Transcription:

Episode 7 – What are bonds

Announcer: This is Blue Money. A finance podcast made for cops by cops. With us you know your money safe. Lieutenant Jim Donnelley of the Bensalem Police Department and co-host Kevin McGarry of Valley Financial Group come together to help protect and serve your financial needs. This is Blue Money.

Jim Donnelley: I want to welcome everyone back to the Blue Money podcast. This is Jim Donnelley. I’m here with my co-host Kevin McGarry.

Kevin McGarry: Jimmy D.

Jim Donnelley: From Valley Financial he’s the management partner. And today’s podcast we want to just touch upon about our bond and what it is and what the importance of the portfolio. So, before we get started, Kev, can, can you tell us everyone’s going on with the bond market out there since it’s going on?

Kevin McGarry: Yeah. Before we dive into the bond market, I think right now a lot of people are concerned with all the volatility in the marketplace and they’re not used to seeing their bonds down the way they are down. But when we’re sitting down with clients and prospects and we’re doing reviews what we’re seeing is really diving in what a bond is and how it works. So Jim, you want to explain really what is a bond?

Jim Donnelley: Yeah, Kevin, I mean, just to make it simple, because we do get that a lot when we have clients down here, police officers and we’re doing the reviews and they just basically tell us, they don’t know what the difference between what a stock is and a bond is. So I mean, a bond and simple terms, it’s basically a loan from an investor to a borrower such as a company or a government. And the borrower uses the money for operations and the investor receives interest on their investment. It’s that simple. So, let me give you an example. Say if someone bought a US government bond and for $10,000, maturity date was 10 years and the coupon rate was getting 5%. So, basically what’s that mean is if I’m giving US government $10,000 for a bond, my bond’s going to mature in 10 years, but for every year I’m going to get 5% back, which is going to be $500. So, I’m going to give $500 a year for 10 years. And at the end of the 10 years, I’m want to get my original investment to $10,000 back. So, basically I made $5,000 over to 10 years. That’s basically how it is. Kevin is pretty simple that way. So Kevin, what’s the importance of having bonds in a portfolio?

Kevin McGarry: I mean, it’s a question that we get a lot lately, especially with bonds being down but the evolution of bond has changed over time. For a long time, as you mentioned, Jim, you clipped at your coupon and received a stable income that was held intact until the bond matured. When it came undone. But since the global financial crisis of 2008 bond yields were low. And there’s been a big arguments, should we use bonds in the portfolio or not? And we use them and we used them for a few reasons. Number one, we see bonds as the balance of the client’s portfolio. It helps to control behavior. Historically bonds fluctuate less than stocks, especially over the last two decades. And what we mean by that is this negative correlation. When one goes up, one goes down and when you have that, you have less volatility in the portfolio historically, and you have less emotion from the clients and less baby investment behavior. The second reason is we look at bonds as your war chest, as your shoebox money for income. We like to put five years of income into the bond portion of the portfolio so you know that over next five years, if you need retirement income, you’re covered. We put the rest in the stocks portion of the portfolio because we also know that stocks over the long term outperform bonds. And  what you get through this is the client’s understanding on the purpose of the bonds, but what it has done, especially since the great global financial crisis, it has helped reduce volatility because they want in opposite directions. We will look to diversify across bond assets, Jim and if a client’s risk tolerance is a little different will increase bond exposure or decrease bond exposure depending on their needs.

Jim Donnelley: Now it makes complete sense. Kevin, there’s so many different kind of bonds out there, but I thought it would be important to talk about the audience too, about the four major prime categories for bonds. And first our corporate bonds, corporate bonds are issued by corporations. Instead of taking bank loans, they will offer bonds. And why do they do that? It’s more favorable terms for them and the lower interest rates for them. So, it’s good for the corporations. Municipality bonds is another one they’re issued by states and municipalities. Some municipality bonds offer tax free coupon income for investors. So, that’s a big perk. The third one I’ll talk about is the government bonds there’s such through issued by the us treasury bonds. Let’s say like if a bond’s going to mature within less than one year, that’s going to be TB bills or your bills. If a bond’s going to mature between one and 10 years, they call that a note. And if the bonds want to mature after 10 years, it’s called a bond. So, the entire category of bonds issued by the government treasury is often collectively referred to as treasuries. So, just so if we ever hear it out there, they can understand where that’s coming from. And lastly, I’m going to talk about are agency bonds, these are issued by the government affiliated organizations, such as Fannie Mae or Freddie Mac. So, that’s basically the four main categories. Kev, what’s currently going on with the current bond market out there at Kev. Can you share that one at the audience?

Kevin McGarry: Yeah, there’s a lot going on with the bond market right now. There’s a lot of different bonds out there too. The one thing Jimmy didn’t describe was a bail bond. I thought he was going to get into that one a little. But what’s going on with the bond market right now? Well stinks. It’s having one of the worst years in history. There’s even an article that just came out in the Wall Street Journal that stated that this is the worst bond market since 1842. Jim, I didn’t even know they kept track of this information since 1842. 

Jim Donnelley: Look like you were born in 1942.

Kevin McGarry: What I can tell you the bond index is down approximately almost 10% for the year. One of the worst starts in the history of the bond market and the question is why? Number one, and we went over this one of the last podcast cases if you want to go back and listen to inflation is, it’s the crypt at the bonds. Most bonds have a fixed rate that can’t protect against rising inflation. So, Jim it’s math. If you’re getting 2% on the bond, but inflation’s 8½%, the math doesn’t work. So, the first reason is inflation. Second reason is how we’re attacking the inflation? Federal reserves, increasing rates. And they’ve been pretty aggressive. It’s the most hikes we’ve seen in the last 20 years. And that has impacted the bonds. Let me explain this. Rate hikes impact the value to bonds in the short term and the long term too, but right now in the short term, it’s impacted. Let me explain this. So, it works like a seesaw Jim, when rates rise, what do bond values do? They go down and the opposite happens when rates go down, bond values, go up. So, in Jimmy’s example of, Hey, I’m getting 5% on a 10 year bond, but now I can get six. What bond do you want? 

Jim Donnelley: Six.

Kevin McGarry: Six, right? And what are you going to have to do to get rid of the bond? The 5% bond? You’re going to have to sell it at the discount. The increase of rates have drove bond values down. And that’s where the declining values are occurring. But we believe there’s a silver lining here. You’re probably like silver lining. It’s one of the worst bond markets in history. My portfolio’s down between 12 and 15%. What’s good about this? Well, we’re finally getting higher yields on bonds now. And also bonds are selling in a discounts. If rates stay elevated so higher in past levels than past years, and when you bond matures, you’re going to reinvest in higher rates. Locking in a higher interest rate payment for the life of the replacement bond. It’s pretty simple. And if it exceeds your time horizons even better. So, let’s say your old bond right now that’s down in value matures in six months, right? But your time horizon’s five years and you’re reinvesting into that higher bond. You’re going to see profit over the long term.

Jim Donnelley: Make complete sense. Kevin, I think the pros that jump out at me, the two that jump out bonds are relatively safe. I mean, right now they’re getting beat up a little bit, but historically they’ve been pretty safe. And bonds also are a form of fixed income, which is a great plus for people that are in retirement. The cons historically they have low interest rates, meaning for long term government bonds historically have earned about 5%. Now stock market historically has returned about 10% annual on the average. So, that’s 5% difference, it’s a big diff a big number. And there’s some risk. I mean, majority already depends what kind of interest rate you’re looking to get back from the bonds, the coupon rate, the more risk, the more reward, but obviously that that’s one risk. They got to make sure each corporations pay you back. So, with that Kev, I think the last question I want to ask you, because I think is important. I get lot from the guys at Bensalem, when you’re looking at the 457s or statements, what should they be looking at their portfolios about bonds and how’s affecting their portfolio. And is there something they should be looking at specifically? Because obviously they’re not going out and buying bonds themselves. So, they’re usually invested in a target fund. So, what should they be really looking at when they look at that statement?

Kevin McGarry: Right at the moment, bonds for this year have failed to cushion equity losses. They actually help with the losses. And over the last 20 years, bonds and stocks have won in opposite directions. They haven’t won in the same direction and right now they’re both playing in the same direction. That’s called the negative game. What you have to remember this performance, these statements that are negative right now, it’s for six months. We have to realize its short term. We understand seas are rough, but you got to stay in the boat.

Jim Donnelley: Yeah, no, definitely. We talk about that all the time. And one thing of value, you got to stay in the game. It’s a long game. You got to stay in it.

Kevin McGarry: And Jim, and just a side note on this is, if you’re investing in a 457 and in a lifestyle fun, right? You got diversification, you got diversification amongst bonds. So, you don’t have to say which bond sector’s going to do best. You got professional money management helping you, your systematically investing, essentially dollar cost averaging. So, right now you’re buying at discounts. So, it’s a long term game because over the long term, if you look at a 60/40 portfolio and look at the index, it’s up over 9.8% over the last decade or close to it. So, it’s a long term game, Jim.

Jim Donnelley: So, what’s the two things Kev, the two main things you want officers to listen from this podcast today, what should they walk away with today? Two things.

Kevin McGarry: Right now, it’s pretty simple Jim, bonds are down, portfolio values are down but yields are up. Valuations are more favorable in both bonds and stocks, opportunity number one. Number two, stay in the boat. Historically investors have been rewarded focusing on the long term. It’s a long term game, especially in your 457.

Jim Donnelley: That’s going to wrap up the Blue Money podcast for today. I want to thank the listeners for tuning in. If anyone has any questions about the podcast or anything about the portfolios, please do not hesitate to reach out to me and Kev directly. Our contact information, be in the show notes. Thanks for listening and be safe. 

Kevin McGarry: Be safe out there.

Announcer: Thanks for listening to Blue Money, to learn more about Jim and Kevin or for a free financial assessment, visit valleyfinancial.com or click on the link in the podcast description or show notes. Until next time safe investing.

This material is intended to be educational in nature and not as a recommendation for any particular strategy approach, product or concept for any particular advisor or client. These materials are not intended for any form of substitute for individualized investment advice. This discussion is general in nature and therefore not intended to recommend or endorse any asset class security or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Before participating in any investment program or making any investment clients as well as all other readers are encouraged to consult with their own professional advisors, including investment advisors and tax advisors. Valley Financial can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.