Bonds Series: How to make or lose money buying bonds

If you invested in bond mutual funds over the last few years, you might have been surprised to see your positions get annihilated. Why did this happen, and what can you do about it moving forward? 

In this new series, we are peeling back the layers on what bonds really are, how they function, and the pivotal role of interest rates and market pressures that can either make or break your bond portfolio.

Step into the world of bonds with our analogies that simplify this complex market, making it as relatable as selling your own home. We'll break down the dual avenues of bond profit—interest payments and capital appreciation—and bust the myths surrounding their supposed safety and predictable yields. The turbulence of the past year's market serves as a foundation for our candid discussion, emphasizing the necessity of a discerning eye when it comes to the fine print of your bond agreements.

Lastly, we navigate the sometimes choppy waters of bond trading, where we dissect how market unrest can lead to opportunities for the astute investor and pitfalls for the unwary. We arm you with the insights to strategically approach your bond investments, ensuring you're prepared for the uncertain tides ahead. 

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Transcript

Speaker 1: 0:08

Welcome to Ditch the Suits podcast, where we share insights nobody in the financial services industry wants you to know about. We're here to help you get the most from your money and life, so buckle up and welcome to Ditch the Suits. Well, welcome back to Ditch the Suits, steve Campbell, here with Travis Moss. Folks, thanks for tuning in for our 100th episode and three years into this sucker. If you've been here from the beginning, we appreciate you being a part of this journey with us. If you're fairly new to DTS because some of the accolades we talked about in 2023, welcome aboard.

Speaker 1: 0:37

We always like to take series topics broken up into usually one to four episodes. We're in the first episode. We always lay the groundwork for what we're talking about and we build upon each one. We just finished an entire series on estate planning, so if you missed it, go back and listen. It could really help change your life and your family's life.

Speaker 1: 0:54

But one of the big topics that's always of popular interest for our listeners has to do around investing, and investing of all kinds, and one that we're really excited to bring to you today is around this whole idea of fixed income or bonds, and how they work and are they appropriate for you. Whether you've realized it or not, if you've been in a retirement plan, you probably have access to fixed income or bond components, whether you're invested in it now or maybe. 2012 was a really eye-opening experience for you as a bond investor, because you don't understand what happened and why your bonds got crushed. So in this first episode, we really want to just lay the groundwork for what is a bond, how does it work and how do we begin to make sense of this big part of investing that I think many of us just might misunderstand. So, travis, where's a good place to start when we want to talk about what is a bond?

Speaker 2: 1:39

I think you met 2022. I think you said 2012. 2022 was a crappy year, right? People who own bonds got killed. They were there because they were going to be safe and then they lost all their money. They probably, depending on what kind of bond you had, you could have lost more than the stock market in 2022, and then last year comes and it's starting to come back. If you own bonds, if you own bond, mutual funds especially you probably didn't make your money back yet. You're probably still in the toilet. And what gives with that? Right, because they're supposed to be safe. It's supposed to be where you put your money. That protects you. And, yeah, why have you lost all this money? This is super frustrating now, and this is why it's like is the system rigged against you? Because they come out and the people with the money, they don't have these problems.

Speaker 2: 2:29

And we talk about this. We talk about stocks all the time, investing all the time and how we're like maybe over complicating things by making things too fancy or trying to make things too simple, like, hey, if you just buy this fund, this index fund, and it's super cheap, you're going to be fine, and if you buy bonds, that's a safe one. Well, we got to kind of look at the fine print, we got to look at what's in there and it's like why do we do what we do? We do it over and over and over again. We get burned over and over and over again and you know how frustrating is that, and what we're going to find out with bonds is the devil in the detail. So let's start out and I want to oversimplify this because it really is quite simple. I think some of the foundational language and concepts are a little bit more tricky, but we're going to do our best to kind of boil this down. One of the ways that I would explain this to a client.

Speaker 2: 3:26

A bond is like you know, have you ever owned a CD? Or maybe your parents or grandparents owned a CD? That's what you get. You go to the bank and you're like I'm going to give you some money. I want a higher interest rate than you need to check in your savings account. So they say, okay, open the CD. Or if you go to credit union, they go open the share certificate and basically you lend them your money. You give the credit union or bank a loan. You say you take my money, go do what you do and what do they do. They go out and they do mortgages. They buy businesses, right. Whatever they do, they use your money. They don't have to tell you about it, they just go do it. And what do they do for you, though? They promise you they go.

Speaker 2: 4:03

Steve, thank you very much for giving me your 100 grand. Here's 5% for the next year. You're going to get 5%. At the end of the year, I'm going to give you your money back For Steve. Here's 4%. I'm going to give you 4,000 bucks a year for the next three years, and at the end of three years I'll give you your money back. And if you want to renew, we'll renew, but it'll be depending on what the interest rates are at the time. And you go okay, that's good, because I had nothing to do with the money. Anyway, you know I'll lock it up.

Speaker 2: 4:26

And then they put these little fine prints in there, right, because everything's got a contract. You go buy a car get a big stack of paper. You have a contract. You go buy a house you got a big stack of paper. You got a contract, right. You go try to sign up for cable or Netflix or Hulu you got a contract, right, everything's got a contract.

Speaker 2: 4:45

So in that little contract, in that CD, you got this little fine print that says hey, look, if you'd like your money back early, you come to the bank and you say give me my money back early. Number one do they have to give you your money back? And number two if they do, what are the terms? Like the terms might be look, steve, I'll give you your money back. You know what? You give me 100 grand. I'm going to give you 5% a year for the next three years. But if you come back to me and you want your money back, you're going to give me all my interest back. Right, because that's a bad deal. We need to be able to commit to having this money here.

Speaker 2: 5:12

So there's fine print in there. But it's a contract, it's a deal. There's a lender In this case it's you, steve and then there's a borrower In this case it's me, the bank. So it's a contract between two parties, somebody who's giving and somebody who's receiving, and the person who's receiving is promising to pay back on certain terms, just like if you bought a house or a car. What are you doing, bank, please lend me your money and I will give you a certain amount back every single year. It's the exact same interest or idea.

Speaker 2: 5:46

In fact you can buy bonds that are made up of mortgages. The actual interest creating like entity behind it is the mortgage payments themselves. So it's contract. Basically, we have a contract and there's a lot of fine print in it. So then that gets you thinking okay, well now, how do I get one of these things?

Speaker 2: 6:07

Well, most people go out and they buy a mutual fund because you know that's just kind of how everybody's being pushed to invest these days. Go buy the cheapest mutual fund you can get, get an index fund, because you know those pesky financial advisors, they're just going to rip you off selling you stuff. That's no good and you can't beat the mutual fund anyway. So go buy that. But in reality the contract was written for somebody in mine originally and these bonds are normally long contracts. They might be like a 30-year contract. So somebody wrote a 30-year contract for somebody else at one point in time and that contract's got all kinds of fine print Like maybe there's a prepayment option in there, just like your mortgage. Maybe they can they have an option to, after five years, pay off and take, you know, get rid of the loan. They can say hey, steve, you know what you did. Give me a hundred grand and I did promise to give you a 5% a year for the next 30 years, but at the end of five years, if I want to give you your money back, I can get out of this. And you go hey, man, that's cool, I like it. Those are good terms at the beginning.

Speaker 2: 7:17

Well, what happens if along the way, let's say 10, 15 years in, you go man, I need my money. My house just burnt down, or I want to relocate, or I need to put my kid through school, or I had a health scare and I didn't. My emergency came up and I need my emergency money here. I need my bond back. What happens? Well, do they have to buy it back for me? The answer is no. You can't go and say hey, look, man, you loaned, I loaned you money for 30 years. You said you'd pay me 5% a year and then my money back at the end of 30 years. I'm 15 years in. Give me my money back. They're going to laugh. And you go no, we don't have to. So then you're stuck. Right, you're either stuck with it or you got to find somebody to buy it from you.

Speaker 2: 7:57

So now you take your loan contract basically your bond, that's what it is and you go out there and you're like hey, man, who wants to buy this from me? I need some cash and depending on how bad you need to cash and the other things like what's the going interest rates and all that kind of stuff will depend on what you can give for it. So somebody else is buying that contract from you to take it over. Because they're like hey, steve, you're going to 5% a year and at the end you know I'm 15 years, you're going to get 100 grand back. I like that, I'll give you 100 grand for that, because, well, maybe that's still the going rate for that type of loan.

Speaker 2: 8:34

Or maybe they look at it and say, man, steve, that that place that you lend the money to they're in deep trouble. Man, they're not managing their business so well. They may go out of there. I heard they might go bankrupt. I ain't going to pay you $100,000 or something I might not get back. So they're obviously going to pay you less. Or they might say gee, steve, you got a 5% payment coming from them. Man, I can't find anything out there. I can't find anybody to loan money to or get more than 2% for it, I'll give you actually more than 100 grand because I'm adding up all that extra interest I can make and I'll split that with you. You know what I mean. So why don't I give you $100 and I don't know $8,000 for your $100,000 loan? Because I basically split some of that interest I'm going to make over the remaining 15 years. So what's happening is we've got these contracts designed for the initial parties and then there's actually they're being traded like baseball cards as time goes by.

Speaker 1: 9:40

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Speaker 1: 10:19

Yeah, and I think that analogy we use mortgages in houses so much and so helpful for people to understand, especially in light of these contracts, because if you had your house listed at a price and you were in dire straits and needed to sell it just because you bought it for a price, what somebody's willing to pay for it, if you are in dire straits, they might offer you $25,000 less and if you're like I need the money, then you're taking it at a loss.

Speaker 1: 10:43

So I think sometimes fixed income is one of those financial literacy terms that I think maybe sometimes people nod their head and they're like oh yeah, bonds, fixed income, but then, as you begin to describe to people every single day, this is why 2022 happened. This is the moving parts. I guess I didn't know that's how bonds worked, and so I think that contract is a great starting point, but then you got some other moving pieces to bonds and what makes them kind of unique, and I know that I think this would be helpful for listeners to kind of understand some of the other moving parts too.

Speaker 2: 11:13

Well, so think about the difference, and this is where it helps to understand this better. We think about the stock market, as everything's in the stock market and everything's the same. When you buy Amazon stock, you are buying a cut of all their profit and losses and everything they own, and for an infinite time. There's no contract, there's no end date. As long as that company is breathing, you get to make money. But when you buy a contract, when you buy a bond, you buy a contract and by definition, the contract has a date on it. It's dated, it's finite, it's going to end and the terms at the end have already been decided. So that's the wild difference between us.

Speaker 2: 12:07

So people think about it like oh, this is my safe money versus stock, that's my risky money, because that can go up and down indefinitely. I have no idea when I'm going to get my money back there. So bonds, I think, are pretty safe, because it's kind of like a pile of dollar bills, just like this big stack, and they're just sitting there waiting for the company to pay it back. And in reality it's not, it's a contract. It's a big stack of papers that people are trading around and you get it back or you'll get the original amount back, right, you'll get. If it's $100,000 face value worth of bonds, I'm going to get my $100,000 back, plus my interest. But that doesn't necessarily mean that's what I paid for the contract itself, right? And it doesn't necessarily mean that there's not fine print in that contract that could impact what I'm going to get back either. And so when we go to the market and we buy the stocks, we actually can understand that a little bit easier, because it's pretty straightforward.

Speaker 2: 13:08

And when we buy bonds, it's like now you got to read a contract. You know you got to, you got to and they're written, you know in like this third language, like you got to be some. You know you really got to be into it to actually understand what you're reading about, and so that kind of then gets you to like, well, how much can you make on a bond? Because people, when you go, and people got creamed in 2022 on their bonds, and why would? Why, you know how did this happen? Well, 2021 wasn't a good year for bonds either, but you go back a little bit earlier than that. There were some pretty good years, and one of the things that happens is you look at the bond mutual funds. You go wow, that one's average 6% a year over the last three years, that must be pretty good, it's safe, it's a bond and it made 6% a year. Well, I want a piece of that.

Speaker 2: 13:59

Not understanding that really more, a big chunk of what you're seeing is the transactions for buying and selling the actual contracts plus, you know, in combination of the interest that they're actually making. And so when we think about bonds, we have to get to the point where we understand how the bonds actually make money. And there's two ways that we're making money on them. One is and people get this confused a lot they say well, you know, how much interest am I going to make on the bond? And a lot of times when you hear bonds you might hear the term yield. Well, bonds are yielding 5%. So they go oh, I'm going to make 5% interest on the bond. No, the interest is a function of what the issuing party has promised to pay. So, steve, if you lent me that $100,000 for 15 years or for 30 years and I'm going to pay you 5% a year, that's the interest.

Speaker 2: 14:55

But if, let's say, you have sold that contract off to somebody else, let's say you sold it to your neighbor and they paid you for lack of a simple or for a simple method. Let's say they paid you $85,000 to buy your $100,000 worth of bonds because you really need the money right away. So they give you $85,000 for your $100,000 bonds and in 15 years, they're going to get $100,000 back. Well, what's another way they're going to make money? Well, they paid you $85,000, and they're going to get $100,000, which is $15,000. Well, $15,000 over 15 years is essentially a percent a year, just about right. So they get the 5% interest that was being paid to you. Plus, they're going to get essentially an extra percent a year, while they've had it because of what they paid for it.

Speaker 2: 15:50

There's two ways to make money. There's interest and then there's capital appreciation, and you can lose money on them too. And this is part of the way that people lost money in 2022 is, believe it or not, people will overpay for a bond. They'll actually go in and say, well, I'll pay you if you're trying to sell me $100,000 in bonds and maybe I don't realize what they're worth or something, or maybe I really want them. Or, in the case of mutual funds, maybe I'm just not paying attention, maybe I paid you $10,000 more than they were worth. Well then, when they mature, I actually lose that money. So they're dropping and we'll get into that more in detail. But the point is, is that two ways to make money? You have interest, and then you got capital appreciation and you put them together and that's what your yield is.

Speaker 1: 16:59

And I think maybe that's the confusing part for a lot of listeners, because even the description of this sounds good in nature, like why wouldn't you want to have that?

Speaker 1: 17:07

But I think it's more of the execution which is where a lot of investors have kind of got themselves in trouble.

Speaker 1: 17:14

So I think even just this understanding for this first episode about bonds is a great place for us to start, so that as we lead into more of these conversations about the semantics of okay, what is a bond mutual fund, what are the components, how does it work, how does it stack up to a stock mutual fund, and even just get into our last conversation around are bonds right for you?

Speaker 1: 17:32

You know, this is pretty similar to the series I think that we did on cryptocurrency, where we kind of just laid out all the facts, how this works, so that you as a listener can hear from us that obviously we have opinions about all of these things, but we want you to understand how they work so that by the time we bring the last episode home and pose the question is it right for you? If you've been jiving with us, hopefully there's enough information for you from what we've described that you can make a call what's right for you and your situation. So I think, even as you just lay the groundwork for what is a bond, it's probably eye-opening to some people who have never really understood the ways that you can make bunnies on bonds and they've just always kind of viewed it as their safe money, but not something you can make money or lose money on. And even just I think that description is going to help a lot of people.

Speaker 2: 18:15

Well, and then a lot of people they have, because it's been thrust upon them figured out that there's an impact of bond performance based on interest rates. Right, the bonds are very interest rate sensitive, and so let's talk a little bit about how that works. So, in reality, bonds are actually sold in thousand dollar increments. So you go out and you buy a thousand dollar bond. Well, if you get a thousand dollar bond and let's say, just to make this a simple conversation, let's say that you're buying this from somebody else and there's three years left so you buy a thousand dollar bond, you're going to have it for three years. You make 3% interest a year, so you're going to get $30 for three years in a row and then you're going to get a thousand bucks back. That's called buying that at par value. Par value is a thousand. It's the face value, right? So you're not getting anything extra. You're not losing anything based on the price that you're paying for it. You paid a thousand dollars. You're going to get a thousand dollars back, plus, while you're waiting, you get $30 a year for your 3% interest.

Speaker 2: 19:18

Now, if interest rates go up and I can go out in the market and I can buy a thousand dollar bond that pays 5%. Why would I buy your bond that pays 3%? I wouldn't. I can get the same thing paying 5% someplace else, so I want to do it. I'd be like, oh, that's stupid, why would I give you my thousand dollars? Sorry, steve, you're stuck with it. So if you really wanted to get out of it, that's where you have to take a little bit of a haircut. So what the smart people do is they look at the individual bond and they'll negotiate based on the fact well, I can get 5% someplace. So, steve, you know that 2% a year difference. It's got to come out of that what I pay you for it. So maybe I got to buy the bond from you for $940, and that essentially equals what I could buy from somebody else. So that's dictating the price. Well, what if the price? What if the interest rates go down? So if interest rates go down, you have a thousand dollar bond that's paying $30 a year, and now the newer bond, new versions, only pay $10 a year, 1%. Well, jeez, I can't even get what you have. So I'd be willing to pay you a little extra to get what you have. So, somewhere in between, you know the 2% spread you know from where they are to 2% spread. So there's an adjustment that will go up if interest rates go up.

Speaker 2: 20:46

But sometimes, like if you're looking at a contract and you're looking at it individually, it makes pretty good sense, right? You look at the contract and you go am I going to make money on this or am I going to lose money on this? Right, am I going to make as much money buying this used one versus buying a new one? It's a pretty straightforward calculation. What happens, though, if I put a thousand of those together, different contracts together, I mash them all together and I put them in one of those big-ass, thick like books that you get in the mail, you know, from your investment company, every time you buy a mutual fund, the prospectus. Right, you get this big, huge I apologize for swearing you get this big, huge prospectus in the mail and in there they've got a legally about all these different contracts that are essentially owned Maybe not even all the details of them, but it just kind of expresses which ones they are.

Speaker 2: 21:48

So now you're buying a fund that makes 6% a year over the last three years and heck, you want that man. So you just put your money in there You're like, hey, make 6% a year, it must be good. But what happens when that fund because it has money to buy interest rates have moved in a certain way? Now it has money, it has to buy stuff, but there's nothing that I can buy where it can figure out how to make money on. So it starts to buy bonds that are guaranteed to have a loss, and this is how 2022 happened for most people. Basically, the fund goes in because it's forced to buy these things and you don't know what's doing it, because you don't actually understand what it's buying. And it's buying, let's say, that $1,000 bond that pays 3% a year, but it has to pay $1,150 for it to get it. So think about what just happened there. You're going to make $90 over the three years, but you had to pay $150 to get it in the first place, because when it matures, you still only get $1,000 back and you're only getting into 3% interest on the par value that original amount. So you are guaranteed to lose $60 on this loan or on this bond. So that's actually what's happening to a lot of people inside of these mutual funds which we're going to get into next, but that's the impact interest rates is causing that, a lot of that, the other things that are causing it. Just to kind of let you know that you know how oversimplified this is, but market events cause it.

Speaker 2: 23:30

People buy and sell bonds, not be sometimes because it's a good time to buy or sell them, but because they're afraid of the stock market or the market crashes or the economy or whatever the feds gonna do so just going to start selling stuff. Every time you hit the sell button on a mutual fund, you're selling stuff that you probably didn't want to sell. There's probably some stuff in there that you would want to sell, sell, but not everything. But you're indiscriminately saying get rid of it, right? So there's market events that are causing the prices to change. There's credit quality If the company was a good company but now is going on hard times and there's concern they're not gonna be able to pay their bills, like their credit rating gets dropped.

Speaker 2: 24:14

People are gonna want to buy that bond back from you. Right, they're gonna be afraid that they won't get them or, if they will, they're gonna take. You're gonna have to fire salad because they're gonna want room for error. Right, they're gonna. They're taking on risk, so you have to pay them extra, take on risk, which is essentially your hundred thousand dollar bond in our first example. Steve, I'm not gonna take it from you chance they won't be around in three years. I'm only gonna give you fifty grand for your hedge net going. Yep, I believe you they may not be around in three years. I'll take your bat. So all you're doing is making bats with people.

Speaker 2: 24:44

And then you also got personal needs, and this is one of the things that's hardest for people, especially when we see the blow up a crypto couple years ago, or when you see Silicon Valley bank that went under. So the thing that happened to Silicon Valley bank or at least what they said on the news and everything was that they you know they had this bond portfolio and they are caught on the wrong side of interest rates. So think about it like this they had, they had these bonds, all these Billions of dollars worth of bonds that we're gonna be doing the next ten years, and interest rates went up so fast that people said I don't want anything that you. I'm not gonna buy those bonds from you. If you want to sell those bonds, I'm not taking them Because I can buy way better stuff on the market. So if you want to sell those bonds to me, you're gonna have to take a major haircut Like maybe a 15% haircut in order to dump those bonds on me, in order for me to take them off your hands because I make better interest someplace else.

Speaker 2: 25:41

So the bank needs let's pretend the bank had a billion dollars in bonds and they need a billion dollars because you know they got there's crypto guys going under and and there's debts being called and people were drawing money and all that kind of. So they got to get a billion dollars Basically out of their reserves. So they go to the bond portfolio, which was worth a billion dollars a year ago, and they say, okay, let's sell that billion dollars, but the billion dollars only worth 850 million because of the interest rate adjustments, because of the resale prices. Now, if they held them for the whole 10 years, they would have got their billion dollars back. But the problem is they don't have 10 years to wait because they got to pay the bills now. So now they're forced to sell these things at less than their they're. They would eventually pay out because that's actually their adjusted value at that immediate time.

Speaker 2: 26:37

You know, or at least in the case of you could also just be adjustment in price, because we like to think of the markets as being rational, but when the market to get really choppy there, anything but rational. So like a rational price for a bond might be, you know, based on interest rates. A particular and this is just a one off example you might say well, geez, you know, if you adjusted for interest rates and it was a perfect environment, the rational price would be to buy that thousand dollar bond. You pay nine hundred and seventy dollars yeah, everybody's panicking because of you know, some news event and the price for some reason on that bond drops a nine nine hundred and twenty dollars. It's irrational, doesn't make any sense. But people are doing silly things.

Speaker 2: 27:23

So, just so happens, you have an opportunity, if you're smart, go in and buy it at a discount. Or you have an opportunity, if you're not smart, to lose a bunch of money on. And that's where we come all the way back full circle. These are contracts that you're trading their promises to future payments. There's a finite value in them. But who? I don't know anybody that I've worked with who comes in and they look at the bonds in their portfolio and they say this is when all my contracts are coming to. This is how much money I'm gonna make as they come. Do they all go in there and go? How much interest am I gonna make on my bonds? And you know why is the price upper? You know why is my statement up or down this time.

Speaker 1: 28:04

When I think, just again, great job of explaining that there is risk involved in how that risk is actually calculated in really has to do with interest rates and what else is out there, and I think that's just a nice Stark difference from maybe stocks and how they operate. So I think again for a first episode laying the groundwork for how a bond works. Maybe we've got you interested enough. Go back and look at your statements, you, what we're talking about. Look for that fixed income, the bond, because I think as we Dive in episode to talking about bond, mutual funds, I think that having this first layer is really gonna help you understand maybe what went awry in two thousand twenty two and what you can do to better be preposition for future opportunities as they come out.