Billions of dollars are flowing into bonds right now — particularly Treasury products — as yields surge and prices drop, which makes the amount of fixed income in your personal portfolio a mere drop in the bucket, even if you’re a millionaire.
Say, for instance, you’re making your regular biweekly 401(k) contribution, which is the way that most people invest. If you max out at the yearly $22,500 contribution limit, and you have a fairly conservative 60/40 portfolio, you’re putting about $350 in new money into bonds each paycheck.
How will you allocate that? It’s more likely than not that the average investor is going to plunk that money into a target-date fund, which a portfolio manager will guide over time so that the funds are ready to start spending at retirement. It’s not sexy or particularly aggressive, but it is easy.
You can automate the fund selection and keep investing steadily over time. Hopefully, your balance will build to an amount that will be enough to sustain you once you stop working.
If you want to get a little more involved than that and allocate your own 401(k) funds or invest outside of your regular workplace contributions, you’ll need both more elbow grease and a greater tolerance for risk. Bonds are supposed to be a safe investment, but they are definitely a cause of retirement anxiety these days due to price volatility. To make the most of the bond market, you’ll have to make a series of educated choices and then manage the flow of your money at various time intervals — like three months
or 10 years
according to the bond durations you choose.
Heavy bond lifting
You can buy Treasury products of all types directly from TreasuryDirect.gov — Treasury bills, bonds and notes and inflation-protected TIPS and Series I bonds — and manage them on your own. You can hold these in your account until they mature and then cash them out, or you can choose one of many rollover features to keep reinvesting.
On the plus side, this allows you to control your own purchases, avoid paying fees to a middleman and reap a steady yield. On the negative side, you can buy on the government’s platform, but you cannot sell there before maturity. If you buy a long-range product and want to liquidate it early, you have to move it to a brokerage and sell it on the secondary market at the prevailing price of the day. Given the way prices have been dropping as yields go up, this could mean you have to sell at a loss.
You’ll also need to go through a brokerage for most other fixed-income products, such as municipal bonds, corporate bonds, junk bonds and brokered CDs, and there could be fees or spreads that could eat into your return. Your chosen platform should have a way to look up each offering by its identification number, known as a Cusip number, so that you can see the rating, the yield to maturity, call features and other details. You should also be able to search by type and yield to get the best offering of the moment. You’ll want to keep track of your durations and track the market, which might involve spreadsheets, software or professional help.
The little guy has a tendency to get squeezed out in markets like this. “When you’re buying bonds, size matters,” says Devin Pope, a certified financial planner with Nilsine Partners in Salt Lake City. He mostly sees clients invest directly in bonds when they have more than $100,000 to put into each product. “If they have $1 million to put in fixed income, they’ll buy eight or 10 different bonds, each with different maturities, at $100,000 each.”
The value of bond ETFs
What if you have more like $10,000 or $25,000 to invest? You might want to consider a bond exchange-traded fund or a bond mutual fund. The difference between those will be that the ETF version will typically have a lower cost ratio and more liquidity as it trades within the day.
Either choice works generally the same way: You buy shares of the ETF or mutual fund and get a regular yield based on the holdings of the fund in aggregate. Those yields will go up as interest rates rise. But the share price of the fund will also reflect the same inverse ratio as bonds bought directly — as bond yields go up, prices go down. The longer the maturities of the bonds in the fund basket, the more sensitive the price is to interest-rate changes, says Raul Diaz, regional senior investment officer for Northern Trust. “The investor needs to understand what strategy they are buying,” he adds.
Today’s rapidly rising interest rates means that when you see your bond holdings in your portfolio, they will likely show up in bright red, indicating a loss. The past couple of years have been bad for bond prices, and they just keep dropping.
But investors, particularly those near or in retirement, also have been desperate for yield. So it’s important to know the dynamics of the market so you can assess the value of fixed income in your portfolio. Bond yields are steady — hence the term “fixed income” — and the reason you invest in them is because they provide you with cash as you go along. You can redeploy this money to stocks or to more bonds, or you can use it for spending money. As long as you don’t sell the underlying fund shares, your price losses are only on paper, as they are with stocks.
In a report on the difference between bond funds and individual bonds, the brokerage Vanguard notes, “[T]he former generally offer greater return opportunities, lower transaction costs, and higher liquidity — as well as time savings for your practice — than comparable portfolios of individual bonds.”
In this study, Vanguard concluded that even for financial advisers, bond ETFs and funds make more sense. “Given the higher risks and costs associated with portfolios of individual bonds, and the time they take to manage, most advisors are better served by low-cost mutual funds and ETFs,” the report says.
If it’s not even worth your adviser’s time to build you an individualized bond ladder — even when they are making a 1% fee or some portion thereof — then how could it be worth your time?
Meanwhile, you could get a basket of bonds of some type, chug out income each month and not worry too much about the price. Take Vanguard’s broad-market Vanguard Total Bond Market ETF
one of the largest bond ETFs by assets. “An investor can’t get that diversity on their own,” says Maria Bruno, a certified financial planner and senior financial planning strategist at Vanguard. “It pays a monthly dividend, and retirees could take that as a source of income. It also offers liquidity and professional management.”
What does the math on that look like? If you had bought 100 shares of BND six months ago, you’d have a paper loss of over $500 right now, and you might not agree with that argument so much. But in that same amount of time, those shares would have have made over $100 in yield. If you had bought the same amount a year ago, you’d only be down about $86 in price on paper, while you could have earned over $200.
Nobody knows what will happen to bond prices and yields in the future, but if you understand their place in your portfolio and use them for long-term planning, you can find the right mix for your needs.