Bond Basics With Mark Biller

This faith and finance podcast is underwritten in part by Soundmind Investing. For more than 30 years, do it yourself investors have relied on SMI for proven strategies and trustworthy guidance. SMI helps people build wealth so they can provide for their families, prepare for the future and give generously. Learn more at soundmindinvesting.org. My approach to bonds is pretty much like my approach to stocks.

If I can't understand something, I tend to forget it. That from Warren Buffett. Hi, I'm Rob West. If the Oracle of Omaha thinks bonds can be difficult to understand, you shouldn't feel bad if you need someone to explain these fixed income securities to you. Fortunately, we have Mark Biller with us today to do just that. Then it's on to your calls at 800-525-7000.

That's 800-525-7000. This is faith and finance, biblical wisdom for your financial decisions. Well, let's face it, bonds are a little mysterious to many people.

For example, when interest rates rise, bond prices go down. What's up with that? Well, Mark Biller is going to make bonds a lot more understandable in the next few minutes. He's, of course, executive editor at Soundmind Investing, where they have a knack for getting down to the basics. Mark, great to have you back with us. Thanks, Rob.

Good to be back with you. All right, Mark, we're talking about bond basics today, and folks can read more about it on your website at soundmindinvesting.org. You, of course, have an article titled Duration, a Simple Way to Gauge Bond Risk. Now, we probably don't need to point out that things have been pretty tough for bond investors lately.

Yeah, that's exactly right. You know, after a decade of the Fed and other global central banks pushing interest rates down to historic lows and then holding them there, the last three years or so have been quite a shock to bond investors. The 30-year Treasury bond yield bottomed at just under 1% in 2020, but it soared to over 5% here recently, and as a result, owners of long-term bond funds have seen cumulative losses of roughly 50% over the last few years. Now, that rivals the worst stock market declines of recent decades, so yeah, it's kind of an understatement to say it's been rough for bond investors lately. Well, especially for an asset class, we don't expect to have those kinds of losses, so how does something like that happen?

Yeah, well, to answer that, Rob, we kind of need to set a little foundation here. Let's call it Bond Investing 101. So, when you buy a bond, which is really a glorified IOU, you're acting as a lender.

You're lending your money at interest to either a company, a government, something like that, and in contrast, when you buy a stock, you're acting as an owner, so with stocks, you're buying a partial equity stake. With bonds, you're a lender. You're lending your money out. So, there are two main risks when it comes to buying bonds. You've got credit risk, which speaks to the fact that you might not get all your money back. You're counting on the borrower to be creditworthy and to keep making those interest payments and eventually pay off the bonds when they mature.

The most common way that you can minimize that credit risk is, first of all, by choosing creditworthy entities like the government, very strong companies, and so forth. The other main way is to diversify by spreading your lending, your holdings across multiple different bonds, and that's exactly what bond mutual funds do. Now, the second major risk for bondholders and the one that's been causing all the trouble lately is interest rate risk, and that's the possibility that you can get locked into a below market rate of return. It's really the same risk that you face when you're trying to decide how long to tie your money up in a bank CD, but it has a lot more significance when you're investing in bonds, and here's an example why.

If you're investing in a one-year CD, let's say, that rates rise after six months, well, for those last six months, that'd be kind of a bummer because you'll miss out on the higher returns for the later six months after interest rates rise. But with long-term bonds, it's not just six months of that. You can hold that below market interest rate now for years and years and years, and so because of that, if you were to want to sell a bond after interest rates have gone up, now your bond looks pretty shabby. It's a below market interest rate, and so you're going to have to drop the price in order to get a buyer to buy that bond, and that's why you get to the iron rule that when interest rates go up, bond prices go down, and of course, the opposite is true as well.

Yeah, that's a really helpful background. Well, that'll serve as an important starting point as we dive into the article that you all have at soundmindinvesting.org right now that focuses on bond duration. How does that affect your bond investments, and what do you need to know for your portfolio?

Mark Biller with us today. He's executive editor at Sound Mind Investing. We're talking bond basics today, and we'll be back with much more.

Stick around. investment objectives, risks, charges, and expenses of Guidestone funds before investing. They're distributed by Foresight Funds Distributors LLC, which is not an advisory affiliate, a registered investment advisor, nor do they provide investment advice. Are you looking for a financial professional who aligns with your biblical values? Certified Kingdom Advisors are trusted financial, legal, or accounting professionals who have completed a rigorous certification program to ensure they provide biblically wise financial advice as part of their practice.

You can find a local CKA professional in your area by going to faithbuy.com and clicking find a CKA. We're excited to have you with us today on Faith and Finance. With me today, my good friend and executive editor at Sound Mind Investing, Mark Biller.

You can check out the article we're discussing today at soundmindinvesting.org. It's entitled, duration, a simple way to gauge bond risk. We're talking bond basics today, and just before the break, Mark was giving us a bit of a primer on bonds, how the prices move, and how in the world we could have seen so much in the way of losses in the last year as rates were rising. Basically, Mark, you were sharing that the length of the bond is very important as rates rise because the longer you're stuck with a lower interest rate, the more that bond will have to be discounted, right?

Yeah, that's exactly right. The longer you have to wait until a bond reaches maturity, the longer you're vulnerable to that interest rate risk. Now, of course, the shorter the maturity then, the less volatile a bond's price will be. And so that's true of individual bonds. It's also true of bond funds. So the shorter the term of a bond fund, the less volatile that fund's price is going to be. Yeah, that's very helpful. All right, well, that's where we get into the title of this month's article, which focuses on bond duration.

What do we need to know? Yeah, so while the exact details of duration can get a little complicated, the main idea here is that the shorter the average length of a bond fund, the less it's likely to move in response to changes in interest rates. Duration is just a term that basically explains how long the term of the bonds are within the fund. And so one way to reduce risk, of course, when investing in bonds is to invest in shorter term bonds rather than long term bonds.

The article that we've got linked for listeners has a full explanation of duration. So listeners can look at that if they want the whole story. But I'm going to lift one point out of there that I think is probably the most interesting aspect for most listeners, at least, and that is that the duration of a bond fund can tell you roughly how much a fund's value is likely to change in response to changing interest rates. Let me give you an example.

It'll make it a lot easier. For every 1% change in interest rates, a bond fund is likely to see its price move in the opposite direction of the fund's duration. So if a fund has a duration of three years, then what that's telling you is that if interest rates rise 1%, that bond fund is likely to fall in price by 3%, the duration. Now, take a long term bond fund that has a duration of 10. Well, that tells you that if interest rates go up 1%, that fund is likely to fall by 10%.

So it makes it a very helpful tool for comparing bond risk and how much risk you're taking in, say, a short term bond fund versus an intermediate term or a long term bond fund. Yeah, and that also helps to explain why we saw the dramatic losses just given how much rates have risen over the last 12 months. All right, Mark, let's turn the conversation to inflation then. What role does inflation play in bond prices?

Yeah, now we're getting into the good stuff, Rob. So inflation and interest rates are directly related because the primary tool that the Federal Reserve and other central banks have to combat inflation is to raise short term interest rates. So if we think of inflation as too much money chasing a certain number of goods, when the Fed raises interest rates, people have to use more of their money to pay interest, which means they have less money to chase those goods, and that relieves that pressure that's driving prices higher, what we call inflation. So higher inflation is normally going to produce higher interest rates. As interest rates go up, bond prices fall. So we can connect these dots then that inflation becomes the boogeyman that bond investors lie awake at night dreading.

Yeah, no question about that. All right, so then the big question investors want to know is where do bonds stand today? Yeah, you know, that's a tough question because when Treasury bonds were yielding 2% a year ago or so, you know, a lot of people said, well, they'll never get the 3%, and then when they were yielding 3%, they said they'd never get the 4%. Well, today a 10-year Treasury bond is yielding like 4.5%. It actually hit 5% during October. Now, of course, people are still saying that those rates aren't going to go any higher, and that may be true, but the point I'm trying to make is it's just a little premature to rule that out, that rates have necessarily peaked. However, I would also stress that bonds have had a massive repricing over the last three years. The lows in interest rates came right after COVID in 2020, and as I mentioned earlier, long-term Treasury bonds are already down about 50% over the last three years. Now, Rob, you know that when you see any major asset class go down 50%, as an investor, that has to grab your attention and make you at least start wondering if there's an opportunity here or at least approaching. As hard as it would have been to buy stocks when they were down by 50% in 2002 or 2009, we can look back and see that that actually would have been a great time to buy.

Absolutely. So given that, Mark, what would you say is the outlook for bonds? Of course, lots of analysts are saying we'll have a recession in 2024. So what would that do for bond prices? Yeah, you know, that recession piece is actually the part of the equation that makes me probably more optimistic than pessimistic about bonds over the next year or two. And that's because during recessions, the Fed almost always cuts interest rates, and often they cut them by quite a bit. So in the same way that we've been talking about how rate hikes cause bond values to fall, well, rate cuts cause bond values to rise. So it's hard to imagine that if we do see a recession in 2024, that bonds won't do pretty well.

So I guess I would shape it up this way, Rob. If you believe a recession is likely, then it's pretty reasonable to think bonds may outperform stocks next year or at least hold up pretty well. Now, on the other hand, if we do manage to dodge a recession, well, then the script flips back the other way, because no recession probably means we have more inflation pressure, which means potentially rates keep ticking higher and bonds have more losses ahead. And that's why I would say you don't necessarily want to run out and load up on risky long-term bonds here, thinking that interest rates just have to fall, because there's always a chance that things don't turn out the way everyone expects.

I guess I would bottom line it this way, Rob. If you've got a diversified portfolio that includes short and intermediate-term bonds, it's probably a mistake to reduce those right now, even though when you're looking at your statements, you might see that those bond funds have been flat to slightly down over the last couple years. Those bond funds, those positions are in your portfolio in the first place to cushion the stock market risk that's probably in your portfolio as well.

And the possible recession setup for next year means that there's a good chance you're going to need that cushioning from bonds, because the recession is likely to be tough on stocks and good for bonds. Yeah, very good. Man, that was a ton of information. Really helpful, Mark, and as always, very reassuring. Thanks for stopping by, my friend. Always my pleasure, Rob. Our guest has been Mark Biller, executive editor at Sound Mind Investing.

Check out that article, Duration, a simple way to gauge bond risk, at soundmindinvesting.org. We'll be right back with your calls. Stick around. My grocery bill went up 11% this year. Gas, utilities, rent, all went up.

But my paycheck, the same. I also pay for my own healthcare, a huge expense. A friend recommended Christian Healthcare Ministries as an option to insurance, and CHM helps pay for medical needs while allowing some breathing room in my budget.

Open enrollment is here, so make the switch today with potential cost savings up to 40%. Christian Healthcare Ministries at chministries.org slash faith buy. Welcome back to Faith and Finance.

I'm Rob West. The number to call is 800-525-7000. Now, before we get to your calls, I want you to know that Faith Buy is here to help guide you with practical biblical wisdom and tools. Every day, we share resources to help you steward what God has entrusted to you. From now through December 31st, we're offering the new book entitled Leverage, using temporal wealth for eternal gain with a gift of any amount. Give that gift right now by going to faithfi.com. That's faithfi.com. We're going to begin today in Syracuse, New York. Hi, Ann.

Go right ahead. Thank you. So, my question is, how can we help one of our children to pay off his student loans?

So, it's pretty high up there, six-figure. Okay. What was your intention going into it? Was the plan that your child was going to pay for it him or herself, or did you all expect to chip in along the way?

How was this set up? Well, there really was no plan. Okay. So, this is one child that has loans in her name that are six figures. Is that right, or are we talking about multiple children?

One in that child's name. Yeah. Okay. And what kind of job does she have? I mean, does she have good earning potential moving forward? Yes.

Okay. And have the payments started at this point? Well, they will start, and I believe the interest is seven to eight percent. You know, we've talked about wondering if it will ever come back to forgiveness, and talked about this person paying a monthly payment and then us matching that. But you've still got all this interest that you're actually paying the interest.

Yeah. No, you're exactly right, and unfortunately it is on the higher side now. Well, you know, I think the key here is, I mean, she has earning potential. You know, that will, because these are federal loans, if she ever, you know, has the inability to pay, there is the potential for income-based repayment if she wasn't able to afford it. Obviously, if you have a desire to help and you can financially do that, meaning, you know, it's not going to take money away from your ability to save for the future so you have what you need for retirement down the road.

I mean, she obviously has a long runway in terms of being able to repay this. I understand it's a significant sum, but at the same time, you know, retirement for you all is much closer. And so I would just take a hard look at your ability to help in a significant way and whether that's going to impact you financially over the long haul. But after you've run through that exercise, whether you do that yourself or do some planning with an advisor, then clearly if you want to bless her by being able to partner with her, I think that's great.

Ideally, we'd be able to pay this back. I usually use a 10-year target, so I love the idea of her having some part in this as you all work together over time to get it paid off. Again, if you can afford to do that, and I think a matching plan makes a lot of sense. So I would just have real clear communication so she understands what you're able to do and not do and how you want to partner with her once these payments resume to try to get this moving in the right direction and get it paid off in a reasonable period of time. And I think if that means you split the monthly payment or she sends the monthly payment, if she can do that, and then you add to it, which would lead to principal reduction and accelerate that payoff, that would be ideal. And then if there is some forgiveness down the road and you all have a conviction that allows you to take that, then so be it. But in the meantime, at least we're working toward bringing this balance down and you're doing it together so long as you can afford it. Does that make sense?

It does very much so. So I think that will be our goal. Well, thank you so much. You are welcome. And listen... We're going to do that. Okay, good. And I would say just be really clear in your communication with her so that we don't get a couple of years down the road and there's unmet expectations.

Just so I think everybody's on the same page about whose role this is and what your intention is going forward according to your ability financially. We appreciate your call today, Anne. Thanks for being on the program very much.

It's a plantation. Hi, Renee. Go ahead. I have a two-part question. My first one is I have three properties. I live in one and two are rental properties. What I've been doing is paying extra towards the principal on the two rentals.

It's only about $200 a month. I'm 62 years old. I plan on retiring maybe 65, 67.

I don't know. I'll see how I feel at 65. But I do have an emergency fund for about eight months or so. I maxed out my health savings account, 401k. So my question is, do I continue to pay towards principal, this extra $200 that I'm giving, paying towards the principal? Or should I put that towards the house that I live in? Because I don't plan on moving from that. And I don't know how long I'm going to keep the rental. Yeah, very good. What are the balances of the mortgages starting with your residence and then the two rentals?

Okay. I just bought my place. It's about two years old. The balance is about $320,000. The value is about $500,000.

The other, the rentals, I have one. The balance is $236,000 left. The value is $600,000. And the other rental is $45,000 is the balance and its value is about, I don't know, maybe almost $300,000.

Okay, very good. And are you going to be relying on this rental income to cover your bills? Let's say you did retire in three years, or is that covered through other sources?

I think the rental properties pretty much pay for themselves, so I kind of rely on them to pay for that. Will I be able to make it? Yeah, I'll be tight.

Okay. Well, you know, I think what I would probably do is if you have extra, and it sounds like you've covered all your bases with maxing out the HSA and the retirement accounts, you know, as long as you're doing the giving you want to be doing and you already got eight months worth of reserves, the only other thing you may want to look at is just do you have enough in the way of reserves for the rental properties to maintain them? Do you need to replace an air conditioner coming up, or is one of them going to need a new roof? If so, you may want to start socking that money away in a replacement fund so you've got, you know, what you need beyond your eight months emergency fund for a maintenance fund. If you didn't have that fully funded for things you know are coming up or just general maintenance, then I'd probably redirect the 200 a month there. Apart from that, I'd probably put it toward your primary residence. I know you're a long way off from paying that off, but I like the idea of you continuing to build equity a little quicker. And if you decided to sell, you know, those properties or one of them, you certainly could pay off your primary residence and cut your expenses way down.

Even if you kept one and sold one, you could do that at any point down the road. But I think my priority would be replacement and maintenance fund first for the rental properties and then your primary residence second, because we want you to own that just as soon as you can. Thanks for your call, Renee. I hope you'll make plans to join us again next time for another edition of Faith and Finance. Faith and Finance is provided by Faithfi and listeners like you.