Diversifying your bond portfolio

First, I’d like to welcome any Get Rich Slowly readers still trickling in. Thanks again for visiting the site. There’s a quick summary of what the site’s about here. And subscribe to this site’s feed here.

Recently, I’ve written about allegedly shady practices at a popular mutual fund company, why many popular assumptions about stock returns might be false, and a big problem with target-date retirement funds.

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Onward.

Yesterday, I wrote a basic intro to bonds for J.D.’s site, and a follow-up, slightly more complicated post on how to screen for and choose bonds. bond-by-paul-jursa

Today, I’m going to address two areas:

1) How to build a bond portfolio or a bond ladder, and

2) How to actually buy a bond

How to build a bond portfolio

You probably already invest in mutual funds or might even have a portfolio of individual stocks. If so, you’re probably familiar with the concept of diversification. In short, you want to spread your investments among many types of securities to make sure that if any one of them gets hurt, your portfolio doesn’t unduly suffer.

Bond portfolios are no different. Here are the considerations you should have as you pick bonds.

1) Pick only high-grade bonds.

Yesterday, I defined this as a bond with a rating of A3 or higher by Moody’s. You might want to pick an even higher grade. Why? In the current environment, the ratings agencies have been downgrading bonds like crazy. Even Warren Buffett’s Berkshire Hathaway recently lost the highest investment grade rating. If you don’t have much to invest in bonds (Say, $200,000 or less), I would stay with bonds that have a AA rating or higher and whose companies are known as conservative, stable earners.

2) Diversify the maturity dates of your bonds.

Let’s say you’re saving for a son or daughter’s tuition payment that comes in 10 years. The highest yielding bonds that you see are probably ones that mature right around the time you need the money. But that doesn’t mean you should put all of your money in those bonds, even if they’re with highly rated companies.

A bond portfolio’s greatest risk actually isn’t that companies default. It’s that interest rates could rise before the bond matures. Imagine that you bought a 10-year bond yesterday at face value ($1,000) that yields 5%. Today, the Federal Reserve surprises the world by letting its target interest rates rise by 3 percentage points. Now, investors can find corporate bonds similar to the one you just bought that yield 8% instead of 5%. You can’t just sell your bond for $1,000 and reinvest the money. Any investor who buys the lower yielding bond will want to purchase it at below face value to compensate for the lower interest rate.

You’re holding your bonds to maturity. Small investors get ripped off when they try to sell bonds on the secondary market. So the only way that the change in interest rates really hurts you is that your $1,000 is tied up in a bond with a lower yield than what you could get now.

So, instead of buying $100,000 worth of 10-year bonds, the college saver might buy $10,000-worth of bonds that mature in 10 years, $10,000 that mature in 9 years, and each year until next year. That way, even if interest rates go up, you’ll always have bonds maturing whose principal you can reinvest in the higher yielding bonds.

Some folks argue that no one should invest in 10-year bonds right now, because interest rates are most certain to go up. I’d answer that the market should already be pricing those fears into the yields of 10-year bonds (that’s why they’re higher than one-year bonds). If you think you know better than the market, good for you. But for those building a simple bond ladder, since you’re holding bonds until maturity, you’re not going to get hurt if they’re right.

3) Diversify among industries in addition to companies.

You probably already gathered that you wouldn’t want to put all your money into bonds put out by one company. You should also consider spreading your bonds out among as many industries as possible. Your portfolio should not only have industrial manufacturers, but utilities, retailers, foodmakers, and so on.

Buying a bond

I’m just going to say this at the outset: Buying a bond is not as easy as it should be. Whereas stock and mutual fund platforms have gotten easier and easier over the last decade or so, bond buying still has silly impediments that the big brokers either can’t or don’t want to sort out. Until a few years ago small investors couldn’t even find out how much some bonds traded for! It’s gotten better, but not by much.

1) Use a broker who gets most of his business from bond trading. The reason for this is simple: The bonds you can buy will often be limited to what bonds the broker has in his inventory. If he doesn’t trade bonds often, he won’t control many bonds himself and won’t know good sources to find the bonds you’re looking for. As an alternate, you can use an online bond platform, like the one at E*Trade, which will aggregate the inventories of many different bond brokers. But when using a platform like that, you effectively pay two commissions. More on that later.

2)Start with “newly issued” bonds. Investors get better deals on bonds if they buy them right when the company is first asking to be lent money. As a small investor, if you can get in on a new issue, you’ll get a much better price on the bonds than if you bought them on the secondary market. Depending on how much money you have to invest, you might not be able to get in on many offerings, but it doesn’t hurt to ask.

3) Try to buy at least 10 bonds of the same company at once. The bigger the purchase of bonds you can make of a company, the better the price you’ll get. Some financial advisors say that an even better increment is $25,000 worth of bonds (about 25 bonds). If you try to purchase smaller amounts, you will get very poor prices.

4) Bond prices are negotiable. Don’t take your broker’s first offer. I can’t emphasize this enough, and this is the primary mistake I hear small investors make. Unlike a stock broker, bond broker’s don’t make a flat commission. In fact, they don’t specify their commission at all! Instead, they make money on the “spread” between what they can buy the bond for and what they sell it to you for. So a broker might buy a bond at a price that yields 6% but sell it to you at a price that yields 4%. His commission is difference in price that causes that 2% spread.

Brokers don’t disclose that difference. So it’s important that you come to the phone call armed with information. You can find the prices that bonds recently traded for here. Click on “Corporate Market At-a-glance” and search for the company whose bonds you’re considering or for the CUSIP (the bond’s id number) if you have that. Once you get to the bond you’re looking for, you should see a list of recent trades of that bond. screen-shot-of-ge-bonds

The “price” on the screen is given in cents on the dollar. So a bond sold at “100.000”, went for $1,000. Under “size” you’ll see how many bonds were bought at once. So in the first line of the preceding image. An investor (or a bond broker, it’s difficult to tell) bought 10 bonds of GE at $1,000 each.

When you negotiate with your broker, try to get a yield as close to what you see at SIFMA’s website as possible. If he wants more than 1.5 percentage points as his commission, look for the bond elsewhere or try for a different bond. Honestly, a 1.5 percentage point hit on an investment-grade bond is already pretty high.

A note on online bond platforms: An online bond platform aggregates many bond brokers onto one site. That’s good because you have access to more inventory. But in exchange, you’ll probably pay a higher commission. The online broker will take the first cut, usually somewhere in the range of $1 per bond. The live-person broker will still earn a commission on the spread. I know E*Trade allows customers to make an offer on a bond and negotiate its price down. But some online brokers don’t let you do that.

5) Monitor your portfolio and reinvest bond payments. One of the biggest mistakes financial advisors tell me they see is that someone sets up their bond portfolio but doesn’t reinvest bond payments or even the bond’s principal as it matures. Unlike with a mutual fund, you can’t instruct your broker to simply reinvest your bond payments. Brokerage accounts generally pay extremely low interest rates. So even though your bond yields 5%, if its bond payments simply sit in the account, your portfolio’s yield will be less.

If you’ve set up a bond ladder by having bonds mature regularly (such as once a year), revisit your portfolio at least that often to find bonds to reinvest in and to keep that income stream coming. Someone who is investing in bonds for income and who wants to keep an average maturity of 5 years, would want to buy a 10-year bond every time one of his bonds comes due. That way, he’ll always have a bond coming due in the next year.

Phew, I hope this post, the two others made yesterday, and the story in Money have given you at least a basic understanding of how bonds work and how to build a portfolio. As you can imagine, there’s more to learn and entire books have been written on the subject. I will recommend two, whose authors I’ve spoken to extensively:

Bonds: The Unbeaten Path to Secure Investment Growth by Hildy and Stan Richelson, and

The Bond Bible by Marilyn Cohen (this one is a little older)

Thanks for reading and hope you come back tomorrow — when I won’t be talking about bonds.

– Joe Light

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4 comments so far

  1. Bozo on

    Since you’re about to exit the “bond” discussion, let me add a few thoughts. Perhaps a few stragglers from GRS might appreciate.

    1. Nominal bonds. A nominal bond is a bond with a named (“nominal”) face value. CDs are nominal bonds.

    2. Despite the arcane and oft-confusing fog surrounding Corporates, TIPS on the secondary, I Bonds (doncha love zero percent interest, what’s next, you pay them to hold your money?) and bond funds (what’s a “net asset value” anyway, when nobody wants your “asset”), CDs are plain vanilla.

    3. The myth that CDs are losers. Wrong (capital “W”). CDs are issued by banks and credit unions. For those few among us who still believe in the free market system, CDs represent the last true bastion of free-market capitalism. Folks, if they want or need your money, they will bid up the price. Think “exogenous factors” here. The Federal Government has no competitors for its bonds; it’s “take it or leave it.”

    4. CDs lose when compared to inflation. Wrong again. Due to the “nimble” nature of the free-market system, CDs tend to be a forward, not lagging, indicator of interest rate trends. Stated another way, if the “market” thinks interest rates are going up, CDs tend to reflect this sooner than the good old US of A government bonds. I’ve beaten TIPS, I Bonds, and stocks the past 2 1/2 years handily with CDs.

    5. CDs are for old farts. Yup, you betcha. We old farts love CDs. With that I can agree. My IRA CD ladder currently yields 5.45%. Beat that with a stick.

    6. CDs have no relevance to “age in bonds” in your asset allocation. Wrong again. CDs are nominal bonds (see above). Even cash in a demand deposit can be seen as a bond with the ultimately shortest term (think LIBOR, here). I have a savings account at a credit union that pays 2.75%. I just think of it as a bond with a daily term yielding (duh) 2.75%. That’s a whole lot more than LIBOR or the CMT might I add (look it up)(we’re talking 200 basis points).

    7. CDs are really hard to find on the internet. Wrong again. Don’t rely on Bankrate, the site touted by many who get “paid” to tout it. Go to bankdeals.blogspot.com. Bankrate has little cred with me. Bankdeals is much better. The blog is populated with anal-retentive savers (like me) who stretch for every basis point possible. Even then, the blog tends to falter in updating its master list of deals. You really need to check every friggin day to see what’s going on. That’s a pain, but it’s worth it if you’re a basis point hound. I swear there are thousands of contributors to the bankdeals blog. It’s sort of like an underground conspiracy.

    Bozo

  2. investwisdom on

    Hey, thanks for contributing so much to the discussion. I didn’t think to write a post about CDs, but if there’s interest, I might tackle it next week.

    Thanks also for mentioning bankdeals. I’d never heard of it before but will check it out. I wonder if you’ve ever used MoneyAisle.com. It’s something that was written about in Money Magazine a few months ago. You put it info on the kind of CD you want and then watch as banks “bid” against each other for your business. I think you have to register to see who the winning bank is, but not to see the interest rate. Just running it quickly myself, I got a 2.55% rate for a 12-month CD in New York. I haven’t done any reporting on the system, and I imagine it’s only as good as the number of banks that participate.

  3. Bozo on

    If you were wondering, 2.55% for a one year CD is fairly lame.
    Alliant Credit Union is offering 2.9% APY for the same term, with a $25K min. Posters to Bankdeals already knew this.

    The “new new” hot deal is the periodic saving plan offered by Korean-American banks, yielding over 5% for piggy-bankers. You sign up for periodic deposits to your account, they pay wildly great interest rates. It’s like a zero coupon bond. All FDIC insured.

    Moneyaisle, well I’ve heard good news and bad news. It’s a “pay to play” site, so you get what you pay for (not much).

    It’s not really a hot-bid site (or so I was told). The site just matches you with current offers for CDs in their “offer base”. Yawn.

    Bozo

  4. Bozo on

    Here’s an example of the piggy-bank installment savings deal. I think the web page is just for example. I would call the bank for precise details.

    http://www.wooriamericabank.com/eng/one_heart_E_all.html

    The point being: there are ever so many deals out there. You gotta be nimble.

    Bozo


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