Table of Contents

1. Introduction
2. Article Discussion
3. Discussion Questions

Introduction

Madison: Hello, everyone, and welcome to the 18th episode of Not Just Numbers, Honest Conversations with a Financial Advisor and Lawyer. I am Madison Demora, and I am here with Mike Garry. Mike is the financial advisor and the CFP and the founder and the CEO of Yardley Wealth Management. He is also an estate planning lawyer, and his law firm is Yardley Estate Planning. Hey, Mike.

Mike: Hey, Maddie. How are you?

Madison: I’m good. How are you?

Mike: Good. Get all your shopping done for the holidays?

Madison: I wish I could say I did. I’m definitely one of those last minute people. I definitely have a head start, but, you know, just the last minute things.

Mike: Yep. Yeah, I still need to buy something for our Pollyanna, which is Sunday.

Article Discussion

Madison: Oh, okay. All right. We are going to discuss an article. The article is “Bonds Vs. Bond Funds, How Higher Rates are Changing the Calculation” and this is an article from the Wall Street Journal and it is written by Heather Gillers. So like previously, I will read a little summary and ask Mike some questions and you can always find the link to the article in the description. So here is the summary. The article discusses the ongoing debate between buying individual bonds or bond mutual funds in the current era of higher interest rates. During low rate periods, mutual funds were favored, but risks became evident with rising rates. Investors now consider individual bonds for capital protection despite drawbacks like concentration risks and active management requirements. The article compares the performance of both options, highlighting the ease of buying and selling funds and the advantages of diversification and professional management. It suggests investors may opt for a combination or hybrid products. Regardless of the choice, the article emphasizes the gains will come from interest payments, with timing being crucial in the current high interest rate environment.

Discussion Questions

Mike: And it’s funny, that article is not from that long ago. And the ten year treasury has gone down from 5% to 4% in that time. And it seemed like the Fed yesterday was saying that the era of rate increases is over and the market seems to have priced in rate cuts for next year. Right now we’re doing this on December 14, the ten year bond is paying 3.93%. So just like six weeks or so ago, it briefly topped over 5%, which is the highest it had been in a while. So it’s interesting to see how these things change. And I’m going to tell you, in the short run, interest rates are as easy to predict as stock movements, which means that no one can do them with any kind of regularity or consistency. All right. So let’s get on to these questions, Maddie. I know you have some good ones for me.

Madison: All right. In the current era of higher interest rates, what factors do you think make individual bonds more appealing to investors compared to bond mutual funds?

Mike: So I think one of the things that led people to start buying individual bonds, and like CDs, is starting a year and a half ago or almost two years ago now, when the Fed started raising rates, you could get more than one or 2% on a bond. So you could see why in 2017, if rates were 1%, why people weren’t going to rush out and lock up their money for 1% for five years. Now that some of those bonds pay 4% or 5%, you can see why somebody would lock that in. Right? Does that makes sense?

Madison: Totally. All right, so the article mentions the drawbacks of buying individual bonds, such as concentration risk and the need for active management. How might investors address these challenges if they choose to go for individual bonds?

Mike: Sure. So we generally don’t recommend individual bonds because of the concentration risk and how expensive it is to buy bonds on your own. So by concentration risk, most people have a limited amount of money, right? So if you only have a certain amount of money to buy bonds, it gets hard to buy bonds that are diversified. So say you have a million dollar portfolio and you want to have $300,000 in bonds. Well, bonds are traded in the $1,000, you know, per $1,000. So then you would only have, at the most, you could buy 300 $1,000 bonds, but nobody’s going to do that, doesn’t make any sense. There are all sorts of bonds you can invest in. There’s treasuries, agencies, corporate bonds, muni bonds, a bunch of different types of bonds. They all have different risk return characteristics. If you are going to buy individual bonds, you’re going to be limited by the amount of money you have to deploy. And so if you were just, if you had that million dollar portfolio and $300,000 was going to go into bonds and you wanted to buy individual bonds, you’d have to really stick with either treasuries or insured munis to make sure, to make sure that you got your money back, because corporate bonds and munis that aren’t insured can default and you would get nothing back. And your portfolio is supposed to be the safe part. So if you’re going to buy individual bonds, that means there’s giant categories that offer higher returns that you can’t invest in at all or you shouldn’t invest in at all because you could lose your money.

Madison: All right. Diversification is highlighted as an advantage of bond funds. How important do you think diversification is in mitigating risks? And what are the potential downsides of relying on diversification?

Mike: Yeah. So the reason that diversification is a good thing, there used to be an old adage in Wall street, diversification is the only free lunch you get in investing because you can diversify and reduce a lot of risk. So for bonds, if you were to buy bond funds with that $300,000 portfolio, maybe you would buy some treasuries or a fund that’s an investment grade bond fund. Maybe you would buy a muni bond fund, depending if you have a taxable account, and then you could buy other bond funds that might pay more, right, then those. And you could have three or four funds make up that $300,000. You can buy international funds. And so you would have small pieces of hundreds or thousands of funds instead of buying three treasuries or six treasuries. And so you can get a lot more diversification in terms of the issuer and the interest rate and the maturity and the duration. You could get a lot for that, and I think its worth it. The other thing in buying funds thats a little bit different is, yes, you pay for that investment manager. So youre going to pay a 10th of a percent or maybe as much as two tenths of a percent, but not a lot more than that. Bond funds are much cheaper than most stock funds. And if you go to buy bonds on your own, you buy them through a typical discount brokerage firm like Schwab or a mutual fund company like Fidelity. You can buy bonds, and it’s easy now. The problem is you’re buying them from the inventory of those fund companies, and they are making money off you. That is much, much, much more than the amount that you’re going to be paying a fund manager, because those places deal with bond traders and they’re going to buy bonds by the millions. And if you want to buy a $25,000 piece or a $50,000 piece, even 100 or $500,000 piece, it’s the difference between buying wholesale and buying retail. You’re going to pay more. Somebody at Schwab has to buy those and sell those. Somebody’s going to monitor the website and they’re going to make money from that. So it’s easier than ever to buy individual bonds and it’s cheaper than it used to be, but it’s not as cheap as it is, say, buying a stock where there’s no commission and the payment for order flow is going to be a really, really small amount.

Madison: Yeah. So what’s the difference between stock mutual funds and bond mutual funds?

Mike: Yeah. I mean, the difference is the stock mutual fund buys stocks and a bond mutual fund buys bonds. And then there are other funds that are, that they call balanced funds or a bunch of different names for them that might have both. Right. So say that, 60/40 portfolio that we talk about all the time. There are plenty of mutual funds that, where you can buy the 60/40 allocation. So you can buy one fund that typically will buy other funds that it holds. But you only see that one fund and you only purchase that one fund and somebody else manages that collection of other funds. It’s a good question.

Madison: Okay, yeah. All right, so the article discusses the ease of buying and selling bond funds, especially in small quantities. How does liquidity factor into your investment decisions, and what are the trade offs between liquidity and potential returns?

Mike: Sure. So the bond funds are generally very liquid. You could buy and sell them, and it’s pretty easy. Buying individual bonds, treasuries are are the most liquid security there is. They’re the easiest thing to turn to cash or to buy with cash. But then other bonds, it’s different. Like, there are, you know, there’s thousands of stocks. There are millions of bonds out there. Um, you know, think of every township, every school district, every state, most publicly traded companies, most countries, all issue bonds. There are all sorts of bonds. And so the treasury, which has the most bonds, they’re really liquid. But like, Lower Makefield township bonds or Yardley Borough bonds, they might not be as liquid. Like, it might be harder to buy and sell them. And the thing about liquidity is, and why liquidity is an issue, is that when you want to go buy a treasury or you want to sell a treasury and you see what the price is, you know that you’re going to get that. If you want to sell a Yardley Borough bond, there might not be an active buyer, you might have to wait, or you might get people to bid on it, and they might not bid at prices that you want to pay. And so liquidity is not just like turning into cash, but it’s like the ease of turning into cash and the threat of loss and turning something into cash. While you have treasuries of the most liquid securities on earth, there’s a lot of other bonds that aren’t that liquid. So if you want to buy a group of individual bonds and you go away from treasuries and agencies and real big company or state bonds, you could have an issue of selling them when you want to, at a price that you think is reasonable.

Madison: Yep. Okay, so professional management is cited as a benefit of bond funds. Do you think the potential advantages of professional management outweigh the costs associated with fund fees?

Mike: I do. Fund fees now are pretty low. If you asked me this 20 years ago, it would be a harder choice. But right now, for ten or 20 basis points, which is like one 10th of a percent or two tenths of 1% per year, to be able to have a diversified portfolio and to get institutional pricing and by diversified, I mean across issuers, across types of bonds, across maturities, across durations, you could have a portfolio that is really suits your needs, whatever those needs are, for a really small amount of money.

Madison: So the article mentions tax considerations for bondholders. How might tax implications influence your decision to invest in individual bonds or bond funds?

Mike: When you buy individual bonds, you have a little bit more control over what the taxes are going to be because you make the decisions to buy and sell them. And so if you have any gains from selling them or if you have taxes from dividends and interests that are paid, you know when you’re buying them, what that’s going to be. So that is a small advantage in buying an individual bond. You buy a bond fund, you’re going to take what you get. So if you buy a muni fund, there should be no taxes to it. But in other taxable bonds funds, they’re going to be buying funds, they’re going to be maturing, some are going to be selling. They have to have some liquidity for when people are buying and selling the fund. And so there will be a little bit of tax based on that. Shouldn’t be a whole lot most of the time if you’re buying a big fund, but yes.

Madison: All right, so the article suggests that a combination of both individual bonds and bond funds might be a viable approach. In what situations do you think this hybrid strategy could be beneficial?

Mike: I think a hybrid strategy could be beneficial if the purpose of part of your bond portfolio is for buying something in a specific time and place. So say you were.. Remember we did the podcast about the guy who put the money in the crypto and lost all of it. In that situation, right, so that was in the Fall. If he knew he wanted to purchase land or start construction on a house in six months, he could have bought a six month treasury bill outside of his regular portfolio that has a mix of stock and bond funds, and then that money would have been safe and it would have matured. He could have bought one that matured probably the exact day that he wanted to, or certainly within a couple of days or a week. That would be a real good use of having an individual bond. Same thing for like CDs. If you know that you’re going to have a need for money at a certain time in the future, and it’s very specific and you don’t want the risk of loss, then buying an insured muni bond or a guaranteed bond like a treasury or CD, is the right thing to do.

Madison: How important do you think timing is in making investment decisions, especially in the context of interest rate fluctuations? What factors would you consider when deciding the right time to invest in bonds or bond funds?

Mike: I would say that people cannot consistently know when to time the market. And the idea of moving to your portfolio, the right allocation, is once you know it’s the right allocation, you should make the move. So if you are moving money from one place to another, or if you’re starting an investment, if you know the allocation should be a certain thing, the thing that makes the most sense is to move that right away. Stock and bond movements are, in the short run, unpredictable, and it’s impossible to time with regularity and consistency. Everybody gets lucky. Somebody’s going to win the lottery tonight. But if you’re going to think like, oh, well, I’m going to wait for rates to do something. You know, nobody saw the ten year treasury going down from a little over five to under four in such a short amount of time in the last six weeks or two months or whatever it’s been. It’s been a short time to make that big of a move. And before that, it was a big move to go from four to 5%. Right. And that wasn’t widely anticipated. So the best idea is once you know what you want to do, take the steps to get there.

Madison: It’s your own timing. There’s no, there’s no perfect timing. Like, do it December 15 at 12:00 in the afternoon.

Mike: Right. The only time that would work is like, hey, if I’m going to take my lunch hour to rechange my portfolio, and I have a little bit time on Friday at 12:00 I’m going to do it then.

Madison: How much should people rely on bonds? Can you have too much in bonds? Did you say you saw another article about people using them more or maybe even more than they should?

Mike: Yes. So now that bonds pay more than zero, although 4% is not huge. There’s article in the paper yesterday saying, and quotes people in their fifties saying they want to get a portfolio of bonds big enough so that all of their expenses in retirement will be paid for by guaranteed bonds. And that’s a lovely sentiment, but it’s not going to work for almost everybody. The reason is, those bonds are not going to keep up with inflation, so they’re not going to grow. That ten year treasury that yields 4%, it’s taxable, so people are going to lose 25% to 40% of taxes. And inflation, while coming down a lot, is still running at 3.1%. So that ten year treasury is not going to keep up with inflation after taxes. So if you get your portfolio, say you’re in your mid fifties and you want to build this portfolio to last for the rest of your life, and you have a reasonable expectation of getting into your eighties or nineties. That portfolio when you’re in your eighties and nineties is going to throw off peanuts of money compared to what it would when you first got it together. So the only people that would work for are people who are really, really rich. Right? Sure, if you have $100 million, you could do that and it’s going to be okay. Or people who are going to rely mostly on Social Security or pensions and the bonds will provide a little bit of interest. So sure, my grandparents who lived a long time ago didn’t buy any kind of stocks. They just had cash and CDs. They didn’t spend that much money. They had pensions and Social Security and they didn’t spend anything. People now, especially people who are quoted in Wall Street Journal articles in their fifties, so they’re probably in pretty good financial shape. It probably gives them comfort to think that they could have this bond portfolio, but it would be a disastrous decision for most people, just disastrous. The difference, here’s an example. Rachels grandfather had a real good job and he had a pension and it paid a big percent of his salary when he retired in 1971, that was $6,000. So that’s 50 years ago. So these 50 year olds who could live to be 100, there’s not a crazy chance they could. Think of the difference between that $6,000 pension 50 years ago and what you would need to live on, even like the basic standard of living here. Right. The $6,000 is going to be a rounding error when you’re spending needs are going to be in 50 years. It’s really short sighted. It’s really not a good idea. So you could rely too much on bonds. Bonds have a time in place. Most people can’t handle the volatility of an all stock portfolio. I get that. And so most people need to have some bonds to cushion the volatility, especially if they’re taking withdrawals that are sizable or material compared to how much they have. But you can’t go overboard because that’s the part of your portfolio that’s not really going to increase that much and the value over time is going to steadily erode. So yes, if you need to have 20, 30, 40%, even 50% in bonds because you need to sleep at night, that’s okay. But once you go above that 50% bonds part, you’re going to run into real issues if you expect to have that for a long period of time.

Madison: Okay. For more information on Yardley Wealth Management or Yardley Estate Planning, you could visit our website at yardleywealth.net and yardleyestate.net. You can also follow us on socials at Yardley Wealth Management this podcast has been produced by Madison Demora and Mike Garry with the technical and artistic help from Poe Productions.