Recently, a very good friend suggested that I discuss bonds in light of our current economy. I think he had a great idea. That will be a topic of a few blog entries. I wish to do this for a few reasons other than it is a really, really great idea, however.
You and Me
I consider our relationship one of the most important professional relationships in our lives. You strive every day for your hard earned dollars in a world that is becoming more competitive by the moment. If you are retired you want to know that your money is going to be there. I take your efforts and desires very seriously. So much so that I do not feel that the industry standard of barely understanding the tools available for investing your money just enough to “tell the story and sell it” is acceptable. Being "sold" when it comes to financial strategy and investing is the last thing anybody should want to be. I know that I do not want to be sold. I also do not feel that the 30 second information bits found in mass marketed channels like Morningstar, MSNBC, Motley Fool, or the local weekend radio show to be of high value by themselves. They can contain accurate information. In the same way descriptions of over-the-counter medicines are accurate, even valuable; but are not the bases of a sound health program. There is a substantial amount of free information available with the goal of leading us all to the sale.
The Point
This leads to the point. In each and every recommendation I make, often the only visible part is what we discuss for 10 or 15 minutes OK, I know I talk a lot, so I’ll change that to 15 or 20 minutes. The vast majority of the information is behind the scenes. In your busy, daily activities I feel it does not provide value bogging you down with two hour conversations on market and portfolio theory. I try to get to the point. Please know that even though I don't go into the exhaustive details, they are being considered before I recommend anything. This series on bonds will show a few of the details. Today's story will be the first in a series over several days or weeks that starts with basics. Throughout the entries information will become more like the behind the scenes stuff that I review daily. If getting down to the nitty-gritty sounds a bit boring, I know it can be. Talking finance isn't as exciting as going to see a Stones concert. I get that. I'll take the edge off by having a synopsis at the beginning or at the end of each entry. So, with that in mind let's explore why bonds can make sense even while our government prints money and artificially depresses interest rates and there seems to be no financial direction at all.
Bonds = Debt, but What Is It, Really?
Corporate, agency, and sovereign debt are generally the types of debt available to you and me in the retail investment marketplace. Sovereign refers to government debt by United States or foreign government originators. Agency refers to agencies that are legislated like Fannie Mae and are technically not backed by the US treasury, but have an implied "good faith" government backing. Corporate bonds are similar IOUs issued by corporations worldwide. When bonds are issued the proceeds are used to provide federal state and local governments as well as private businesses the funds they need to make their systems work. All their systems come together to make our system.
Make no mistake about it; bonds are not only a centerpiece of our economic system, but perhaps thecenterpiece. All of this debt trades in several ways. There are centralized exchanges like the New York bond exchange and negotiated or over-the-counter markets that are organized through the web. According to the Securities Industry and Financial Markets Association, the average daily trading volume in 2009 in the US bond markets was about $814 billion per day. During the same period the average daily stock market trading volume was about $105 billion per day. This isn't some little pansy market. So, why do we hear about the Dow Jones stock index many times a day and not a bond market index? I am not sure but I have a good guess. The stock market has entertainment value and the chance for BIG gains. Also, I truly believe that this is a case where if we are told enough that something is important; it becomes important society-wide.
How Do They Work?
You give the issuing organization your money, you get a certificate that is essentially an IOU, they pay you interest along the way, and you get your money back in the end…almost.
For example: as of today, you can get 3% from a US backed 30 year Treasury bond. Do you really want to hold onto a bond for 30 years and receive only 3%? Further if inflation happens to be 3% for the 30 years you lose purchasing power after-tax.
What's More Important How Much Money You Have, or What You Can Buy?
At the end of the day you are probably far more interested in your power… That is purchasing power. Think of it like the Great Depression example I used on an earlier post where a dollar in 1933 bought six cents worth of goods in 2009. So if you earn 3% and inflation is 3% you might think you are breaking even. You are not. Remember that the Government thinks that part of what you earned belongs to them. They tax you on your gain. If your federal tax rate (forget state and local taxes right now for simplicity) is 20% then your real net is only 2.4% per year in a 3% inflation environment. You have actually LOST purchasing power. You may not lose MONEY on a US government-backed bond, but you CAN lose purchasing power. How much you lose is largely out of your control.
As is almost always the case in life, short-term thinking will rarely get you where you really want to go. Long-term thinking is far more involved but more likely to get you where you want to go.
So, what if you would like the higher interest of a thirty year Treasury, but need your money before thirty years is up? The next blog entry will be about what determines bond value during your ride along the way.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing
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Bonds are subject to market and interest rate risk. It sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.
Securities offered through LPL Financial. Member FINRA/SIPC.
