Podcast: Risky Bond Markets

bonds-risk

Clark: More and more it’s becoming difficult to parse out exactly what your managers are doing. And with bonds, it’s one thing if I have a large-cap stock fund and I look and there’s Apple and big names that I’ve heard of. But with bonds, if you read some of the names of bonds, you’ll wonder, “What the heck is that?”

You’re listening to Retire Happy with Roger Gainer, president of Gainer Financial and Insurance Services Inc. Thanks for joining us. I’m your host, Clark Buckner. Bonds and bond funds are a common form of investment but do people really understand the risks associated with them? In today’s episode, we’ll explore the differences between treasury, municipal, and corporate bonds, and the unseen risks that come from bond funds. We’ll also hear about some of the alternatives that can yield higher returns and lower volatility. For more content like this, you can visit gainerfinancial.com. Enjoy the show. Roger, good to talk with you again. First of all, how are you doing?

Roger: I’m doing great. Really feeling strong, feeling good.

Clark: Good.

Roger: How about yourself?

Clark: I’m feeling strong, I’m feeling good. I like that. Feeling strong. That’s a good way to start in.

Roger: Something about springtime. It just brings out the best in you.

Clark: Yeah. So what I like about this, I always enjoy catching up with you, connecting. And I know we talk throughout the year on a variety of topics and whether it’s springtime, summer, fall, whenever, all these topics have such an important message, it has a long, long shelf life. And the other day I heard you talking about bond funds and I know recently there’s been a lot of movement in interest rates and stocks and it seems like things are always at some point being volatile. So I would love to talk about bond funds, hear your take on it, see what we need to know and just continue the conversation here on Retire Happy.

Roger: Okay. Well, thanks for the question because bond funds I think are extremely misunderstood by the people who own them for the most part. And people’s reasons for owning them I think don’t match up with the actual reality of owning them. So, I think our listeners, the first question you have to ask yourself is why would you own a bond fund? And the answer for most people is to reduce risk. That’s what they’re trying to do. They’re nervous about the stock market or the volatility of stocks makes them a little uncomfortable. So, they either read a book or working with a financial advisor and they said, “I’m conservative and I don’t feel good about losing money. So, what can we do to reduce risk?” And the knee jerk reaction for the last 30 years has been, “Well, add some bonds to the mix.” And while adding bonds to the mix can certainly reduce volatility and moderate price movements, it is very different owning individual bonds and owning bond funds. So, what I want you to understand, Clark is that they’re very, very different ways of owning that asset class. Does that make sense?

Clark: Right.

Roger: So, in a bond and the reason people look at them to add some safety and reduce volatility is bonds have a guarantee. And the guarantee is that at some point in the future, there is a date where you’re guaranteed to get your money back. Now, like with anything else, the guarantee is only as good as the entity providing it. So, if we have treasury bonds, which are the most widely traded and most widely thought of type of bond, you have the United States government and the treasury backing those bonds and making good on the promise to repay. So, you know, a bond is just a loan and whoever that entity is is just borrowing money from you. It’s like you became the bank and they’re borrowing money from you and that’s what’s happening in the bond investment.

Now, in between the day you buy the bond and the day the bond matures and you get your money back, the value of that bond is gonna go up and down. Have you ever heard that as interest rates go up, the value of bonds goes down? Have you ever heard that Clark?

Clark: It sounds familiar. I’m still learning my way through that.

Roger: Okay. Well, a lot of people are really confused.

Clark: Like supply-demand when there’s no correlation in there. Is that related at all?

Roger: Well, interest rates are really the price of money. So, if you think of it that way, if you go on and go buy steaks, sometimes they go on sale, right? So, maybe it’s $10 a pound and they go on sale for $7 a pound and you stock up, right?

Clark: Right.

Roger: Because the price dropped. So, with bonds, the price is based on just like you said, supply and demand. So, if there’s a large demand, people will bid up the price of bonds and the yield will go down. So let me explain how this works. Bonds are a fixed-income asset. Have you ever heard that?

Clark: Yep.

Roger: Okay.

Clark: Yep. And we talked about that a little bit here.

Roger: Right. So what’s fixed in a bond? The only thing that’s really fixed between the day they’re issued and the day they mature is the payment. So, a bond will yield a certain dollar amount of payment. And I’ll use some round numbers to help you understand. So, say you bought a bond for $100,000 and it was paying $5,000 a year for that bond. That $5,000 represents 5%. So, that would be a 5% bond. Now, say I own this bond and interest rates dropped to 2.5% and you were looking to buy a bond. You sure would be attracted by my 5% bond and you’d love to buy it. But I’m not that stupid. I know that interest rates are 2.5% so I’m gonna tell you, “I’ll tell you what. You can buy my bond, but it pays $5,000 a year. You’re gonna have to pay me $200,000 for this bond because then that $5,000 is now 2.5%.” Does that make sense?

Clark: Right.

Roger: And the opposite is also true. Say it was now 10% world and I’d love to sell my bond, I need the cash. And I come to you and I say, “Hey, Clark, would you buy my bond?” And you’d look at me and say, “But Roger, I can get 10% in the marketplace today. I’ll tell you what, I’ll give you $50,000 for your bond.” And that way, my $5,000 a year represents a 10% yield. And if I needed to sell that bond, that’s what I would have to take. So, when interest rates go up, the value of the underlying bond goes down. Does that make sense? Do you follow what I’m saying?

Clark: Right.

Roger: Okay. So, once you understand that, when you put all of these bonds in a portfolio, in a mutual fund, now the mutual fund manager is gonna buy and sell bonds and carry very few of them to their actual maturity. And even if they do carry them to actual maturity, there’s all kinds of different bonds maturing in different times and different days. And yet, because interest rates move, the value of those bonds has to be determined each and every day because that mutual fund has to be able to be redeemed each and every day. So, one of the advantages, some would say disadvantages of an open-ended mutual fund is that the mutual fund sponsor, whether it’s Fidelity or Vanguard or American Funds or Janus or any of those mutual fund families, they guarantee that if you place the order during market hours, you’re gonna get cashed out at the end of that day at whatever the share price is for that mutual fund. You’re aware of this, aren’t you, Clark?

Clark: I did not know about that.

Roger: Okay. So, this is just a big advantage to many people. They consider it an advantage because I can just call up the mutual fund company and say, “Hey, I wanna sell my position today.” And as long as it’s before the market closes, at the end of the day, I’ll be sold out. They have to by law redeem those shares. So, in bonds, if we’re really looking at the totality of bonds, so again, when most people think of bonds, they’re thinking U.S. treasury bonds or maybe when you were young you got a birthday present from grandma and grandpa of a savings bond. And so this is what most people are thinking of when they think of bonds.

But there’s all kinds of bonds, Clark. There’s municipal bonds, there’s corporate bonds, and then there’s some exotic other types of bonds and bond offshoots which we’re not gonna get into today. But those are the main categories. U.S. government treasuries, municipal bonds which are issued by states and municipal governments and government agencies like water districts or sewer districts or towns, villages, cities or other taxing authorities like the prison system or an energy system.

And then you have corporate bonds. And corporate bonds are pretty interesting and this is where I think a lot of the risk has been coming in here in the last few years. So we have a record amount of corporate bonds outstanding today in the marketplace. There’s never been so much debt because frankly, companies could borrow money for the last five, six, seven years at very low-interest rates. And because the interest rates on high-quality stuff like treasuries has been so low that bond investors and many, many mutual funds, especially, things like total bond market indexes and stuff like that have been moving more and more into these corporate bonds to try to get more yield, a higher interest rate. And because most people buy their funds based on what’s the interest rate. I had a client the other day, a couple of weeks ago, I was going through her portfolio and she had a bond fund that her broker had put her in that said it was yielding 6%. Now, the rate of return on that fund in 2018 was 2%. So, it’s distributing six but it only made two. So, the rest of it was just them cashing in bonds and paying you this 6%.

Clark: Okay.

Roger: It’s really important that you understand these kinds of things that are going on. But corporate bonds don’t trade as much. Treasuries are probably the most liquid market in the world. There are literally trillions of dollars of treasuries that are traded each and every day. The bond pit in Chicago and the Chicago Board of Trade is in a dollar volume the most active market we have, it dwarfs the size of this New York Stock Exchange. And what the dollar value of what’s being traded every day, it just goes on in the background. But a corporate bond may only trade once or twice a year, sometimes, sometimes only every month or two. So in between, that mutual fund has to guess what the value is because they have to publish a share price every day. So, sometimes the guesses are better than at other times. And because they don’t trade every day, when I redeem my shares of the mutual fund, the mutual fund is forced to sell assets to raise cash to buy my shares back.

If there’s a lot of people trying to get out of these funds at the same time and these managers are forced to sell corporate bonds and even some municipals, but we’re gonna go there a little bit later and there’s nobody interested in buying, I have to put them on sale. I have to offer enough discount to attract buyers because I don’t have a choice. I have to sell. And if there’s not a lot of people out there looking for these bonds, then I have to make it attractive enough for somebody to raise their hands and say, “Oh, yeah. I’ll buy that.” So this is the real risk of what’s going on because it can become like a waterfall or well, we’ve had some firestorms here in the last couple of years and firestorms create their own wind and we’ve seen this happen…

Clark: Yeah. Firestorm. What do you mean by that?

Roger: Yeah. So, we’ve had a couple of really bad fires, high wind, low humidity. We had one…

Clark: Oh, you’re like legit. Okay. It’s called…

Roger: Natural firestorm. Yeah. Big fires and you see…

Clark: I thought you were talking about that’s like a slogan or like some sort of jargon of it.

Roger: No, no, no, no.

Clark: Like a fire sale. Right? I’m sorry.

Roger: Yeah. They’re not fire sale they’re firestorm. If you’d seen some of the footage of the fires that were here last fall, we had a little fire cyclones were happening, fire tornadoes. And because they create their own wind from the heat and embers go flying and it just expands the fire, it becomes its own weather maker because it’s so extreme and so intense. And when we start to see sterling in the corporate bond market or even the municipal bond market, there’s a cascading effect because we don’t have a huge number of willing buyers. Governments and treasuries all over the world buy our treasury debt, but they’re not so interested in maybe buying a Schlumberger corporate bonds that they borrowed money so that they could buy some more equipment or something like that.

So, like I said, then they have to make discounts, prices fall further, more people panic, they say they wanna sell and on and on. See, there’s an inherent danger that’s evolved. Mutual fund companies, their job is to sell mutual funds. That’s how they get paid. So, if they can convince you to buy mutual funds, then they have more cash which they charge their management fee on and they make more money. So, naturally, they’re interested in selling as much of this stuff as they possibly can. So, if there’s a demand for bonds and there’s a demand for yield, well, they’re gonna go out and buy bonds that maybe yield a little bit more to attract more buyers. But when we add liquidity to illiquid investments, we increase risk dramatically.

Clark: Right. Got It. And you can’t back it.

Roger: Right. I wanna state this again because so many people come to me and they say, “Well, I wanna be totally liquid.” Now, the guys and ladies that own and run private equity funds and hedge funds, a lot of what they invest in is illiquid. And they understand that that illiquidity actually can reduce volatility and increase overall returns in the long run. So, if you wanna be in some of these higher-paying things like real estate investment trust or oil and gas or startups, these kinds of things…startups, great example. We were having all kinds of IPOs in initial public offerings in this area. We had Lyft go last week and there’s a bunch of them lined up here. And early investors have been waiting years for liquidity but they’re gonna make a fortune. I saw an interview with a lady who bought her Lyft shares for 23 cents.

Clark: No.

Roger: Yeah. And so her $10,000 investment was worth millions of dollars when she cashed out.

Clark: So, how did they get to be so low in value?

Roger: Well, because they started up. They were starting, they had little cash, they were making no profits. Early investors, they know they’re in it for the long run. They know that, “I can’t sell these shares, I can’t do anything, I have no control over what’s gonna happen. I just believe in the business model and I hope that at some point in the future, I’m gonna be able to sell, but I’m investing only the money that I know I’m not gonna need in a pinch.” So, they’re long term money and this is just how you reduce risk and increase returns. This is true across many, many asset classes.

So let’s get back to bond funds. So, we have a record amount of corporate bonds that are outstanding. There are two other risks in the corporate bond world right now that I think are underappreciated. Half. Well, 49%. I read about two months ago, 49% of all outstanding corporate bonds are rated BBB. BBB is the lowest rating for investment grade. Okay. Why is that important? Because a lot of pension plans, mutual funds that are investment-grade bond funds and other types of managers can only invest in investment-grade bonds.

So, if a triple B bond is downgraded to say BB1, these managers are forced to sell. And if you’re forced to sell and there’s no buyers, prices go down, you get less money, I’m forced to sell. And again, it goes on. And so a lot of the borrowers were able to get really low-interest rates, probably lower than they deserved based on their credit profile. But there has been this huge hunger and so people were willing to look the other way at risk and take less yields just because I need yield. I needed to get a higher interest rate than what I could make. Look back in 2016, we had the 10-year treasury bottomed out at 1.36%. That’s not a lot of yield over 10 years. So, again, managers and when everybody is trying to buy, the other thing happens, interest rates go down, the value of bonds is bid up. And so we saw a lot of people, a lot of companies able to borrow a lot of money at rates much lower than they anticipated.

Now, what’s the problem here is that between 2021 and 2025, a very large percentage of the outstanding corporate debt has to be refinanced. So you’re gonna have these companies scrambling and if interest rates increase between now and the time they’re looking to come back to market and borrow again to pay off those bonds, if those interest rates go up, their businesses in many cases are not gonna be able to support paying that higher interest rate. So, the bonds get downgraded, and etc., etc., etc. And it becomes, again, the self-fulfilling prophecy. Add to that, the fact that we’re on the way back to trillion-dollar deficits this year, we’re gonna have the federal government competing with borrowers for corporates and municipal bonds. And there’s just so much money to go around. And if you have all these people competing at the same time, you’ve got a lot of people wanting to borrow simultaneously and a finite number of people looking to lend. Hence interest rates are quite likely to go up during that kind of time period. It could get very ugly.

So, this is what I’m trying to get through to folks. We had a podcast a couple of months back about mutual funds and how they’re becoming more and more like little black boxes. I challenged people to figure out what they’re actually investing in, in some of their mutual funds. I think they’d be surprised to find out what they actually own. And because more and more it’s becoming difficult to parse out exactly what your managers are doing. And with bonds, it’s one thing if I am a large-cap stock fund and I look and there’s Apple and Google and AT&T and big names that I’ve heard of, Chase Bank and that kind of stuff. But with bonds, if you read some of the names of bonds, you’ll wonder what the heck is that? Because they talk about the maturity day and the call day and the interest rate and there’s things like duration and other measurements of risk that can help you understand what you’re buying into. But even at that, many of the top bond funds have hundreds if not thousands of different bond issues in them. We had a little taste of this back in 2016 to 2017. Like I said before, the 10-year treasury bottomed out at about 1.36 prior to the election. And then there was a big stock market rally and bond interest rates jumped dramatically in a very short period of time.

And if you go back and look at what bond funds did just with that 1% shift, so they went from basically 1.36 up to about 2.45 in a very short period of time, A lot of funds lost between 5 and 10% of their value during that really short time span of about nine months to a year. And that’s certainly counter to why those folks bought those bond funds. Now, it was a short-lived situation. Some prices have recovered a little bit. Most bond funds haven’t done more than a two or 3% positive return net of fees here really since that time. We’ve seen them struggling. But if interest rates were to rise, if the economy slowed down and we started seeing decreases in revenues for these companies, there’s some really new big names that might surprise some of our listeners who are right on the razor’s edge of being able to pay these bond interest rate. They’re called coupons and they have to make these payments to the bond investors on a regular basis. You can’t just say, “Oh, sorry, we had a slow quarter, you guys will let me slide till the next quarter?” That’s called a default. And you get immediately downgraded and there’s a run on the bank and people start selling your stuff and it becomes again, a spiral accelerator. So, we bounced around here a little bit but I’m hoping our listeners, maybe you can tell me, are you getting where that risk is by adding liquidity to illiquid assets?

Clark: Right. Yeah. And I think another value to highlight here is you clearly have a firm grip on a lot of these things and just have an idea of the different tools that are available. And by working with you, you’re able to access that knowledge. So, I understand, I’ve heard you say before as well how there are different tools that do different things. And although sometimes there can be misunderstanding around risk and bonds, it’s just another tool. So…

Roger: That’s right. Yeah. I tell clients that I tend to have a little bigger toolbox than a lot of traditional advisors out there who basically just work with stocks and bonds and then different arrangements of stocks and bonds like mutual funds and ETFs and that sort of thing. But there are other asset classes, there are other strategies that will reduce your portfolio volatility, will protect you from the downside, and do those things that people wanted their bond funds to perform for them. Because let’s face it, unless you’re worth quite a bit of money and can afford to buy individual bonds for 10 to 20,000 each and build your own portfolio, mutual funds really are the way to go to get diversified. But again, you’re adding this risk that I think a lot of people don’t understand. See, we’ve been in 35 years, actually more than 35 years now of interest rates coming down. Back in 1980, you could buy a money market fund and get 18 plus percent on your money market fund. And so every…

Clark: That’s great, right?

Roger: That was fantastic back then and made retirement planning very easy. You could just buy some CDs or government treasuries and sit back and cash your coupons and just go about your business and enjoy life. But ever since 1980, we’ve seen interest rates coming down steadily during that entire time. See, investors believe that whatever has been happening is gonna continue to happen. So, these mutual funds gained in value when interest rates were dropping over this period of time. So people started thinking, “Okay. I jumped out of stocks and I jumped into bonds because my advisor told me to, or my buddy told me to, and I got compensated.” Here’s a great example. In 2002, part of the .com bubble bursting, stocks were down over 20%, bonds were up 10% in the same year because interest rates dropped quite a bit during that time. And so investors were rewarded. And we, again, strategy works, we’re gonna keep doing that strategy.

If you’re a baseball pitcher and you get this guy out on a curveball on the inside corner, you’re probably gonna throw him a curveball on the inside corner again because, “Hey, it worked last time and I’m gonna keep hammering that until it doesn’t work anymore.” But with money, especially people that are approaching retirement, losing money is a whole bunch different than walking a batter or giving up a base hit. So, this is why I’m so strongly encouraging people. Now, if any of our listeners are interested in one potential alternative to these things, I am offering a white paper to anybody listening to this today. You can go to our website, www.gainerfinancial.com and hit the contact us button, or you can call our office at (415) 331-9030. And I’ll be happy to give you a copy of the Roger Ibbotson white paper.

Roger Ibbotson, Nobel Prize-winning economist, professor emeritus of finance at the Yale School of Management, and he’s the head of Zebra Capital Management. And he released a research paper in January of 2018 called “Fixed Indexed Annuities: Consider the Alternative.” And this report explains how as an alternative to bond funds, these will actually benefit in a rising interest rate market, protect you in a decreasing interest rate market, and provide that reduction of volatility that most people are seeking from bond funds. If you want a copy of this report, call the office or go on our website and request a copy and we’re more than happy to send this to you. It’s really very interesting. We also have a program that if you wanna evaluate the risk in your bond funds, give us a call or contact us and we will submit your bond fund portfolio and get a really thorough analysis back and a plotting of where the risk levels are so that you can anticipate what may or may not happen to you as interest rates change in the future.

Clark: Excellent. Roger, thank you so much for taking the time to share. As always, I always enjoy these. So, I’m looking forward to our next conversation. All right. Keep smiling and retire happy.

Roger L. Gainer, RICP, CHFC California insurance license number 0754849 is licensed to sell insurance and annuity products in California, Illinois, Arizona, Nevada, and Oregon. Roger L. Gainer is an investment advisor representative, providing advisory services through HFIS Inc., a registered investment advisor. Gainer Financial and Insurance Services Inc. is not owned or affiliated with HFIS Inc. and operates independently.