You’ve heard the pitch countless times – in magazines, on the radio, in books, or over the internet. It’s the wisdom of the experts, and it goes like this: Invest in the stock market. Invest for the long term, because the market always goes up over time. Make sure you have a diversified portfolio, meaning a mix of stocks and bonds. In fact, hold these stocks and bonds in funds, known as mutual funds, which are collections of stocks and/or bonds that lower risk by having a range of holdings. These funds have important-sounding names, like Strategic Small-Cap Equity Fund (Vanguard) and Emerging Europe and Mediterranean Fund (T. Rowe Price), and they do better than you would do on your own, because they are managed by the top talent in the industry, smart people with years of experience, who have keen insight into the markets. Finally, invest in risky funds (stocks) when you are young, and switch to more conservative bond funds, for income production, as you approach retirement.
That is what they experts say, with voices full of confidence. There is only one problem with this strategy: It doesn’t work!
How can you go wrong with such smart and talented people on your side? These are the people who graduated with top honors from Harvard business school and got 800 on their SAT math test. The fact is that investing in the market, whether in individual stocks or in equity (stock) mutual funds, is a speculative game. And what is speculation but a form of gambling, no more, no less.
I am not saying that the stock market is like a betting game. I am saying it is a betting game, just like casino betting. There are different bets you can make. For example, you can “short” a stock. A short position is a bet that the stock will go down. If the stock goes down, you win money. If it goes up you lose. Options are another type of bet. Essentially, the stock market is a big game, in which the way you make money is by buying the stock at one price and selling it at a higher price. Sounds simple, right? There is only one problem: In order to buy low and sell high, you need to be able to tell the future. And history has proven that no one can do that for the market, any more than someone can predict whether the roulette wheel will stop on, say, 22 red.
My poster boy for this assertion is Jim Cramer, the host of CNBC’s popular “Mad Money” TV show, and one of the most informed and educated guys on Wall Street. He reads dozens of financial publications every day, and has made millions trading stocks. In 2008, he was recommending AIG and Bear Stearns stocks just months before they both collapsed. Now, if Jim Cramer, who most would agree is the smartest boy in the room, cannot read the future, I propose to you that no one can. And that includes every mutual and bond fund manager alive.
Theoretically you can get good advice by reading Investors Business Daily and watching MSNBC. But I suspect that if the talking heads who advise about the market on MSNBC really knew anything, they would be billionaires and wouldn’t have a job talking on MSNBC.
In addition to the inherent risk of stocks, mutual funds are entirely dependent on the fund manager, who gets paid hundreds of thousands of dollars to sit at a desk and make predictions about which way the market is going to go. In other words, he is guessing, just like everyone else. The only difference is that managers get their paychecks whether or not they make money for you. You, on the other hand, are putting your hard-earned money into a fund that has no guarantee of return. You are paying management fees, and you may even be paying a “load” (a fee for the privilege of investing your money in the fund) – all so that someone with a Wharton Business School diploma can make guesses which may or may not pan out! What a great deal! Where can I sign up!?
The Answer: Individual Bonds
There is a solid business investment available out there, and it is called a bond. Handled correctly, bonds can be the basis for a solid reliable investment fund.
What is a bond? As opposed to equities (stocks), in which you are buying a share of a business, a bond is a loan you make to some “entity,” such as a city, state, country, or corporation. Here’s how it works: Let’s say Caterpillar Corporation, which makes heavy earthmoving equipment, needs money. One way they can do that is by issuing bonds. The bond is a request to borrow some money from you, the bond purchaser.
Bonds are always worth $1,000 on issue. You buy them in $1,000 increments, effectively lending Caterpillar $1,000 for each bond you “buy.” Why would you do that? Because Caterpillar will pay you interest. The interest rate is called the “coupon.” They promise to pay back the money at the end of a specified period, called the “term.” The terms of loans are usually in the 15 to 30 year range. (Not as bad as it sounds, as I will discuss below).
So, let’s say the coupon of this bond is 5 percent. That means every year you hold this bond, Caterpillar must pay you $50. At the end of the term, they must give you back the $1,000. It’s that simple. They must pay the coupon every year, and they must pay it back at the end of the term. This is vastly different from the stock market, which is basically a casino where you could win or lose at a moment’s notice.
Safety
The big risk with bonds is that some issuers are more financially stable or reliable than others. In our example, if Caterpillar were to go bankrupt, they could not pay your coupon or pay back the bond. That means that some bonds are better quality, and some are worse, depending on how stable the issuer is. How can we tell the quality of a bond? That is the job of the rating agencies: Fitch, S&P, and Moody’s. These agencies rate bonds according to various technical criteria. For example, a high grade bond (low risk of default) would be rated AAA (S&P) and a low grade bond (higher risk of default) might be rated BBB. BB and less are what are known as junk bonds. Naturally, the riskier the bond, the higher the coupon has to be to get people to buy them. AAA and AA+ bonds have a negligible risk.
Bond Types
There are three main classes of bonds: government (federal), municipal (state and city), and corporate (private corporation). Government bonds do not incur state and local taxes but do incur federal taxes, oddly enough. Municipal bonds have a special status: no federal taxes. This gives them a distinct advantage. Corporate bonds incur all taxes.
Here are the relative merits of the types of bonds:
Government bonds: Pros: full faith and credit of the U.S. government (if this bond goes into default, then money is not usable anyway); no state or local taxes. Cons: incurs federal taxes; low coupons.
Municipal bonds: Pros: no federal taxes; cities and states rarely default (if they are in danger of default, their ratings will reflect that status); higher coupons than government bonds. Cons: incur state and local taxes.
Corporate bonds: Pros: highest rates. Cons: incur all federal, state, and local taxes.
Term
The last thing we need to talk about is the term. I said before that terms tend to be 15 to 30 years. Who wants to be stuck with anything for 30 years! (I am referring here to financial instruments, people.) Luckily, however, bonds can be bought and sold. That is, once the entity issues them and people buy them, those people can then sell the bond to others in what is known as the secondary market. So you can buy a bond today and sell it next year. What you need to know is that bonds on the secondary market can change price from the $1,000/bond that they originally went for.
Why would that happen? Let’s say that my Caterpillar corporate bond has a coupon of 5 percent. Then the Federal Reserve raises interest rates, and corporations start offering 8 percent. Why would someone pay you $1,000 for your 5 percent bond, when they can spend $1,000 and get an 8 percent bond? They won’t. But they might pay you a discounted rate, such as $980 for your bond. In this case the bond is selling at a discount. Now, what if you are holding this 5 percent corporate bond and the interest rates go down? Now corporations are issuing bonds with only 2 percent coupon. Suddenly, your 5 percent bond is worth more. People might pay $1,020 to get such a bond. That is called selling at a premium. But these price fluctuations are not so important in my system, where I hold bonds to term if possible. I am after the interest payments, not buying and selling.
The System
Obviously bonds are fairly complex. There are a lot of combinations out there. So you have to decide how you are going use bonds to invest. You have to set up criteria as to what you will accept in terms of coupon, rating, type, and term length. I have developed my own criteria, which I will share with you.
I do not buy a bond unless the coupon is 5 percent or higher, net. By net, I mean that I get to keep the equivalent of 5 percent. So, for instance, if it is a corporate bond, I only buy it if, after all taxes are taken from the coupon payment, I am left with a 5 percent coupon. Let’s say my Caterpillar corporate bond has a coupon of 8 percent, meaning they will pay me $80 every year I hold this bond. Let’s further say that I have to pay taxes on this $80 dollars of 25 percent. That means that, after taxes are taken out of this payment, I am left with $60, which is 6 percent of $1,000. I find this acceptable according to my criteria. (If my bond is inside an IRA, then all taxes are deferred, and it doesn’t matter if the bond is corporate, municipal, or federal.)
Will I buy a bond on premium? Sure, if my 5 percent criterion is met. The price of a $1,000 bond is referred to as if it were $100. Why? I don’t know. So if a bond was selling at a premium of $20, so that it cost $1,020, the price is quoted as $102. If I buy this bond and it has a coupon of 8 percent, but I have to pay $102 ($1,020), that means that first year I pay $20 extra to have this bond (“extra” over the $1000 original price). The coupon I get that first year is $80, but I paid $20 extra to buy the bond, so I am left with $60 dollars the first year, and $80 every subsequent year. That first year $60 net is the same as 6 percent coupon, and once again I have met my criteria.
My second criterion is that I only buy AA+ or better rated bonds. And I only buy a bond if it has a rating from all three agencies. Sometimes all three don’t get around to rating some bonds, so I don’t buy those. This keeps my risk at a minimum.
What if the rating falls suddenly? The fact is that ratings usually only fall by a single unit at a time. So if you have an AA+ rated bond, it will most likely first go to AA. When it is AA, it is still highly rated, and you have time to sell. So there is a lot of security built into the bond market.
My third criterion is type. If my bond is going to be held “out in the open,” that is, not in an IRA or other tax-deferred instrument, I have to be concerned with taxes, as I mentioned above. For those bonds that are not tax deferred, therefore, I look first at municipals, since they will not incur any federal tax. Then I look at corporates, and finally at government bonds – whatever will give me my 5 percent net. I don’t care what the term is, since if I need the money, I can sell with the loss of a few percent, at most.
Win Win
The beauty of this system is that you win either way. The goal is to hold these bonds all the way to term. If you do that, you collect your coupon every year and accumulate steady, reliable cash. At the end of the term, they give your money back – all of it. If you need to sell for an emergency, you will either get a small premium or a small discount. Either way, you are probably much better off than if you had your money in volatile and unreliable stocks.
The other benefit of this system is compounding. Let’s say that you have $100,000 in bonds, with a net coupon overall of 5 percent. You will earn $5,000 per year, guaranteed. That pays directly into your brokerage account. What do you do with this money? You take it and buy more bonds. In the first year, when you buy bonds with this money, you will have $105,000 in bonds. Next year, you will earn $5,250. You take that and buy still more bonds. The growth accelerates as you go; this is called compounding, and is one of the beauties of investing in bonds.
Implementation
Now we know what to do and why. How does one go about investing in bonds? We are all used to the idea of self-service when it comes to stocks. With services like Ameritrade and Scottrade allowing us to make stock purchases on our home computers, one might think that the same applies to bonds. However, I have found it is much more difficult to find bonds that meet my criteria than it is to find stocks. First, there are many more bonds available than there are stocks. Secondly, we don’t care so much about the identity of the bond as its coupon and rating. I have found that when using freely available services, like Yahoo Finance, it is very hard to find the bonds you need. The data in these services is not updated fast enough.
For these reasons, I use an account representative at UBS, a financial institution. There are people at his office who specialize in bonds and are experts in tracking them down according to various criteria. Also, big companies like UBS or Merrill Lynch have access to real time feeds, which gives them much more accurate data than we can get. My account representative has been very helpful in finding prospective bonds that meet my criteria and sending me reports on them, which I then peruse to find ones to buy.
UBS is only an example; I’m not saying you should do business there. What I am saying is that, in my opinion, the best way to implement this strategy is to have an account at an institution you trust, with people who are knowledgeable, have access to advanced tools, and are willing to work with you. The beauty is that you pay almost no fees, since these are not mutual funds. Any transactions costs are already reflected in the price you pay for a bond.
Examine carefully any other services the institution offers, like checking accounts, etc., since these may have fees. In general, if you only buy bonds, and do not use their other services, you will pay the least fee possible. It is worth accessing the resources at these firms, as long as you know what you want and stand firm on it.
The process can be slow at times, because there may be periods where there are no bonds to be had for 5 percent net. It could take months before you can convert all your money to bonds. What to do? Park your money in the safest, most conservative account you can find, such as a money market account. The money held in a money market account can almost never go down, so it is relatively safe. Wait out the market until 5 percent bonds become available.
Oh, but wait, you say, a money market account is giving a minimal return of only about .2 percent! Yes, you are right. But with the stock market so volatile, your money will not be going below your principal; you will therefore be doing far better than some people holding their money in stocks. And soon you will have the opportunity to put that money to work in bonds. I also recommend not putting all your money into any single bond issue; rather, put only about 5 percent of your money in any one bond issue.
The Results
My money is now entirely in single bond issues (that is, not in bond funds), with an overall average net coupon of about 5.6 percent. So far, my bonds are paying right on schedule, and soon I will be able to buy more bonds with the income from the existing ones. My investment in bonds cannot go down, and my income from the bonds is guaranteed. I don’t have to “follow the market.” I don’t have to try to “predict trends.” I don’t have to read financial publications for hours to try to anticipate the next market move. And I don’t have to get angry when my investment in mutual funds goes down with the market, even as the geniuses running it were supposed to prevent that. Best yet, instead of casino-like speculating on stock market trends, my bond investments are straightforward business transactions between two parties.
And that is why I like investing in bonds.
