Investing in Bonds For Dummies. Russell Wild

States of America is not going bankrupt anytime soon. And for that reason, Treasury bonds have traditionally been referred to as “risk-free.” Careful! That does not mean that the prices of Treasury bonds do not fluctuate.

      ✔ Collecting corporate debt: Bonds issued by for-profit companies are riskier than government bonds but tend to compensate for that added risk by paying higher rates of interest. (If they didn’t, why would you or anyone else want to take the extra risk?) For the past few decades, corporate bonds in the aggregate have tended to pay about a percentage point higher than Treasuries of similar maturity. Since 2008, this spread has broadened, with ten-year corporate bonds paying about a percentage point and a third more than their governmental counterparts.

      ✔ Demystifying those government and government-like agencies: Federal agencies, such as the Government National Mortgage Association (Ginnie Mae), and government-sponsored enterprises (GSEs), such as the Federal Home Loan Banks, issue a good chunk of the bonds on the market. Even though these bonds can differ quite a bit, they are collectively referred to as agency bonds. What we call agencies are sometimes part of the actual government, and sometimes a cross between government and private industry. In the case of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), they have been, following the mortgage crisis of 2008, somewhat in limbo.

      To varying degrees, Congress and the Treasury will serve as protective big brothers if one of these agencies or GSEs were to take a financial beating and couldn’t pay off its debt obligations.

      ✔ Going cosmopolitan with municipal bonds: The bond market, unlike the stock market, is overwhelmingly institutional. In other words, most bonds are held by insurance companies, pension funds, endowment funds, and mutual funds. The only exception is the municipal bond market.

      Municipal bonds (munis) are issued by cities, states, and counties. They are used to raise money for either the general day-to-day needs of the citizenry (schools, roads, sewer systems) or for specific projects (a new bridge, a sports stadium).

      Buying Solo or Buying in Bulk

      One of the big questions about bond investing that I help you to answer later in this book is whether to invest in individual bonds or bond funds.

      I generally advocate bond funds – both bond mutual funds and exchange-traded funds. Mutual funds and exchange-traded funds represent baskets of securities (usually stocks or bonds, or sometimes both) and allow for instant and easy portfolio diversification. You do, however, need to be careful about which funds you choose. Not all are created equal – far, far from it.

      I outline the pros and cons of owning individual bonds versus bond funds in Chapter 11. Here, I give you a very quick sneak preview of that discussion.

Picking and choosing individual bonds

      Individual bonds offer investors the opportunity to really fine-tune a fixed-income portfolio. With individual bonds, you can choose exactly what you want in terms of bond quality, maturity, and taxability.

      For larger investors – especially those who do their homework – investing in individual bonds may also be more economical than investing in a bond fund. That’s especially true for investors who are up on the latest advances in bond buying and selling.

      Once upon a time, any buyers or sellers of individual bonds had to take a giant leap of faith that their bond broker wasn’t trimming too much meat off the bone. No more. In Chapter 4, I show you how to find out exactly how much your bond broker is making off you – or trying to make off you. I show you how to compare comparable bonds to get the best deals. And I discuss some popular bond strategies, including the most popular and potent one, laddering your bonds, which means staggering the maturities of the bonds that you buy.

Going with a bond fund or funds

      Investors now have a choice of well over 5,000 bond mutual funds or exchange-traded funds. All have the same basic drawbacks: management expenses and a certain degree of unpredictability above and beyond individual bonds. But even so, some make for very good potential investments, particularly for people with modest portfolios.

      Where to begin your fund search? I promise to help you weed out the losers and pick the very best. As you’ll discover (or as you know already if you have read my Exchange-Traded Funds For Dummies), I’m a strong proponent of buying index funds – mutual funds or exchange-traded funds that seek to provide exposure to an entire asset class (such as bonds or stocks) with very little trading and very low expenses. I believe that such funds are the way to go for most investors to get the bond exposure they need. I suggest some good bond index funds, as well as other bond funds, in Chapter 5.

      The Triumphs and Failures of Fixed-Income Investing

      Picture yourself in the year 1926. Calvin Coolidge occupies the White House. Ford’s Model T can be bought for $200. Charles Lindbergh is gearing up to fly across the Atlantic. And you, having just arrived from your journey back in time, brush the time-travel dust off your shoulders and reach into your pocket. You figure that if you invest $100, you can then return to the present, cash in on your investment, and live like a corrupt king. So you plunk down the $100 into some long-term government bonds.

      Fast-forward to the present, and you discover that your original investment of $100 is now worth $11,730. It grew at an average annual compound rate of return of 5.5 percent. (In fact, that’s just what happened in the real world.) Even though you aren’t rich, $11,730 doesn’t sound too shabby. But you need to look at the whole picture.

Beating inflation, but not by very much

      

Yes, you enjoyed a return of 5.5 percent a year, but while your bonds were making money, inflation was eating it away … at a rate of about 3.0 percent a year. What that means is that your $11,730 is really worth about $885 in 1926 dollars.

      To put that another way, your real (after-inflation) yearly rate of return for long-term government bonds was about 2.5 percent. In about half of the 89 years, your bond investment either didn’t grow at all in real dollar terms, or actually lost money.

      Compare that scenario to an investment in stocks. Had you invested the very same $100 in 1926 in the S&P 500 (500 of the largest U.S. company stocks), your investment would have grown to $567,756 in nominal (pre-inflation) dollars. In 1926 dollars, that would be about $42,800. The average nominal return was 10.2 percent, and the average real annual rate of return for the bundle of stocks was 7.0 percent. (Those rates ignore both income taxes and the fact that you can’t invest directly in an index, but they are still valid for comparison purposes.)

      So? Which would you rather have invested in: stocks or bonds? Obviously, stocks were the way to go. In comparison, bonds seem to have failed to provide adequate return.

Saving the day when the day needed saving

      But hold on! There’s another side to the story! Yes, stocks clobbered bonds over the course of the last eight or nine decades. But who makes an investment and leaves it untouched for that long? Rip Van Winkle, maybe? But outside of fairy tale characters, no one! Real people in the real world usually invest for much shorter periods. And there have been some shorter periods over the past eight or nine decades when stocks have taken some stomach-wrenching falls.

      The worst of all falls, of course, was during the Great Depression that began with the stock market crash of 1929. Any money that your grandparents may have had in the stock market in 1929 was worth not even half as much four years later. Over the next decade, stock prices would go up and down, but Grandma and Grandpa wouldn’t see their $100 back until about 1943. Had they planned to retire in that period, well … they may have had to sell a few apples on the street just to make ends meet.

      

A bond portfolio, however, would have helped enormously. Had Grandma and Grandpa had a diversified portfolio of, say, 70 percent stocks and 30 percent long-term government bonds, they would have been pinched