Thursday, March 25, 2010

Investing in Bonds – What Do You Need to Know?

Rebuild Your Wealth on Solid Ground (Part 4 of 4):

Investing in bonds and CDs. People buy bonds and CDs primarily for safety and income. If you own high quality bonds and FDIC insured CDs, and hold them to maturity (or to when they are redeemed or “called” early), you should get your money back and steady interest income along the way. These are valuable qualities when the stock market is in a swoon like it was in 2008 and early 2009, as well as when you are retired and need steady income.

In fact, if you buy them right, bonds and CDs can be an effective counterbalance to the part of your portfolio that’s invested in stocks. That’s because many of the conditions that make the stock market go down can cause bond prices to be stable or even go up. Most of the time, the higher the percentage of your portfolio that you have in bonds, CDs, and cash, the lower the up and down volatility you experience, which means you’ll have less risk of loss in a given year than investors with a heavy weighting in stocks. Of course, over long periods of time stocks tend to give higher returns than bonds, so investors with a greater need for growth often have to have more invested in stocks and less in bonds.

So, how should you buy bonds and CDs for your portfolio? Is there a good strategy for buying them? Are there any risks? What about the growing amount of government debt, inflation, and the economy—don’t those things have an effect on bonds? Are bond funds better than individual bonds? Let’s address these questions one by one.

Strategy for buying bonds and CDs. Most of the time, the best practice is to “ladder” (or spread out) the maturities of the bonds and CDs you are buying. The reason for owning some short and intermediate maturities is so that every year or two you’ll have a CD or bond maturing. Every time one matures, you can reinvest in a new long term bond. That way, you’ll constantly be walking your bond portfolio forward, and be somewhat insulated from the effects of changing interest rates.

The reason for having some bonds with longer maturities is that they generally pay higher interest rates than bonds and CDs with shorter maturities. Also, if interest rates go down for a few years (as has been the case recently), the longer maturity bonds you bought earlier will continue paying the higher interest rates they had when you purchased them.

Risks of buying bonds. There are two main risks to consider. The first is that you buy a bond from a corporation, municipality, or state that goes bankrupt. This is called credit risk, which is really the risk of defaulting (not paying interest and principal) at some point in the future. Lower credit quality bonds (also called “junk bonds” or “high yield bonds”) usually pay higher interest rates, but the risk to the safety of your principal is rarely worth it (unless you have a small amount in a junk bond mutual fund). It’s much better to get a lower interest rate from a high quality company or municipality than a higher interest rate from a questionable or struggling company. If you invest in quality, and diversify among various issuers, your portfolio’s overall risk of losing money from a default should be very low.

The second risk is that interest rates will rise in the future, causing the resale value of the bonds you’ve already bought to go down. This can be caused by a pickup in inflation or by a massive increase in government debt, among other things. If you’ve laddered the maturities in the bonds you’ve already bought, you’ve done most of what you can do to protect your portfolio. However, during periods of extraordinarily low interest rates, like now, it’s best to invest new money in very short maturity (up to two years) bonds and CDs. At some point the current appetite of the world for more and more bonds (particularly the large supply of new U.S. treasury bonds being issued each year to fund the deficit) will probably diminish, and interest rates will likely have to move higher to continue attracting buyers. This will, in my opinion, push yields up (and prices down) in all types of bonds, with the biggest effect on the longest maturity bonds. So, for now, I recommend keeping your maturities short for new bond and CD purchases.

Which to buy: bond mutual funds or individual bonds? Each one has its benefits and drawbacks. A bond fund is invested in many different bonds, so if one bond goes bad (defaults) it shouldn’t have a major impact on the fund. Also, it’s the responsibility of the fund’s manager to monitor the bonds in the fund and sell any whose risk of default is increasing. This diversification and professional management is valuable when you are investing in complicated bonds (like convertibles), or in riskier bonds (such as junk bonds or bonds from emerging markets), or in your 401(k) where CDs and individual bonds aren’t available. It’s not as valuable, and may not be worth the cost, when you are investing in high quality bonds like treasuries, or investment grade corporate or municipal bonds, where the risk of default is very low.

Bond funds have one major disadvantage, in my opinion. Unlike individual bonds, funds do not have a maturity date with a promise that you’ll get your principal back at that time. If interest rates rise after you invest in a bond fund, the price of the fund’s shares will go down and may or may not come back up to the full value of your original investment when you eventually sell the fund. Individual bonds, on the other hand, do mature at full face value on a certain date (or on a predetermined “call” date). If you’ve bought high quality bonds with a low risk of default, you can be confident of getting the full face value of your bonds if you hold them to the call or maturity date. Therefore, in general, I recommend owning individual CDs and high quality bonds with laddered maturities. Of course, each investor’s situation is unique, and for some people bond funds are more comfortable and appropriate.

As you work hard and invest to rebuild your wealth, make sure you are on solid ground. In the last four blogs, we’ve outlined the most important steps:
  • Part 1. Start with a good investment plan based on your personal needs.
  • Part 2. Have the right mix of stocks vs. bonds and cash – for you.
  • Part 3. When you invest for growth in stocks – diversify and keep your costs low.
  • Part 4. When you invest in bonds and CDs – ladder maturities (but stay short term for now) and buy quality.
Coming soon: How to reduce and eliminate your debt.

Wednesday, March 3, 2010

When You Invest For Growth In Stocks – Diversify and Keep Your Costs Low.

Rebuild Your Wealth on Solid Ground. (Part 3 of 4):

Can you find the next hot technology stock before other people do? Are you sure? Or better yet, can a stockbroker working at a big bank or brokerage find it for you, and then tell you to buy it before all the hedge funds and money managers and the rest of the world does? You should know the answer to that.

Let’s step back for a minute. What's the real reason that you invest in stocks? To lose sleep? To help replenish the profits of the bailed-out banks and brokerages by paying lots of hefty commissions when they sell you mutual funds and stocks? Of course not. Your purpose for owning stocks is to build wealth over a long period of time by the compounding of your returns, and to offset the wealth-destroying effect of inflation.

So why does it seem so hard to invest in stocks and achieve long term success? Do stockbrokers have some mysterious inside knowledge of which stocks to buy (and when to sell them) that they only share with their best customers? They’d like you to think that, but no, they don’t. Neither do the experts on TV. (Even if they occasionally did, after they announced their picks on TV, everyone who was going to use that information would already have acted on it.) The truth is, there's a lot of research that demonstrates that very few professional money managers (including managers of mutual funds) can consistently beat the stock market. They do in some years, and then fail to in other years. If those full time professionals can’t, how can your stockbroker, the cable TV screamers, your best friend, or even you—do it consistently?

The better way, in my opinion, is that you should quit trying to beat the stock market and join it. Over very long periods of time, the stock market itself (all stocks combined) has given good returns. Of course, over the last ten years, that hasn’t been the case. 2000 – 2009 has been called the “lost decade” because the stock market actually ended lower than it started, and the decade ended with a deep recession. But previous decades with very low or slightly negative returns for stocks, even when accompanied by a rough economy (such as the 1930s), have been followed by better times for both (stocks and the economy) in the next decade [1]. I think that’s likely to happen again in the next few years, although, of course, there's no guarantee.

What does it mean to “join the market” when you invest? It means to diversify your investments in stocks so well that your portfolio holdings are very close to the stocks that make up the whole market. One of the most efficient ways to achieve good diversification is to use index funds—which you can invest in as ETFs or traditional mutual funds. For example, the most widely known index funds are those that invest in the S&P 500. These funds own the stocks of 500 of the largest companies in America. Other index funds invest in mid cap and small cap stocks, as well as in other groups of large cap stocks in the U.S. By investing in a group of broad-based index funds (meaning those that don’t concentrate on certain industries), the returns of the U.S. portion of your portfolio can be very close to that of the stock market itself. You should also have a part of your portfolio invested internationally, and you can achieve great diversification there with index funds.

Index mutual funds also help keep your costs low, compared to actively managed mutual funds. “On the whole, expense ratios [ongoing annual fees charged by the fund] range from as low as 0.2% (usually for index funds) to as high as 2%. The average equity mutual fund [in U.S. stocks] charges around 1.3%-1.5%. You'll generally pay more for specialty or international funds...” [2] Since the SEC says that "Higher expense funds do not, on average, perform better than lower expense funds,” [3] there is rarely a good reason to buy higher expense mutual funds.

Another expense you can avoid with index mutual funds is the commission, or “load” that you pay brokers and agents to buy mutual funds. If you pay a broker a front end commission of up to 5% to buy a mutual fund, you often also pay annual 12b-1 fees of 0.25%. If the broker or agent sells you a fund with a “contingent deferred sales charge” instead of a front end commission, your annual 12b-1 expenses and shareholder service fees can add up to as much as 1%. In this case, your annual bill (embedded in your mutual fund) can be 2% or even higher. Ouch. Much better to invest in index mutual funds with no broker “load”, redemption fee, or 12b-1 charges, and a very low management fee.

Buying ETF index funds is a little different. ETFs have very low expense ratios, but you buy and sell them just like stocks. So, you have to pay a commission each time to a broker unless you are buying them in a fee-based account where commissions are waived. Many stockbrokers and insurance agents have caught on to the popularity of ETFs, and are using them as trading vehicles to generate commissions from their clients—just like they used to do with individual stocks. This can be bad for two reasons: short term trading isn’t investing, and when a broker receives a commission every time you buy or sell, he has a big incentive to get you to trade—which is a distinct conflict of interest.

Keeping your total investment costs low is very important to your long term success as an investor. To control your costs, understand what they are, and think about whether you benefit from the incentives they create for the person you’ve hired to help you.

[1] Tom Lauricella, “Investors Hope the ‘10s beat the ‘00s,” WSJ, 12-21-2009, p. C1.
[2] Quote [with information in brackets added by me] is from Investopedia at http://www.investopedia.com/university/mutualfunds/mutualfunds2.asp See also: William J. Bernstein, The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between (New York: John Wiley & Sons, 2010), p.140. The SEC web site that explains types of mutual fund fees is http://www.sec.gov/answers/mffees.htm#distribution
[3] Investopedia, http://www.investopedia.com/university/mutualfunds/mutualfunds2.asp