Updated: Mar 31, 2020
Bonds are investments in which an investor lends money to a corporation. They are issued by corporations that want to raise money. For example, a company might want to buy new equipment to make widgets but they don't have enough cash on hand to buy the new equipment outright. So, they ask investors to loan them money by issuing bonds.
In return, a corporation agrees to repay the investor at maturity. Maturities can range from a few months to up to 30 years. To compensate investors for their risk, the bond usually pays interest. It's a lot like a mortgage, except that the investor gets to play the role of the bank.
WHY USE BONDS
Most investors prefer at least some allocation to bonds. Bonds provide two main roles in a portfolio. First, they provide income in the form of interest. Second, they act as a buffer against the volatility of stocks. Historically, we see fewer negative annual returns for bonds compared to stocks.
In 2008, during the worst recession in modern history, bonds achieved a 5.05% return while global stocks lost -38.73%. Investors with a goal of reduced expected volatility were happy owning bonds during this tumultuous time.
As the chart above illustrates, bonds have provided investor relief whenever the stock market experiences a down year. For this reason, bonds are an integral component for investors in or approaching retirement. For most retirees, it's prudent to balance the dual goals of protecting the portfolio while outpacing inflation. This is why a "balanced" portfolio is so popular with retired investors. Bonds provide diversification and protection against outsized losses while stocks drive long term portfolio growth.
OTHER USES FOR BONDS
A bond's "yield" is a percentage based metric to let investors know how much interest they can expect to be paid for holding a bond. According to Morningstar, the current yield of the Bloomberg Barclays Aggregate Bond Index is 1.85%. That means that for every $1,000 an investor owns, they can expect to receive $10.85 in annual interest income.
Since the average bond's expected return isn't as high as the expected return of stocks, investors commonly stretch for yield by buying bonds with higher yields. Two ways to accomplish this are to purchase "extended duration" or "high yield" bonds. Currently, high yield bonds are yielding 7.60% and extended duration corporate bonds are yielding 3.95%.
The issue with these two particular types of bonds is that they tend to behave like stocks. For example, high yield bonds returned -24.9% in 2008. Imagine loading up on high yield bonds and thinking they were going to help protect your portfolio from declines like the one we saw in 2008. Even right now as the market navigates this Corona Virus crisis, we're seeing a repeat of this high yield bond behavior. At the time of this post, high yield bonds are down -13.1% for the year.
The unfortunate thing about owning the wrong types of bonds is right when you need them to hold their ground, they can decline in value alongside stocks. Just because you're buying a bond doesn't mean you own something that's designed to help protect your portfolio.
BONDS FOR TAX EFFICIENCY
As previously discussed, most bonds pay periodic interest. When an investor holds bonds outside of a retirement account, the interest counts as income, which may be taxable. In general, bonds issued by corporations are taxable at the state and federal level. Bonds issued by the federal government are generally free of state income tax.
For example, if you owned a corporate bond, you'd pay ordinary income tax on the interest the bond generated throughout the year. If you were in the 24% federal marginal tax bracket and owned $100,000 corporate bonds all paying a 2% yield, you'd owe $480 in tax on that bond income.
Municipal bonds are a unique type of bond generally issued by state and local governments. They can be attractive from a tax standpoint as they are free from federal income tax. There is a simple formula to calculate whether a "muni" bond's yield is preferred (from a tax standpoint) over a regular bond's yield.
R(te) = R(tf) / (1 - t)
R(te) = tax-equivalent yield
R(tf) = muni bond's yield
t = investor's marginal tax rate
Yes, it's a bit of math, but it tells us if we'd be better off replacing a conventional bond with a muni bond based on bond yields and our marginal tax bracket.
Here's an example. Let's take Vanguard's muni bond ETF (ticker: VTEB) and its current yield of 1.80% and compare it to iShares Core US Aggregate Bond ETF (ticker: AGG) and its current yield of 1.85%. On the surface, AGG looks better since it's yield is a bit higher.
Assuming a 24% marginal tax bracket and using the formula above, we can calculate a taxable equivalent yield on VTEB at 2.37%. Looking at VTEB through an after-tax lens, VTEB looks better even though it's stated yield is only 1.80%. Once you layer in taxation, the muni VTEB becomes a nice option.
Vanguard's ETF (VTEB) is just one muni option available to investors. There are hundreds of different muni funds to choose from. Most major fund companies offer at least one muni fund.
MORE MUNI SELECTION CRITERIA
Yield is only one important variable we should investigate when selecting bonds. We have to remember what our objective with bonds actually is. If it's to protect a portfolio during a market decline, then the after-tax yield probably isn't our most important selection criteria. Here's why this matters.
In early March 2020, muni bonds experienced a brief period of approximately 40% more volatility compared to normal bonds. In the last month, VTEB (the muni example) is down -3.01% while AGG (our conventional bond example) is only down -0.26%.
Expanding on the example from the previous section, let's say you own a $100,000 bond portfolio. While it might feel good to save $480 on your tax bill using the muni bond fund, from a total return standpoint, you'd be down $3,010.
You have to ask yourself what's most important, how the bond interest is taxed or your total return? For different investors with varying bond goals, the answer isn't always universal. That's why investors shouldn't assume one option is better than the other. It takes some work to figure out what's best.
Sometimes it makes sense to replace conventional bonds with munis. For example, an investor in the highest tax bracket might need to pull out all the stops to reduce taxable income. Or, perhaps an investor is close to the next lowest marginal tax bracket and swapping to munis would get them there. For most investors, there are times when the tax-free nature of muni income is not worth the additional risk. Right now looks to be one of those times.
HOW WE USE BONDS
One of the main tenets of diversification is to consistently own "noncorrelated" and low correlated investments. Noncorrelated investments tend to zig when other investments zag. Bonds generally exhibit low correlations to stocks, which makes bonds a nice portfolio diversifier to stocks.
Our philosophy is that we don't want surprises from our bond holdings. We know that not all bonds are created equal. Some experience a much higher level of volatility than we're comfortable with. For this reason, we stick to relatively boring bonds, mostly those issued by the United States Treasury.
More specifically, we almost exclusively use short and intermediate duration bonds. Technically, we use bond funds that collectively own a few thousand underlying individual bonds. These bond funds have historically acted as the noncorrelated investments we count on during periods of market declines.
Sure, the trade-off is that we don't offer bonds with a sexy yield or an exciting expected return, but that's not the goal for us. If our bond choices mean we sacrifice some of our total return during the good times, so be it.
As of 3/30/2020, the bond portfolio we use in client accounts has produced a total return of 2.91% year to date. Compare that to global stocks which have declined -20.50% over the same time period. While the bonds we use aren't completely immune to the occasional decline, these declines are generally limited in scope and duration. Most importantly, our bonds have behaved largely as expected during the current Corona Virus market decline.
WHAT YOU SHOULD DO
You should use this blog post as a starting point in your bond decision-making framework. This information isn't meant to be an end all be all guide.
Before you select the types of bonds most appropriate for your situation, you should first determine what percentage of bonds should be owned in your portfolio. A competent financial advisor can help by working through a risk tolerance questionnaire, having a conversation about the results, and better yet, developing a FINANCIAL PLAN that supports a suitable bond recommendation.
Tying all this together, bonds aren't usually the focus of portfolio conversations, but they shouldn't be ignored. Don't assume your bonds are the most appropriate for your tax bracket, portfolio objectives, and financial goals. This is part of what we do for our clients, so ask us if you have questions and consider hiring us.
You can initiate a conversation by clicking the "Contact" link in the upper right corner of this page.