Are Bonds Missing from Your Portfolio? David Stein Explains Why They Matter

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2:25So again, they were at 1%, it was 5%. That's why bonds fell double digits. And when you look at the five-year return, it's still negative. Love this podcast because it crushes your dreams of getting rich quick. They actually got me into reading stats for anything. You're tuned in to the Investing for Beginners podcast. Led by Andrew Sather and Dave Ahern. Step-by-step premium investing guidance for beginners. Your path to financial freedom starts now. Starts now. All right, folks. Welcome to Investing for Beginners podcast. We have our friend David Stein back. David is an author. He's also a co-founder of Asset Camp, and he runs a great podcast, Money for the Rest of Us.

3:16And David is back to talk to us about finance, and we're going to talk about bonds today. So this is a topic that probably is not discussed enough. And David is going to educate us and you, our dear listener. So David, welcome back to the show. It's great to be here. Thanks for having me. You're welcome. All right. So let's start with an easy one. Like, what are bonds? Bonds is debt. And when you think about companies, they have different ways to finance their various capital projects and they can issue stocks, which many do in terms of secondary offerings, but they can also issue debt. And there's corporate debt, governments issue debt, and there is debt tied to the housing market as mortgages are packaged into bonds.

4:12and a bond has a coupon rate, which is an interest rate that is paid on the bond. It has a maturity date and you just get the interest payments until the maturity date and then you get your principal back. And so what I like about bonds is it's based on math and you can use that math to your advantage to lock in a particular yield over time. And it's surprising how that the bond universe doesn't get as much, that doesn't get more attention because it's actually, I believe it's bigger than the stock market. But it's often kind of overlooked, especially younger investors, because it just doesn't, it's not terribly sexy.

5:05But on the other hand, I've always gravitated toward the bond market because there's just more predictability there. So can you give us a backdrop, maybe go more in depth about, you said the bond market is bigger than the stock market. What kind of historical backdrop is there on bonds, maybe around performance and risk and things like that? Sure. Well, let me share some. So we have a tool called Asset Camp, which we analyze the stock market, but we analyze the bond market. So I'll pull up for those watching. We can pull it up, but we can kind of look at, first off, the returns of bonds over time.

5:54And so there's many different types of bonds. There's the global bond market. There's the U.S. bond market. And probably the most common return for, when we think about the U.S. bond market, would be the U.S. aggregate bond index. And that's put together by Bloomberg. And over the past year, it's returned 6%. Like longer term, you go out 20 years, it's returned 3.3%, which sounds incredibly boring. But one of the things with bonds is they're impacted by interest rates. And so if we look at, let's just take a look at longer term bonds.

6:43Over here, bonds have what are called a yield. So you have with a bond, you have a coupon payment. So that's the stated interest rate in the bond indenture. Let's say the government right now issues a 10-year treasury bond. It has a coupon rate of around 4%. But as interest rates go up, that coupon rate, let's say the 10-year treasury bond yield, when it doubled to 8%. And this is an important element of bonds. If it goes to 8%, that means the government's now issuing new 10-year treasuries at 8 % yield, which means that if you own an existing one and you're only getting 4%, that you're at a disadvantage to the new bond.

7:31And so what happens is the old bond falls in price to where its price, on a price-adjusted basis, if you take your interest payment divided by the new price, that would equal roughly 8%. And so that's why I talk about bonds being very math-driven. you can always kind of look at, you know, a rule of thumb for bonds is over a longer term holding period, seven to 10 years, the starting yield to maturity is your best estimate of your return. And so, you know, unlike the stock market where investors can get overly zealous and bid up one particular company to where it's selling at a PE of 50 or 60, I mean, there's a lot of emotion in there.

8:18And then if the company disappoints, the stock crashes, the bond market is all connected together. It's connected by the yields. What are the prevailing interest rates on government bonds? And then there is some emotion involved in terms of, at times, investors are like for non-investment grade bonds or higher risk bonds. They might, like right now, they're more bullish toward that. And so they might not want as much of an additional yield or interest rate above treasuries, but at other times they'll want a lot. And so let me illustrate that point specifically. So when we think about US high yield bonds, so these are non-investment grade bonds.

9:09So a high yield bond is a corporate bond. And it... So in this chart right now, for example, the yield, if you go out and you buy an ETF that tracks the non-investment grade bond market in the US. And you're going to get around a 6.8 % yield if you bought that ETF. Now you think about that, that's pretty good. That's a good yield. I mean, if I can get 7 % return, I think sometimes when we think about the stock market, we get sort of skewed by recent performance. There's a recency bias. Well, of course, the stock market is up 15 % a year because the U.S. market has gone up 15 % annualized over the past decade.

9:55But 4 % of that performance was because investors had bid up stocks, and now they're way more expensive. So when you think about the bond market, you can see that right now the yield's 6.8%. So that's kind of what you can get right now if you held an ETF for seven to 10 years. But there's been times when, in 2008, when the yield on non-investment grade bonds was 21%, which is super high. And what you saw there is what I talked about. Back in 2008, during the crisis, you could get 18 percentage points more than treasuries in terms of additional yield by investing in high-yield bonds. The average incremental yield, or it's called a spread, is 4.8%.

10:50Now we're at 2.8%. And so that's why I talk about one benefit of the bond market is the ability to kind of to see, well, you have all these investors that make it up. How worried are they about the economy crashing? Not terribly worried if the incremental yield for non-investment grid bonds is 2.8 % right now. So it's near a record low. The average is 4.8%. And you can see like during a recession, here's the 2008 recession, spreads bloomed out. They did again during the pandemic. And then you see spreads got above average 5.5 % in 2022 because there was concern about recession as the Federal Reserve was raising its interest rates.

11:38But now they're not. And so I use the bond market to help judge where we are in the economy and how worried investors are because with something like, you know, why do you have a spread of 18 % in 2008? Because investors are worried about defaults. So bonds can default, which means they don't make their interest payment or they miss their coupon payment. Governments can default on their bonds. So that is one of the risks of bonds is defaults, which is why you use ETS or index funds and diversify among hundreds, if not thousands of bonds. And there are indeed hundreds, if not thousands of bonds out there.

12:20If we look at the number, the total value of the bond market around the world, according to Bloomberg is$78 trillion. And just the bonds that are in their various indexes, there are 35 ,000 bonds. So there's a lot of, I mean, there's a lot of bonds out there. Let me stop there and you can ask clarifying questions or we can go in many different directions. I'm excited to share our friends over at the Plink app released a major upgrade featuring a sleek new look, real-time insights, smoother trades, and tools that help you feel more confident with every move. Here's the bonus I think you'll love.

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15:07I guess one thing I would be curious to, I guess, talk a little bit about is what is the difference between investment grade and non-investment grade? I think people that don't understand bonds will probably be like, I have no idea what he's talking about. Well, that's good. So bonds, corporate bonds, and many other bonds, municipal bonds, are rated by credit rating agencies. And they're rated on whether, you know, the most pristine bonds are rated AAA. So a year or so ago, there was a lot of news that the U.S. got downgraded, U.S. debt. So basically, U.S. lost its AAA rated. Now it's AA. And so investment-grade bonds, you've got the A's, which are the best, AAA, AA, A.

15:59Then you have BBBs. And then below that, so the more speculative, those with a higher default, those are called non-investment-grade bonds. So those would be BB down into the C to where they default. And it's important because the higher the risk, or the higher default risk, the higher the yield. And because investors need to be compensated for the potential default risk. And so when we look at the yield to maturity on bonds, and we can kind of compare non-investment grade bonds to investment grade bonds. And let's just hold it up real fast. So here's the bond market right now. So investment-grade corporate bonds are yielding 4.8%.

17:00So you get more yield than you do with treasuries. So treasuries right now are yielding 3.9%. So you get about 80 basis points more or 0.8 % more investing in investment-grade corporate bonds. And then we look at high-yield bonds. They're yielding 6.8%. So you can pick up another 2.4 % investing in non-investment-grade bonds. And so that's why there's different ways to do it. Now, investors can just buy an ETF that owns them all, just like you can own VT in the stock market. You can own BND, the Vanguard Total Bond Market ETF, and it will own all these different sectors. It'll own investment-grade corporate bonds.

17:46It'll own mortgage-backed bonds, which are bonds backed by home mortgages. It'll own treasury bonds, but it won't own non-investment grade bonds. So it's just investment grade ETF. So why would you own bonds? Or how would you go about doing that? And oftentimes an individual, let's say they're saving for a house. So it's going to be three, four, five years until you can make a down payment on the house. that's not necessarily money you want in the stock market because the stock market could fall 50 percent right before you want to close on your house in fact if the stock market fell 50 it would probably be a pretty good time to buy a house because you know housing prices would be more affordable and so you would want to have had that down payment secure or somebody that's early retired, a new retiree.

18:49Sometimes you want to put your longer term assets in stocks, but your living expenses can be in bonds. And it's a yield-oriented play. So you're getting 4 % to 6%. And yeah, you're not going to earn as much as you would in the stock market. but it's the security of it to be able to lock it in. Now, that doesn't mean you can't lose money on bonds. And that's an important element because we talked about if interest rates go up, the value of bonds fell. And a lot of people had bonds and interest rates, they went up very high in 2022 and the bond market fell. It is the Vanguard total bond market ETF fell 14 % that year.

19:40And that still shows up in those longer term numbers. A lot of people were surprised. Those that understood bonds understood that and had sold Vanguard total bond market ETF and put it in cash. And when it comes to bonds, it's not... If you sell the stock market, put the cash, people think you're a market timer, right? But if you, in the bond market, if you sell longer term bonds and put them in cash, you get the yield. Back in 2022, you were yielding 5 % on cash. Why own a longer term bond that's yielding 5 % when you could own cash and get 5.5 %? The only reason I own a longer term bond is because you think interest rates will fall and the opposite will happen.

20:37The price of bonds will go up. And so there's sort of all these permutations when it comes to bonds. I mean, there's some complexity there, but at the end of the day, it's based on math. And what you care about is what is the yield and what is the yield to maturity? And every bond ETF or mutual fund in the U.S., it says here's the SEC yield. So you care about that and you care about what's known as the duration, which is how sensitive is that ETF or that bond to changes in interest rates. So something like a longer-term bond, when we think about duration or interest rate sensitivity, and we look at the treasuries, long-term treasuries have a duration of almost 15 years.

21:28And short-term treasuries, one to three treasuries, have a duration of two years. And the way duration work is kind of a back-of-the-envelope calculation. if interest rates go up 1%, a bond ETF or a bond with a duration of 15 years, it will fall in price 15%. Price, the price will fall. And that's where duration is important. Whereas if you have a duration of two years and interest rates go up 1%, it would only fall 2%, which means you can recover faster. And so again, when we think about what do we care about with bonds? We care about what the yield to maturity is because that's a good predictor of the return over the next five to seven years.

22:15But we also care about the duration because that's what impacts the volatility and how much you could lose in the short term. yeah kind of to use your example of like if you have a four percent bond and then now there are eight percent bonds if your duration is like only a year or a year and a half you're not really hurt as much by that because we're only talking about one or two years of income instead of 10 exactly and we we can kind of see that here if we look at some expected bond return modeling. So I talked about, so this is our, in those listening audio, I'll explain, but we're looking at our expected bond return modeling.

23:06So we're just kind of figuring out, well, what can we earn with bonds? And we can, we use it to sort of model out, you know, what's a 10-year expected return on bonds? And I mentioned, if nothing changes, if interest rates don't change, there's no defaults or anything, the best predictor of bonds over a 10-year period is what sets starting yield and maturity. So I mentioned U.S. aggregate bond index is yielding 4.3 % right now. And if we were going to predict the bond returns over the next decade, that'd be a pretty good guess. And it's actually pretty close. It's a lot harder with stocks. What's what's the return of stock market going to be?

23:47Well, we can look at the dividends, which is a good starting place. We can use an earnings growth estimate. But the big wild card is what's the price to earnings ratio going to be 10 years from now versus today. And that can really swing things. With bonds, that's starting yield to maturity. But I mentioned that, let's say just catastrophic, for whatever reason, and bonds go up 3%.

24:19And what happens in the one year? Well, again, the duration, the longer-term bonds I mentioned had around a 15-year duration. And so if interest rates go up 3%, it's going to fall in price about three times that 15-year or 45 % decline. Here we show is 44%. But that's pretty close. There's some minor adjustments. But here's the thing. You're now getting more yield. Interest rates went up 3%. So we were getting 4.7 % yield on long treasuries. Now we're getting almost 8%. And we still own that ETF. So we're picking up that income. So over time, we're offsetting that loss, that price decline, but we're getting higher income.

25:13And so if we go out, so you lost 39 % with long-term treasuries in one year. Let's look what if we five years later, our return is still negative. It's negative 4 % because we lost so much money. But again, we're recouping it because we're now getting more interest income. And that's what we saw in, if we go out 10 years, we can see that we're now positive, right? Now, that's because it's very long-term bonds. If we look at something with a little shorter duration, so the broad U.S. bond market, U.S. aggregate, our starting yield and maturity was 4.3%. Interest rates go up 3%. So we lost that first year 18%, which hurts.

26:04but now we're getting that higher interest rates to 10 years later, our total annualized return was 5.2 % because yeah, we lost money, but now we're getting higher interest rates. And that's what happened when we look at the longer term returns for the bond market, the US aggregate index. We go out five years, it's still a negative return, negative 0.2%. If we go back to December 2022 and look at what happened in that year, see that U.S. aggregate lost 13 % in 2022. And the reason why is because interest rates went, they soared in 2022. So let's pull up the yield to maturity of the U.S. aggregate, the broad bond market.

27:03So in 2020, the yield to maturity on the bond market was deplorable. It was 1.2%. That was a bad time to own bonds. But by 2023, we were, or 2022, we were over 5%. So again, they were at 1%, it was 5%. And that's why bonds fell double digits. And when you look at the five-year return, it's still negative. So that's a lot to throw at you. But the takeaways are we care about the yield. We care about the duration of the interest rate sensitivity. We care about our time frame, like what particular expense are we funding? or perhaps right now we're not real comfortable. Maybe we're going to retire in five years.

27:59And we've always been 80 % or 90 % stocks. And the S &P 500 has turned into this AI index and it's now selling for two standard deviations more expensive than average. I mean, when you look at the valuation of the stock market, it's just incredibly high right now. So just on many different measures. But if we look at it on a price to cash flow basis, the U.S. stock markets, the price to cash flow is 21. The long term average is 10.7. So we're two standard deviations more expensive on a price to cash flow basis. If we look at it based on expected earnings, we're 23.4 versus a long term average is 16.6.

28:42So more than two standard deviations more expensive. and on many different measures, price to book. And so why own bonds? Maybe right now, given the AI index of the S &P, we can pull some risk off and invest in something that's more mathematically driven than emotion driven. Yeah. Can we pull on that? I imagine there might be somebody out there who is in that situation you're talking about. So some of these five years to retirement, they are worried about having too much allocation to the stock market. What's their next move? Do you like ETF, bond ETFs? Do you like individual bonds? What's kind of that blueprint for moving forward?

29:33Yeah. Most individuals shouldn't invest in individual bonds, especially corporate bonds. like one bonds, individual bond they could invest in are what are known as treasury inflation protection securities, which are bonds that you protect against inflation. The benefit of owning an individual bond is it matures, which means you see the starting yield of maturity when you buy the bond. And if you hold it to maturity, your annualized return will be that starting yield of maturity because that's how the math works. assuming the bond didn't default, right? But most of the time it does not. But that's why we own baskets of bonds with an ETF because then you're diversified for the default risk.

30:24But somebody in that situation, they're gonna retire in five years. They could buy, go out right now and buy a five-year treasury inflation protection security. and its yield before any inflation adjustments around 2 % right now, maybe a little under 2%, which means they can lock in close to 2 % return plus inflation over the next five years. So that would be one way to do it. A second way is there's something in the ETF world called a bullet ETF. So it's most ETFs, you go out and buy the BND, the Vanguard Total Bond Market ETF, or you buy VOO, VT, right? It doesn't mature. But there are ETFs that act like an individual bond in that they have a maturity date.

31:14So you can go out and buy BSCV, for example, is a bullet shares. It's invested in investment-grade corporate bonds. It has maybe 150, 200 bonds that mature, I think, in 2032, which means it's a basket that acts like an individual bond. So you can lock in right now it's yielding around just over 5 % and around 5%, which means that you can take whatever, your 50 ,000, your 100 ,000, you can buy this ETF and just rest back and know that this returns or matures in 2022. I'm locking in and going to earn a 5 % return, annualized approximately. So, I mean, there's some little nuances because you're getting cash flow that has to be reinvested back.