is a bond? Everyone knows what a stock is. A stock is, you're purchasing a share of a publicly traded company. So you have ownership in that company, even though it might be hundreds of thousands of millions, of a percentage of ownership, it is still considered ownership, right?

Whereas a bond is actually a debt instrument. So a bond i,s you're lending money to a company or government or an agency. And in return, you're getting interest for the money. You're lending, kind of like when a bank lends you money, you're paying them interest, but this is you lending other people like corporations or the government, or municipalities or agencies money in return, they're paying you interest.

Jag: So people talk about stocks and bonds, a stock, like you said, easier to understand. You're owning a small piece of the company. The bond, your money is going to that company. They're borrowing that money from you. 

Rich: That's correct. JAG, I always tell clients or people I talk to, I truly believe that understanding bonds is so much more complicated than understanding stocks.

Jag: I'm beginning to understand. So why should our listeners consider adding bonds to their overall portfolio? 

Rich: Okay. I'm going to say thi., not every single client should own bonds. Okay? So depending on your goals, your suitability it's possible that you may want to put bonds into your portfolio or other type of fixed income products.

So I want to start off with that. It's not for everyone. It has to make sense. So first off is diversification. We've all heard, never put all your eggs in one basket, right? Spread your assets across multiple asset classes like your investments through multiple asset classes, being large cap equities, large cap values, small caps, international, emerging markets.

And one of them is fixed income. There's times where people put money into fixed income for capital preservation. They believe, and there are times where. Not usually on rising interest rates like we see right now, but a lot of times bonds are a lot more conservative than equities and, usually we can figure out what the downside risk is and we can use it for capital preservation.

Maybe we can earn a little bit more money than we can from CDs or money markets or savings accounts. And there could be a place just to try to protect some of your money. And, I haven't seen this for a long, long time. I got in the business in 1999, right? When interest rates started going down.

But back in the day, people were buying bonds and CDs for income. It was generating 5%, 6% income. We haven't seen that for a while, but as we see right now, interest rates are beginning to climb. I was looking at some CD rates other day for two year CDs and there were back 2.5, 2.55% on some brokerage CDs.

So I was kind of surprised to see those rates started climbing up. That's pretty good. 

Jag: So there are several reasons to have bonds. Like you said, as we say, often in this podcast, it's not for everybody. And that's why you'd want to talk to a professional, like Rich. What are the different types of bonds out there for someone who's interested in adding this to their portfolio?

Rich: How much time do we have jug? 

Jag: Well, we've got about 25 minutes, so, it's got to stay top level here. 

Rich: Okay. So let's just go over the major types of bonds. I mean, there are so many different types of bonds out there. But let's go over the, like you said, the top level, the broad classes. So first off are the corporate bonds.

There's companies out there like Ford who wants to raise capital. So what they do is they issue bonds and in return they give you interest. Then we have municipal bonds. So it could be your state. It can be your local township. Those bonds are issued for projects. Maybe they want to upgrade their public utilities or the schools or the highway.

Within municipal bonds or different types of muncipal bonds, general obligation revenue and so forth. But in general, municipal will cover your local bonds and your state bonds. And there are some tax advantages form as we call them, not all bonds, but usually they're triple tax free. Tax-free from local state and federal.

So that's an advantage again, not obviously all bonds will qualify for that tax advantage, but most of them will.

Jag: Okay. So the first two are corporate and municipal bonds and okay. I'm,, I'm following with you so far, corporate bonds companies to make money. They issue bonds. You buy the bond. Now they have the capital raised and the can pay you income on that municipal, same thing with all these projects we're seeing with highways and schools, like you said, public, utilities.

The town needs some money, they issue bonds, you buy the bond, they use that money for what they need, and then they pay you interest on it. What else?

Rich: Then there's Uncle Sam's bonds. We call those the treasury securities. Most common treasury securities we see out there, again, this is not all of them, but this is the major ones is your treasury bills.

Those are short term maturity, meaning less risk, but also less yield they're going to pay. But those are usually between 4 weeks to 52 weeks in maturity. Next we have treasury notes. They go from two years to 10 years. Then we have those long 30 year treasury bonds. We always hear about. And then of course, as kids, we probably were gifted savings bonds.

That's a treasury, believe it or not, that's issued by our federal government. And then there's agency bonds, Freddie Mac, Ginnie Mae, or some agency bonds out there. 

Jag: I remember getting the saving bonds as a kid. It's a great vehicle, but no kid wants Christmas or Hanukkah morning to get a savings bond.

Rich: Do you want to know when you want a savings bond? When you lose it or you didn't know about it. So I have a friend she's probably a 45 now and on their fridgerator is a savings bond. She received when she was a child and it got lost and she was going through boxes of old stuff and they found it.

And when I was there, I went online. You can go to treasury.gov and put the CUSIP, or I think the serial number of the CD in there, or the savings bond. I'm sorry. And you can see the value because at some point it will stop paying interest. But if you think about it or savings, bond is worth more than the face value.

Jag: Yes, because that interests may have stopped, but it did grow to a certain point. It's like the first time of the season, you grabbed your winter coat and reached into the pocket and you find $20 inside. And you're like, Hey, I've totally forgot about this. This is great. 

Rich: Yeah. I mean, they used to be really easy to buy. I used to go to the bank and you would, make your deposit for your paycheck. And then, oh yeah, I have to go to a wedding or a birthday party this weekend. Let me go buy a savings bond because you look like a big spender spending 50 bucks and getting a hundred. 

Jag: Exactly. Well, as you said, rich, there are a number of different types of bonds out there.

We only hit on a few. How would you even start to think about which type of bond to purchase if you wanted to go this route? 

Rich: Okay. So first off, this particular podcast is not going to educate you enough to get all the information you need to go out and become a bond expert where I would say you should go out and buy all these bonds and build a bond.

You need to do your research. And then I strongly recommend, cause you can get hurt, especially right now with rising interest rates. So let's go over some definitions first because I think that's the most important thing. You go online, you start doing research, you don't understand the terminology, right.

Jag: That's fair. Okay. 

Rich: Right. Or you call your broker up. He sends you a proposal for bonds and there's abbreviations for all these terminologies. You don't know what they are. 

Jag: Alphabet soup. 

Rich: Exactly. So first off let's understand bonds are usually, not always, are issued in thousand dollar increments. Okay. Then there's a coupon rate. The coupon rate is the amount of interest the bond is going to pay you. So you'll see 3%, 5%, whatever, five and a quarter. 

Jag: And is that annually? Generally?

Rich: Each bond is different. It can be monthly, could be quarterly semi-annually or annually. Most bonds are usually semi-annually or annually. There's a term called maturity and that's when the bond is going to mature. So when a bond matures, you get the thousand dollars back, okay. Then there's a term called callable which is not always good for the bond holder. Callable is when the insurer, the company or government or township state issues, the bond, and they can buy those bonds back earlier than the maturity.

Some of the reasons they might do it. Maybe they have a lot of cash on hand. Why pay all this interest ou?, let's call those bonds in and pay the bond holders. And then we have less cashflow going out. The other reason might be is when interest rates go down. Let's say they issued these bonds. When Jimmy Carter was President. Double digit interest rates, maybe these bonds are paying 17% well interest rates have gone down.

Over the years. So if they're able to refinance those bonds from 17, maybe to 5, well, that makes sense for them to do it. So bonds can be callable. You can also buy non callablel bonds. Non callable bonds might give you a little bit less interest. 

Jag: Okay, so Rich I want to make sure I'm still with you at this point and our listeners are as well.

Most of them were probably smarter than me. So if I get it, they probably get it. So with the non callable bond, you might have a lower rate, but it's not going to change because it's locked in. But the callable, you might get a higher rate, but it could change. So there's more risk involved. So I have that piece of it right?

Rich: That's correct. That's correct. But you know what? It's really important to understand the next two terms. Because if a bond is callable, there's a term called "yield to worse" or "yield to call." But before we go over that, let's talk about yield to maturity because it's much simpler to understand. Okay. It's basically the purchase price with the money they returned to a thousand.

So purchase price, not all bonds are sold at initial offering. You can go on the general market to buy bonds, which have already been issued. Someone's owning them just like a stock. You can buy and sell bonds on the open market. So if a company currently has a bond paying 5% and that same bond issued today, might only pay 3%.

Well, the person who owns that bond, isn't going to sell it to you for a thousand dollars. They're going to charge you a premium to get that bond. So the reality. Let's say you paid 1200 and in 10 years you get back to a thousand. These numbers I'm throwing out are not going to calculate properly, but you'll get the idea what I'm trying to say.

Jag: Purposes of example.

Rich: You bought it for 1200, 10 years from now. You get a thousand, but you're getting the 5% know per thousand. You're not getting 5% on the 1200. You're getting the 5% on the thousand. So in 10 years from now, you get a thousand. And you've been getting the interest off the thousand at 5%.

So you're really not getting a 5% return on your money. You're getting less than that. And it should be close to what the current coupons are out on new issue when you do the math. 

Jag: So what you're saying is you may buy a bond for more or less than the face value due to the fluctuating interest rates. And that's a calculation that goes into it. 

Rich: Correct. Okay. So that's yield to maturity. So then we have yield to call or another term for it is yield to worst. That doesn't sound too good. Does it?

Jag: It doesn't. 

Rich: So imagine that same bond paying 5% and let's say you bought it for $1,200 and now they call it two years from now at a thousand dollars.

So you were projecting to get that 5% for 10 years, but instead you got the 5% for two years and you pay that $200. That's not good. I mean, your yield is going to be very bad and that's called yield to call or yield to worse. You need to know that when you're buying the bonds and then you have to understand the risk of them actually, calling it. 

Jag: Risk, worst case scenario, go into it. Eyes wide open. Got it. Okay.

Rich: Correct. So you can actually buy bonds which are not callable. If that's your fear on rising interest rates, you may want to consider callable or non callable, depending on the rate difference, how much the coupon is. The other thing you have to take consideration is the credit rating of the bond, the lower the rating, usually the higher, the interest rate, the coupon.

They're going to pay you the better rating, just like your own credit report. If you have a really strong credit rating of high sevens, low eights, you're going to get a lower interest rate when you have to go buy a car. It's the same thing for these issuers or bonds, the lower their rate, the more interest they're gonna have to pay for that risk.

Someone's going to take on a lower rate of bond. 

Jag: Got it. Okay. 

Rich: So you'll hear companies like Moody's, Fitch, Standards and Poor's, these are some of the companies who rate bonds. If you remember a couple of years ago, the US treasury has got downgraded from AAA to a AA. 

Jag: Yeah. That can affect a lot of different things.

Rich: I don't think our government's ever going to default on our payments, but saying that. You know right now it's April 21st and Russia is still in the conflict with Ukraine. The war going on there and there's risk of them defaulting on their payments. So I guess anything can happen.

Jag: Talk to me about duration and discounted premium of other bond terms. I need a little clarification on Rich. 

Rich: Discount and premium is what we just talked about. You could buy a bond for more than a thousand or less than a thousand. So if it's under a thousand, it's a discount. If you're paying more, it's a premium.

That's pretty easy. So duration is the one I love, you can ask financial advisors. And a lot of them won't even know what this is. A lot of people say, oh, duration. That's how many years the bond matures? I'm like, no, that's maturity. Duration, and when I'm talking about duration, there's actually one called Maculay Duration.

That's the most common. And what that's going to show you or tell you is how much the bond price is going to be affected by a 1% change in the interest rates. 

Jag: Ah, which is going to be very relevant, theoretically, as we look at what the what the fed has said throughout 2022. 

Rich: Right? So when interest rates are going up, like we saw a lot of bond holders lost money then.

Especially if they're buying intermediate bonds, those are bonds which have a few years out before they mature. Those are going to probably have a higher duration, be affected more than what we call short duration bonds, which have a lower timeshare before they mature. Okay. So bond holders to protect themselves should a shorten their duration, knowing that this was coming and this should have been done, not in 2022, but in 2021.

Jag: Got it. Okay. You got to pay attention to these things. So there's always this cliche out there, Rich, that bonds are safe and a safe way to invest your money. But based on what we've been talking about for the last 15 minutes here, I'm going to go out on a limb and say, that's not always the case. 

Rich: No. Bonds aren't always safe and you need to know what kind of bonds and how they're secured. Are they going to be paid back to revenue from general obligation from tax revenues? So there's a lot of things will go into the bonds which you need to understand. But the biggest risks in the bonds right now are interest rate risk.

We just talked about that when interest rates go up, bond prices go down. When interest rates go down, bond prices go up, but usually the lower the coupon, the more volatile that bond would be. Okay. The longer the maturity until that bond comes due is going to be more volatile. Usually not always, but usually we talked about the bonds.

That's going to increase the risk. Then there's something called re-investment risk. Let's say you're having a bond paying you 5% and it comes to in 10 years, but the current rates are 3%. Your income just went down by 2%. I say, okay. So there's a reinvestment risk on what you can buy after the bond comes due.

And then there's the default risk let's use Enron. You had a few bonds in Enron. No one expected Enron to go bankrupt, go out of business. Now the good thing is bond holders are usually paid before stockholders on the liquidation. But you may be getting pennies on the dollar. There are so many different ways you can reduce some of this risk.

There's laddered bond portfolios, which means you're going to buy, let's say a 10 year ladder portfolio. You have a bond coming due every year. So you only have one bond being reinvested that helps with every investment risk. There are a lot of different strategies. I can't list them all today. Unless you want to record episode two, three, and four for bonds. But again, if you're going to be buying bonds, think about this and think about how you're going to protect yourself on those risks. 

Jag: All right. So bonds, I knew they were going to be complicated, but you've actually broken it down for me and I've got a better feel for it, but it's still a little bit overwhelming.

So let's bring it back to the 30,000 foot view here, rich, as we start to wrap up. How would somebody go about purchasing the bonds? They've made the decision, they've done their homework. They can understand all the terms we've talked about today. Where do we start? 

Rich: Okay. So I would say the average investor probably is purchasing them through mutual funds or exchange traded funds.

But again, you still need to know what you're buying. Yeah. There are diversified bond portfolios, which have a little bit of everything in. There is tax-free bonds by utilizing the municipal bonds. So there's many different types of mutual fund, fixed income, short duration. I can keep going again. You got to know, you know what you're looking for, what risk you're trying to avoid and do your research.

Again. If you're working with a financial advisor, give them a call, ask them for some recommendations and ask them for their reasoning. If you're one of those self doers, you can probably call Vanguard or Schwab, whoever, and ask for their offerings. I'm not sure if they'll give you advice, but they'll give you their offerings and lists.

And then you can always, if you want to buy treasuries or savings, bonds, treasurydirect.gov. You go right online, you open an account and you can just buy treasuries, notes. T-bills, whatever you want right through their website. 

Jag: Got it. Okay. Lots of different things to consider here. If you want to know more, obviously talk to Rich. And I'm going to take back the closing here, because you stole it from me in the last couple episodes rich, but I'm going to ask it back to you.

If somebody wants to talk to you about bonds or anything related to financial planning, retirement, their financial future, best ways to find you at new century financial group?

Rich: All right. Before I give you all that contact information, I'm going to say one last thing. You might be listening to this podcast and saying to yourself.

I'm not at the age, I'm not the risk where I want to start putting fixed income into my portfolio by utilizing bonds. But you know what your parents might be. Your grandparents might be. Share this podcast. They need to understand about the bond markets. I can't tell you how many portfolios I just reviewed from other brokers where the bond portfolio got demolished over the last rate increase from the feds.

I'm talking about a lot because they went into those bonds thinking that they were not going to lose money and they lost. Now the reality is if they hold it for 12 years, it might come back because the bond price is good. Again, mature at a thousand. So the closer, I told you that bond prices go up and down the closer it gets to maturity, the closer it gets to a thousand.

Okay. All right. So where you can get ahold of me is pick up the phone. Call me (609) 924-2049. My extension is 126. If I'm not availaleb hit zero. Ask one of the staff members to schedule a call with you. This way we can avoid playing phone tag, you can always go to www.ncfg.com. That's Nancy, Charlie, Frank, George.com.

On that website, you can schedule a call, a zoom meeting, a live meeting in my office. And the last you can always shoot me an email at ROring@ncfg.com.

Jag: Again, as Rich said, if you're listening to this podcast and know one person that could benefit from the stuff we talked about today, just forward it on over to them.

Richard Oring from New Century Financial Group. Always a pleasure. We'll talk again soon.

Rich: Thanks Jag. It's always a pleasure to talk to you. And again, it was really nice. It was just the two of us this time. It feels like we're dating again. 

Jag: I'm not sure what our wives would have to say about that, but we'll leave it there.

Rich: I think my wife would say better you than her.