Episode 12: Certified Financial Planner Jeb Jarrell provides insights into investing in bonds. He’ll explain a few different types of bonds and how they work as an investment. Depending upon the state of the economy, your bond strategy has a specific role as part of your overall, financial portfolio. Let’s listen to Jeb explain the how you may be able to use bonds more effectively to accomplish the goal of Maximizing Your Return on Life.
What Is a Bond?
A bond is a contract between you and someone else (or some entity). You are essentially loaning them money, for a defined period of time. In return, I’m going to get my money back, plus interest.
There are many different kinds of bonds but today, Jeb discusses on 3 major types of bonds: Government Bonds (i.e. Bills, Notes and Treasuries), Municipal Bonds (tax-free), Corporate Bonds.
What’s a Coupon Rate?
The specified interest is sometimes called the coupon rate. Years ago, the bond holder would turn in the coupon to redeem. Today, this is done digitally.
There are Bond Ratings
Bonds with a triple-A rating (AAA) are the most secure. These bonds may also have a lower rate of return. As you move down the ratings scale, the risk that the issuing entity or company may not be able to pay back the bond increases. Therefore, the interest rate for its bond would typically be higher. It’s a risk-reward scenario.
How Does a Tax-Free, Municipal Bond Work?
There are different ways a bond is taxed. A corporate bond will pay the interest on the bond. That interest is considered ordinary income for the bond holder. It is subject to tax. The interest from a bond issued by the federal government (“Treasuries”) will be taxed at the bond holder’s federal income level, but not at the state or local level. A municipal bond’s interest is not taxed at the federal level. Typically, the interest is also exempt from state and local taxes, as well.
Municipal bonds typically pay a lower level of interest when compared to corporate bonds. The key is that the income is generally tax-free, whereas the interest from a corporate bond is not. You can calculate your tax-equivalent yield to see which option would be better for you, depending upon your tax rate.
Bonds vs. Stocks
A well-designed investment portfolio could include a combination of various types of investments. Traditionally, a basic portfolio may consist of 60% stocks and 40% bonds. The stocks provide growth and the bonds provide income (or safety). The bond market is typically less volatile, so the downside dips might be shallower.
Jeb discusses the “bucket strategy” and other financial planning topics on his YouTube channel and his Instagram. This is a way to maintain the balance of your portfolio, while taking disbursements along the way.
The Environment Is Changing
In the past, bond yields have been in the 4-5% average range. Now, the average range is closer to 2-3%. The 60/40 allocation isn’t as effective as it used to be. Many investors are moving more money into stocks, as it relates to the allocation ratio.
Inflation is on everyone’s mind, these days. The inflation rate is heading toward 10%. The yield curve analyses what the Fed is paying on its treasuries over the 1-, 2-, 5-, 10-, 20- and 30-year periods. Generally, the return on a 1-yr bond is much less than on a 30-yr bond. The longer term requires the bond holder to assume more risk.
Interestingly, the Fed is raising the rates on the shorter-term bonds. The Federal Reserve sets the Fed Funds Rate. This is the rate at which the Fed loans money to other banks. You and I are subject to a higher interest rate, because the banks add their percentages and fees on top of the Fed Funds Rate.
As the Fed increases the Fed Funds Rate (“the interest rate”), bond prices actually go down. Jeb will record a video on this relationship, in the future. Nonetheless, as bond prices go down, the yields go up. A short-term bond won’t be hit as hard as a long-term bond, when interest rates go up.
The outlook for bonds isn’t great, as of the recording of this episode in June of 2022. We’re probably going to have some rough water, ahead, due to volatility. But, it’s important to understand the bonds can still play an important role in your comprehensive, financial plan.
At the end of the day, you should sit down with a qualified, investment advisor who can help you to think through your investment strategies. A good advisor will bring a solid perspective, but also know how to develop and implement your strategy. You can schedule a meeting with Certified Financial Planner Jeb Jarrell, by clicking this link.
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Thanks for listening!