A few years ago, I purchased a $1,000 bond while carrying out "academic research"—my chosen designation for what other people seem to perceive as fooling around on e-Bay.
The bond is dated 1861, the first year of the Civil War, making it precisely 150 years old. Worthless except for its collectible value, the bond once paid 7 percent annual interest. It was issued by the Bowery Savings Bank for the Street Improvement Fund Bond of the City of New York to finance the "regulating, grading, curb and guttering, flagging, and paving" of "streets and avenues." Embellished and ornate, it is signed by Fernando Wood, a Confederate-sympathizing Democratic mayor who suggested that the city of New York should secede from the union. I bought the bond for a grand total of $35.
I occasionally use it as a visual aid in the classroom when teaching about the Civil War, 19th-century urbanization, or the meaning of bonds (as, for example, in certain William Dean Howells novels, or in reference to the life and times of Alexander Hamilton, first secretary of the Treasury).
But you need more than a visual aid if you're considering the role of bonds in your retirement portfolio. Hence Professor Pennywise's two-part series on bonds. In the first column, I explained that the global bond market is simply a $51-trillion counterpart to debt. Today we tackle how you can make bonds work in your portfolio.
Bonds are best comprehended in contrast to stocks. When you own stock, you own a tiny piece of a company. To own bonds is to own debt. Stocks produce dividends, a share of profits. A bond provides interest and eventual full return of the bond's face value. Bonds are privileged in the capital structure. If an issuer goes belly up, bondholders are first in line to be made good, before stockholders.
Bonds are critical to capital markets. When universities want to build a student center, a business school, a hospital—perhaps even a library, now and then—rather than deplete the endowment, they can issue bonds to finance their project. Standard & Poor's gives a AAA rating to Princeton University bonds, which are handled by the likes of Goldman Sachs and Morgan Stanley.
The bond market, you see, is vast. Bond traders were the iconic capitalists of the 1980s, from the "masters of the universe" in Tom Wolfe's The Bonfire of the Vanities to the hostile takeovers orchestrated by corporate raiders through leveraged buyout in Oliver Stone's Wall Street. The insatiable Wall Street appetite for mortgage-backed bonds was the driving force of the housing bubble, which precipitated the credit crunch, resulting in our current economic mire.
How do bonds work from an investing vantage? They have a nominal amount (or face value, to be made good at date of maturity) and price (market value). Then there is the bond's coupon (the rate of interest paid on the nominal amount, leading bonds to be known as "fixed income" investments) or yield (the rate of return, which fluctuates with the bond's current price).
Yields rise when bond prices fall. A very high yield indicates distress. Greek two-year bonds now have a stunning 28.5 percent yield, for example—the proverbial dogs with fleas, since Greece teeters on the brink of default. A very low yield, by contrast, indicates a high valuation. The yield on U.S. Treasury bonds is now 0.38 percent, virtually nothing, because they are seen as pretty safe bets in a crazy world economy. The price of U.S. government bonds can only fall from here. Caveat emptor.
If anything in what I've just written baffles you, then simplify things: Just buy into a respected general bond fund such as Pimco Total Return, TIAA-CREF Bond Market, or Vanguard Total Bond Market. That will put bonds in your portfolio with sufficient diversification to hold you in good stead.
For those with more aptitude and interest, let me share some perspective on how small investors might rationally approach bond investing.
Bonds as an asset class. Bonds are distinct from stocks and cash—or, for that matter, from real estate, commodities, and other more exotic asset classes. Bonds have a specific role to perform in portfolio diversification.
Think of bonds as the Tea Cup rides at Disneyland. Sometimes bonds whirl you around, but they are hardly daring. Cash is even tamer, like shaking hands with Minnie Mouse. Stocks are Mr. Toad's Wild Ride.
Over most long periods of time, bonds gain less than stocks, but they also tend not to lose as much. Bonds tend to increase in value when stocks decline and therefore act as stabilizers. They also tend to have less volatility, meaning they don't tend to ratchet up or down in price nearly so much.
Shortly after the 2008 financial crisis hit, a reader wrote to Professor Pennywise, recommending a book that said all of one's money should be in bonds. I was not persuaded. I believe in spreading money out across all major asset classes. Best to own some bonds, just in case of a catastrophic stock-market decline (which bonds typically offer protection against) or a rare long-run stretch of bond supremacy. But bonds sometimes tank, and other asset classes can outperform them, so why be in bonds exclusively?
To arrive at a sane asset allocation, weigh your risk tolerance. Conservative investors, who fear losses, tend to put a higher proportion of money in bonds. But even if you are young and gung-ho, you are advised to keep something in bonds. Consider them a hedge, a slice of insurance.
Individual bonds or bond funds? Once you understand the role of bonds in your portfolio and determine what percentage you wish to own, you need to pick between the two ways to own bonds. An individual bond is the specific security issued by City Government Y or Corporation Z. A bond fund, by contrast, holds and manages hundreds, if not thousands, of individual bonds.
Which is better? The short answer is bond funds. There is a case to be made for individual bond ownership, but for most people, bond funds are sounder.
- First reason: superior diversification. If you own Corporation Z's bond and the company goes bankrupt, you're out most of your money, perhaps all of it. If a bond fund owns the very same bond, however, the individual investor barely takes a hit because of the many hundreds of additional bonds in the mix.
- Second reason: costs. Buying and selling individual bonds requires paying a commission to a broker, a dealer like Fidelity's Open Bond Market. Bond funds, by contrast, buy in volume. They spend far less on per-bond transaction fees. Plus they buy wholesale, so they get cheaper bond prices. True, funds charge an expense ratio, but it is likely to be negligible by comparison.
- Third reason: complexity. Purchasing individual bonds demands research and vigilance—attentiveness to the creditworthiness of the issuer, for example. Do you have the required expertise? If so, here is a tip: Do not go off the bond prices on your broker's Web site alone. Instead, look to the Trade Reporting and Compliance Engine, or Trace, which is free and provides the most recent price information. Then call your broker's trading desk and use that market information to get yourself an optimal deal, rather than buying off whatever price is listed on the Web site.
The one instance in which Pennywise sees individual bond ownership making a certain amount of sense for most of us is in the purchase of federal-government bonds from TreasuryDirect.
Bottom line, however: If you don't know the meaning of "yield spread" and never care to find out, a bond fund is the way to go.
Diversity within the world of bonds. There are many different types of bonds: U.S. Treasury, municipal, and corporate; long-term, intermediate-term, and short-term; investment-grade and hi-yield junk bonds; municipals and Treasuries; international and domestic. Specific funds gauged to those categories—and even subcategories, such as emerging-markets bond funds—let you devise an asset allocation of very different bond types.
A few tips: Don't get suckered by high-yield bonds. They perform more like stocks than bonds, because they are higher risk. A little dab will do you. Second, short-term corporate bonds may be safer than short-term Treasuries at the moment. Third, it's wise to put some money into international bond funds, so not all your holdings are dollar-vulnerable.
Seekers of simplicity can just purchase two bond funds: a total bond index fund (which will be about half Treasuries and half corporates, mortgages, etc.) and an international bond fund. Presto, bond diversification.
There are risks. Typically, bonds are lower-risk assets than stocks, but they do carry their own risks. Right now bond prices have been pushed up by a combination of panicky markets, unbelievably low interest rates, and "quantitative easing" purchases by the Fed. If and when interest rates rise again, as they inevitably will, then bond prices will fall. That is why right now, at least, a tilt in one's bond allocation toward short-term or intermediate-term maturities makes sense. They will be less adversely affected by interest-rate increases.
Remember this, too: Even if bond prices fall, their yield will rise—and your dividends will be reinvested at lower prices.
Bonds are not risk-free, but the same can be said for stocks or cash. Maximum diversification remains prudent.
Editor's Note: This is the seventh column in Pennywise's retirement-investing series. The earlier installments are "Investing for Retirement"; "How Much Should I Save?"; "Tolerance, Risk, and Reward"; "Saving, Speculation, Investment"; "Diversification Still Works"; "Choosing Investments for Balance," and "Of Human Bondage."