Bonds in 2022

Bonds in 2022

Resuming last week’s Investment Themes, today we consider Bonds in 2022. It is a challenging environment for bond investors. We are coming off record low yields and the yield on the 10-year Treasury is still only 1.5%. At the same time, yields are starting to move up. And since prices move inversely to yields, the US Aggregate Bond index ETF (AGG) is actually down 1.74% year to date. Even including the yield, you’ve lost money in bonds this year. With stocks having a great year in 2021, it is frustrating to see bonds dragging down the returns of a diversified portfolio.

Inflation Hurts Bonds

Inflation is picking up in the US and globally. Supply chain issues, strong demand for goods, and rising labor costs are increasing prices. The Federal Reserve this week said they would be removing the word “transitory” from their description of inflation. And now that it appears that Jay Powell will remain the Chair, it is believed that the Fed will focus on lowering inflation in 2022. They will reduce their bond buying program which has suppressed interest rates. And they are expected to gradually start increasing the Fed Funds rate in 2022.

It is difficult to make accurate predictions about interest rates, but the consensus is that rates will continue to rise in 2022. So, on the one hand, bonds have very little yield to offer. And on the other hand, you will lose money if interest rates continue to climb. Then, to add insult to injury, most bonds are not maintaining your purchasing power with inflation at 6%.

Bond Themes for 2022

There aren’t a lot of great options for bond investors today. But here are the bond investment themes we believe will benefit your portfolio for the year ahead. This is how we are positioning portfolios

  1. We will be increasing our allocation to Floating Rate bonds (“Bank Loans”). These are bonds with adjustable interest rates. As rates rise, the interest charged goes up. These are a good Satellite for rising rate environments.
  2. Within core bonds, we want to reduce duration to shorter term bonds. This can reduce interest rate risk.
  3. We continue to hold Preferred Stocks for their yield. While their prices will come under pressure if rates rise, they offer a continuous cash flow.
  4. Ladder 5-year fixed annuities. I have been beating this drum for years. Still, multi-year guaranteed annuities (MYGA) have higher yields than CDs, Treasuries, or A-rated corporate and municipal bonds. If you don’t need the liquidity, MYGAs offer a guaranteed yield and principal.
  5. I previously suggested I-Series Savings Bonds rather than TIPS. These are linked to inflation and presently are paying 7.12%. Purchases are limited to $10,000 a year per person, and unfortunately cannot be held in a brokerage account or an IRA. Read my recent article for more details. I personally bought $10,000 of I-Bonds this week.

Purpose of Bonds

Even with a negative environment for bonds, they still have a role in most portfolios. Unless you have the risk capacity to be 100% in stocks, bonds offer crucial diversification. When we have a portfolio with 60% stocks and 40% bonds, we have an opportunity to rebalance. When stocks are down, like in March of 2020, we can use bonds to buy more stocks while they are on sale. And of course, a portfolio with 40% in bonds has much less volatility than one which has 100% stocks.

Yields may eventually go back up to more normal levels. While it would be nice to have higher yields, the process of yields going up will be painful for bond investors. Our themes are trying to reduce this “interest rate risk”. We hope to reset to higher rates in the future, while reducing a potential loss in bond prices in 2022.

Do You Need Bonds?

Do You Need Bonds?

With ultra low yields today, more investors are asking if you really need to have bonds in your portfolio. It’s going to depend on your objectives for your overall plan. First, let’s take a look at expected returns and how this impacts your allocation.

The primary role of bonds is to reduce the risk of a stock portfolio. Bonds fluctuate a lot less and most are relatively low risk. The trade-off is that they have a lot lower return than stocks. Of course, the stock market has a negative return in approximately one of every five or so years. From 1950 through 2019, 15 of 70 years had a negative return in the S&P 500 Index. Bonds are more consistent, and they can help smooth out your overall returns. In years when stocks are down, you can rebalance by selling some bonds and buying stocks.

The more bonds you have, the more you reduce stock risk, but also the more you probably lower your long-term returns. With the 10-year Treasury bond yielding only 0.721% this week, bonds offer almost no return on their own. Bonds used to offer safety and income, but today, you are really only owning them just for safety.

Portfolio Asset Allocation

We describe a portfolio by the percentage it has in stocks versus bonds. A 70/30 portfolio, for example, has 70% stocks and 30% bonds. Our asset allocation models target different levels of stock and bond exposure:

  • Ultra Equity (100% Equity)
  • Aggressive (85/15)
  • Growth (70/30)
  • Moderate (60/40)
  • Balanced (50/50)
  • Conservative (35/65)  

Expected Returns

Next, let’s consider what Vanguard projects for the next 10 years for annualized asset returns, as of June 2020: 

  • US Equities: 5.5% to 7.5%
  • International Equities: 8.5% to 10.5%
  • US Aggregate Bond Market: 0.9% to 1.9%

Let’s calculate hypothetical portfolio returns using these assumptions. If we take the midpoint of stock projected returns, we have 6.5% for US Stocks and 9.5% for International Stocks. If we invest equally in both, we’d have an 8% return. For our bond return, we will take the midpoint of 1.4%. Now, here’s a simple blend of those expected returns when we combine them in a portfolio.

PortfolioProjected 10 Year Return
100% Equities8.00%
90% Equities / 10% Bonds7.34%
80% Equities / 20% Bonds6.68%
70% Equities / 30% Bonds6.02%
60% Equities / 40% Bonds5.36%
50% Equities / 50% Bonds4.70%
40% Equities / 60% Bonds4.04%
30% Equities / 70% Bonds3.38%
20% Equities / 80% Bonds2.72%
10% Equities / 90% Bonds2.06%
100% Bonds1.40%

If you simply want the highest return without regard to volatility in a portfolio, you could invest 100% into stocks. Moreover, any addition of bonds should reduce your long-term returns. Of course, this assumes that returns are simply linear. In a real portfolio, there would be up years and down years in stocks. That’s when you would rebalance, which could be beneficial.

For young investors, in their 20’s, 30’s, or 40’s, you probably should be more aggressive in your asset allocation. For some, it may even make sense to be 100% in stocks. If you have 20 or more years to retirement, and aren’t scared of stock market fluctuations, being aggressive is likely going to offer the highest return.

The 10-year expected return of stocks is not bad, 8% combined today. That’s a little bit lower than the historical averages, but still an attractive return. Bond returns, however, are expected to be very weak. Consequently, 60/40, 50/50, and more conservative portfolios, are expected to have much lower projected returns.

Retirement Planning and Your Need for Bonds

For those closer to retirement, low yields are a challenge. You want to have less volatility but also want good returns. If you are within five years of retirement, you probably want to reduce the risk of a stock market crash hurting your retirement income. Now, if the hypothetical 8% stock returns were guaranteed, our decision would be easy. But getting out of bonds today, with the market at an all time high, seems too risky. This week has certainly been a reminder that stocks are volatile.

I think most pre-retirees will want to keep their current allocation through their retirement date. After that, they may want to consider gradually reducing their bond exposure by selling bonds. There is evidence that this strategy, The Rising Equity Glidepath, is a beneficial way to access retirement withdrawals. It allows retirees to benefit from the higher expected return of stocks, while reducing their risks in the crucial 5-10 years right before and at the beginning of retirement.

Some retirees have a high risk capacity if they have ample sources of income and significant assets. If their time horizon is focused on their children or grandchildren, they can also consider a more aggressive allocation.

We want to calculate your asset mix individually. I wanted to show you what the blend of stocks and bonds is projected to return over the next decade. We’ve had strong returns from fixed income in recent years because falling interest rates push up bond prices. Going forward, it looks like bond returns are going to be quite low. We do have to consider these projected returns when making allocation decisions.

If you’re looking for advice on managing your investment portfolio today, let’s talk. Our planning process will help you address these questions and have a better understanding of your options.

How to Increase Your Yield

How to Increase Your Yield

Opportunities for a Low Yield World, Part 2

Last week, we discussed how not to increase your yield today: by replacing safe bonds with high yield bonds. That’s because the potential for rising defaults today in junk bonds could have a major drag on what would otherwise appear to be a healthy yield. While the typical default rate for single-B and double-B bonds is 2-4% a year, in a crisis it could go much higher. In 2009, for example, global high yield bonds saw a 13% default rate that year.

It’s important to understand the risks in your bond portfolio and know what you own. There are four opportunities today for investors to improve their yields today, without simply trading down to junk bonds. None of these are home runs, but offer a bit more yield. And in the current low interest rate environment, increasing your yield by even one percent could be doubling your rate of return from your bonds. Some investors will choose to skip bonds altogether and add to their equities, but that would take on a lot of additional risk. For investors who want the risk and return profile of say a 60/40 portfolio, there’s no substitute for the safety of bonds.

1. Cash: Online Savings Account, not a Money Market Fund

Today, the Federal Reserve has lowered rates to basically zero. There is almost no yield on T-Bills, bank accounts, and short-term CDs. I see a lot of investors who park significant cash in a money market fund or in a Bank savings account. Those rates may have been near two percent a year ago, but many are now at 0.01%. That’s a whole one dollar of interest for a $10,000 investment each year! Not only are you not growing your cash, you probably aren’t going to keep up with inflation either. Your purchasing power is likely to decline with each passing year.

Instead of a money market at 0.01%, park your cash in an online savings account. You can link it to your primary checking account, and transfer money as needed. Most are FDIC insured, and several have no account minimums and no monthly fees. The one I use: Marcus.com from Goldman Sachs Bank. The current rate is 1.05%, with no minimums and no fees. You can open an account in about 1 minute and there’s an app for iOS and Android. I cannot think of any reason to not do this if you are presently earning 0.01% on a money market.

2. Buy Insured Municipal Bonds, not Taxable Corporates

The Coronavirus didn’t just hurt companies. Municipal Bonds – which are issued by cities, states, schools, and local entities – depend on taxes or revenues. Revenues from Stadiums, Toll Roads, etc., are down and so are taxes from sales, restaurants and bars, gasoline, income, and everything else which is taxed. The municipal bond market really doesn’t know how to evaluate this unprecedented problem. Compounding this issue is the fact that there are hundreds of thousands of different bonds, issued by 50,000 different entities. Some of these bonds are so small that they rarely trade.

The result is that we can now buy a tax-free, A-rated municipal bond with a higher yield than we can buy an A-rated corporate bond which is taxable. This doesn’t help retirement accounts, like a 401(k) or IRA, but if you are buying bonds in a taxable account, taxes matter. Imagine two bonds both yield 2%. One is tax-free and the other one is going to cost you 22 to 37 percent in income taxes. That’s a big difference when we consider after-tax returns!

It is unusual to find yields on tax-free municipal bonds being higher than on corporate bonds of a similar credit quality and duration. For folks in a high tax bracket, taking profits on your corporate bonds and shifting to munis can make sense. (Profits on your appreciated, high-priced corporate bonds can qualify for long-term capital gains rate of 15%, a lower tax rate than receiving the bond’s income and waiting for them to mature at par.)

If you are concerned about the credit quality of municipal bonds, look for bonds which are insured. Bond insurers offer protection to muni bond holders to cover losses of income and principal, should a municipality default. At this point, defaults on municipal bonds remain much lower than from corporate bonds. The highest rated insurer is AGMC, and those bonds remain AA- rated.

We build portfolios of individual municipal bonds for clients with taxable accounts over $250,000. For investors with smaller portfolios, you can achieve a similar benefit with an intermediate municipal bond fund.

3. Buy 5-year Fixed Annuities, not 5-year Bonds

Where are the yields of 5-year fixed income products this week? The 5-year Treasury bond has a yield of 0.27%. The best rate I have on a 5-year CD is 0.55%. I see an A- rated 5-year corporate bond from JP Morgan at 0.95%. Munis are better, but still only 1.0 to 1.3% tax-free for an A-rated bond.

The best place to park money for five years remains a fixed annuity. Today I see several annuities in the 3.0 and 3.1 percent range for a five year product. That’s basically triple the yield of corporates and about 6-times the yield from CDs. A fixed annuity is guaranteed, both for the rate of return and your principal. There is a trade-off with annuities. They charge very steep surrender charges if you need to access your money early. However, if you aren’t going to tap the account for 5+ years, it can make sense to put some money into an annuity.

Whenever people ask me how they can earn more while keeping their money safe, I discuss the pros and cons of an annuity. For today’s bond investors, a Multi-Year Guaranteed Annuity (MYGA) can be a way to increase your yield while keeping high credit quality.

4. Buy Preferred Stocks, Not a High Yield Fund

The High Yield ETF (HYG) currently has an SEC yield of 5.06%. There are a couple of reasons I prefer to own preferred stocks, besides the default risks I shared last week. First, I can save the ETF expense ratio of 0.49%. This is actually low compared to most high yield funds. When you own Preferreds directly, you might be saving one-half to one percent versus paying the expense ratio of a fund. At a 5% yield today, that is a 10-20% improvement. Yields are very low today, but expense ratios have not come down. Now, expenses eat up a larger portion of your return, leaving you with less income.

Second, preferreds today are offering a yield of 5-7%, which is attractive compared to bonds from the same company. For example, AT&T has preferred which yields 4.8% and is callable in 5 years. The February 2030 AT&T regular bond, however, yields less than 2.25% today. First Horizon Bank sold a 6.5% preferred this year, callable in five years. Their five year bonds, today, are available for a purchase with only a 1.865% yield.

Generally, the bonds are “safer” than preferreds, as they would rate higher in a bankruptcy liquidation. That’s one reason for the different yields, as well as the longer duration of the preferreds. Still, if you are comfortable with the credit risk of a company, the Preferreds may be trading at a significantly higher yield than the bonds of the company. That’s an opportunity today.

Why do we write so much about fixed income? For many of our investors who have achieved their accumulation goals, moving from growth into preservation and income is important. And there is an opportunity for us to add value through our fixed income choices: to increase yield, improve credit quality, or to reduce your risks. While it is relatively easy and fast to trade equity ETFs, buying individual bonds can require hours of research and trading.

Stocks have gotten all our attention this year, but don’t ignore your fixed income. The great return of fixed income in recent years has largely been the result of falling yields increasing the value/price of your bonds. Today, at nearly zero, yields could prove disappointing going forward. Our goal is to help you get more yield without simply taking on a lot of credit or duration risk.

Of these four ideas, you can certainly do #1 on your own. For #2 through #4, though, I think you will want to work with a financial professional. If you’d like to learn about individual municipal bonds, fixed annuities, or Preferred Stocks, please give me a call.

The High Yield Trap

The High Yield Trap

Opportunities for a Low Yield World PART 1

Everyone wants their investments to make more money, but we have to be careful to avoid the High Yield Trap. Since the Coronavirus Crash, central banks have been lowering interest rates to near zero. Last year, I was buying CDs at 2-3%. This week, I’m looking at the same CDs with yields of 0.1% to 0.2%. To which, my client innocently asks: What can we buy that will make more than a couple of percent with low risk?

Nothing, today. The five-year Treasury Bond currently yields 0.22%. That’s unacceptable for most investors, and it will push them out of safe fixed income, like Treasuries, CDs, and high quality municipal and corporate bonds. The yields are just too darn low.

Where will they go in pursuit of higher yields? Oh, there are plenty of bonds and bond funds with higher yields today. Credit quality has been plunging, as rating agencies are trying to keep up with downgrading firms that are being devastated by the shutdown or low commodity prices. In fact, through June 16, $88 Billion in BBB-rated bonds were downgraded to Junk Bond status this year. Each downgrade causes selling, which lowers the price of the bond, and the yield goes up (at least for new buyers).

Why It’s Called Junk

Before you get too excited, there are reasons to be concerned about buying lower grade bonds. In an average year, 2% of BB bonds and 4% of single-B rated bonds will default. That’s why high yield bonds are called junk bonds.

When those companies file for bankruptcy, the bond holders won’t be getting paid back their full principal. They will have to wait for a bankruptcy court to approve a restructuring plan or to dissolve the company. According to Moody’s, the median recovery is only 24 cents on the dollar when a bond defaults.

And while a 2-4% default rate might not sound too bad, that’s in an average year. In a crisis, that might rise to 8-10% defaults. In 2009, global high yield bonds had a 13% default rate in that year alone. These are historical rates, and it could be worse than that in the future. Additionally, the possibility of default increases as a company gets downgraded. If your BB-rated bond gets cut to CCC-rated, the chance of default is now a lot higher than 2%. And the price will probably go down, which creates a difficult choice. Do you sell for a loss or hold on hoping that the company can pay off your bond?

Here in Dallas, we are seeing a lot of companies go bankrupt, pushed over the edge by the Coronavirus. Big names like J.C. Penney, Neiman Marcus, Pier One, Chuck E. Cheese, Bar Louie, and others have filed for bankruptcy in 2020. Most of these companies were issuers of high yield bonds and had a lot of debt. When they got into trouble, they could not keep up with their debt payments and had to fold. Expect more retailers, oil companies, and restaurants to go under before the end of 2020. Bond holders in those companies could lose a lot. (In all fairness, stock holders will do even worse. There is usually zero recovery for stock holders in bankruptcy.)

Funds versus Individual Bonds

If you are investing in a high yield bond fund, you may own hundreds or thousands of bonds. The fund may have a 7 percent yield, but don’t get too excited. A high yield fund is not a CD. You are not guaranteed to get your principal back. It’s likely (even more likely in the current crisis), that your return will get dinged by 2-4% in defaults and losses due to credit downgrades.

If you own individual high yield bonds, it can be even more precarious. Either the bond defaults or it doesn’t. Having the potential for an 75% loss, while earning an average 5-7% annual yield, is dangerous game. Everything is fine until you have a default. A single loss can wipe out years of interest payments. That’s why I generally don’t want to buy individual high yield bonds for my clients.

The quoted yield of 5-7% for high yield bonds does not reflect that some of those bonds will default. If you consider a 2-4% default rate, your net return might be more like 3-5%. That’s the High Yield Trap. Your actual returns often fall short of the quoted yield.

High Yield bonds are issued by companies. Stocks are companies. If companies do poorly – really poorly – both the stocks and bonds can get walloped at the same time. That’s the opposite of diversification. We want bonds to hold up well when our stocks are doing poorly. In finance jargon, we would say that there is a high correlation between high yield bonds and stocks. We want a low correlation.

Instead of High Yield?

What I would suggest, if suitable for an investor, would be a 5-year fixed annuity at 3% today. That would give you a guaranteed rate of return and a guaranteed return of your principal. That’s not super exciting, but it’s what investors need from fixed income: stability and dependable income. Don’t buy bonds for speculation. And above all else, Bonds should avoid the possibility of massive losses.

Be wary of the High Yield Trap. The yields appear attractive in today’s super low interest rate environment. But let’s be careful and not take unnecessary high risks. All bonds are not created equal. When you reach for yield, you are taking on more risk. Defaults have the potential to drag down your performance in a fund. In individual bonds, they could almost wipe out your original investment.

High Yield bonds are not inherently bad. If you bought at the bottom in 2009, they recovered very well. But I am very concerned that today’s yields are actually not high enough to compensate for the potential risk of defaults. We’ve already started to see corporate bankruptcies in 2020 and it’s possible we will have above average defaults in the near future. Until we have a real fire sale in high yield bonds, I’d rather stay away.

We will discuss ways of improving your yield next week. Yes, it’s a low interest rate world, but there are ways we can incrementally improve your portfolio while maintaining good credit quality. We will also discuss financial planning strategies for low rates in an upcoming post. If you’d like a free evaluation of your portfolio, to better understand your risks, please send me a message for an online meeting.

A Bond Primer

We have been adding individual bonds and CDs across many accounts since December, as we looked to reduce our equity exposure and take advantage of higher yields now available in short-term, investment grade fixed income. When you are an owner of individual bonds, you are likely to encounter some terminology that may be new, even if you’ve been investing in bond funds for many years. Here are some important things to know:

Bonds are generally priced in $1,000 increments. One bond will mature at $1,000. However, instead of quoting bond prices in actual dollars, we basically use percentages. A bond priced at 100 (note, no dollar sign or percentage symbol is used) would cost $1,000. 100 is called its Par value. If you are buying newly issued bonds, they are generally issued at Par (100). This is called the Primary Market – where issuers directly sell their bonds to the public. We also buy bonds in the Secondary Market, which is where bond desks trade existing bonds between each other. 

In the Secondary Market, bond prices are set by market participants. A bond priced at 98.50 would cost $985, and would be said to be at a discount to Par. A bond priced at 102 would cost $1,020, called a premium. As interest rates rise, the value of existing (lower yielding bonds) will fall. There is an inverse relationship between price and interest rates – when one rises, the other falls.

Bonds have a set Maturity date. That is when the issuer will return the $1,000 they borrowed from the bondholder and cancel the debt. Some bonds are also Callable, which means that the issuer has the right to buy the bond back before its maturity date. This benefits the company, but not the bondholder, because when interest rates are low, companies can refinance their debt to a lower rate.

Most bonds pay interest semi-annually (twice a year). We call this the Coupon. A bond with a 4% coupon would pay $20 in interest, twice a year. If the bond is priced exactly at Par, then the coupon is the same as the effective yield. However, if the bond is priced differently, we are more interested in its Yield to Maturity, commonly listed as YTM. This is very helpful for comparing bonds with different coupons. 

Most bonds pay a fixed coupon, although some pay a step coupon, which rises over time, and others are floating, tied to an interest rate index, or inflation. When we purchase a bond between interest payments, the buyer will receive all of the next payment, so the buyer will also pay the seller Accrued Interest, which is the interest they have earned calculated to the day of sale.

For bonds which are callable, we also have the Yield to Call (YTC), which measures what your yield would be if the bond is called early. Generally, if we are buying a bond at a discount, Yield to Call is attractive. If we buy at 96 and they redeem at 100, that’s a good thing. But if we buy a bond at a premium, we need to carefully examine if or when it might be callable. Yield to Worst (YTW) will show the worst possible return, whether that is to maturity or to a specific call date. 

Some bonds do not pay a coupon and are called Zero Coupon Bonds. Instead, they are issued at a discount and grow to 100 at maturity. Treasury Bills are the most common type of zero coupon bonds. US Government Bonds include Treasury Bills (under one year), Treasury Notes (1 to 10 years), and Treasury Bonds (10 to 30 years). There also are Treasury Inflation Protected Securities (TIPS), which are tied to the Consumer Price Index, and Agency Bonds, which are issued by government sponsored entities, such as Fannie Mae or Freddie Mac.

In addition to Government Bonds, we also buy Corporate Bonds – those issued by public and private companies, Municipal Bonds issued by state and local governments, including school districts, and Certificates of Deposit (CDs) from Banks. 

Most Municipal Bonds are tax exempt, at the Federal and possibly at the state level. If you live in New York, any Municipal Bond would be tax-free at the Federal Level, but only NY bonds would be tax-free for NY state income tax. In states with no income tax, such as Texas, a tax-exempt bond from any state will be tax-free for Federal Income Tax purposes. 

To make their bonds more attractive, some municipal bonds are Insured, which means that if they were to default, a private insurance company would make investors whole. Those municipal insurers got in trouble in the previous financial crisis, and some are still weak today. My preferred insurer is Assured Guaranty (AGMC).

Please note that some Municipal Bonds are taxable; we sometimes buy these for retirement accounts. In addition to the types of bonds we’ve discussed, there are thousands of bonds issued outside of the US, in other currencies, but we do not purchase those bonds directly. 

There are several agencies that provide credit ratings to assess the financial strength of the issuer. Standard and Poor’s highest rating is AAA, followed by AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-. These are considered all Investment Grade. Below this level, from BB+ to C are below Investment Grade, often called High Yield or Junk Bonds. D means a bond has Defaulted. Moody’s ratings scale is slightly different: Aaa is the highest, followed by Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, and Baa3 for Investment Grade. Junk Bonds include Ba(1,2,3), B(1,2,3), Caa(1,2,3), Ca, and C.

There are about 5,000 stocks issued in the US, but there are probably over a million individual bonds issued, each one identified by a unique CUSIP number. Every week, there are bonds which mature and new ones which are issued. 

Our approach for individual bonds is to buy only investment grade bonds, and ladder them from one to five years with diversified issuers. We also sometimes invest in other types of bonds, such as floating rate bonds, mortgage backed securities, emerging markets debt, or high yield. For those categories, we will use a fund or ETF because it’s more important to diversify very broadly with lower credit quality.