Tuesday, May 6, 2008

For the Middle Class Investor: How to Invest in Bonds (Dinner with Frugal Bill)

A couple of weeks ago, I went to dinner with two of my brothers. We began talking about investments and Frugal Bill said he had recently taken a position in a bond mutual fund. He seemed disappointed when I was less than enthusiastic about this development, so I decided to do some research and write a post to clarify my own thoughts about the matter.

We will be roaming through the subject of bond investing in future posts, so do not expect to find all of Frugal Ben's thoughts about the matter right here.

The first thing you need to know about bond investing is that it is extremely complicated. Far more complicated than the financial press and the mutual fund companies want to admit! When these sources of information represent bond investing as relatively simple compared to investing in stocks, they are misleading you and you are correct to wonder if they do so out of ignorance or from outright desire to deceive. Either way, be careful!

There are basically five ways for the middle class investor to invest in bonds:

  1. Buy U.S. Savings Bonds at the local bank. This is a very safe investment, but a lot of trouble because you have to deal with the paper.
  2. Open a Treasury Direct account and invest in TIPS or other kinds of United States notes or bonds. This is an extremely convenient way to invest for the future with vehicles backed by the United States government. Frugal Ben says: Every middle class investor should have a Treasury Direct account which is used to make sure money needed for known future purposes will be there when it is needed. See prior post.
  3. Buy bond mutual funds. We will examine this later in more detail. Frugal Ben says: Mutual funds for bonds are very tricky. They are not nearly the conservative investments that mutual fund companies would like you to believe they are, but they are somewhat better than nothing.
  4. Buy the bonds yourself through a brokerage. Whether the bonds are corporate bonds, municipal bonds or junk bonds, this is an extremely complicated undertaking wherein you have to know a lot about inflation risks, default risks, recall risks, and all kinds of other risks. If the bond you are buying is a junk bond, all the normal risks are magnified. Buying bonds directly is something that is beyond the expertise of the average investor. Frugal Ben says: Don't do this unless you have devoted a lot of study to the matter.
  5. Invest your money in Certificates of Deposit. That's right, CD's. The kind that are offered by your local bank or savings and loan. Strange to say, few people realize that a CD is actually a bond!
In an earlier post aimed at challenging the folk wisdom which says stocks outperform bonds over the long haul, I showed information from Vanguard which indicated that bond fund investments could have been much less risky than stock fund investments over the past 10 years:

Investments of $10,000 would have grown as follows:
Total International Stock Index $20,527
Total Bond Market Index $17,546
Total Stock Market Index $15,477
Here's an update on that post.

I did some crude research on CD rates for the 10 year period roughly overlapping the same information from Vanguard. First, I looked for information about historical cd rates. That led me to a Federal Reserve webpage from which I was able to construct estimates of what an investor would have achieved if he or she had invested in 6 month certificates of deposit from 1998 to February 2008, roughly the same 10 year period covered by the Vanguard figures reported above.

An investor who used average 6-month CD's to manage $10,000 in this 10 year period would have had $15031 at the end of the 10 years. This is a very conservative estimate of the investor's results. It presupposes that the investor did not shop around for the best rates in his/her area or on the internet and it also presupposes that the investor did not take advantage of higher rates offered for longer term investments. It is quite possible that an investor who searched aggressively for good CD rates of varying durations would have done at least as well and maybe even better than the investor in Vanguard's Total Stock Market Index.

Speculation aside, what can we learn from comparing the CD investment with the others?

On the one hand, $15031 is the lowest of the results cited above. All the investments cited above beat this estimated result.

On the other hand, consider the risk factor. The $10,000 investment in CD's had absolutely no risk of a loss of principal. At any time during the 10 year period, the investor could have gotten back the entire principal plus interest except for the interest for the last 90 days before redemption. In regard to both of the stock mutual funds, the loss of principal for an investor who suddenly needed the money could have been substantial, especially in 2003. An investor who chose the Total Stock Market Index would have taken on enormous risk to principal to earn an additional $446 over the 10 year period.

Frugal Ben says:

As of May 2008, CD rates are nothing to write home about.

Nevertheless, CD's are an extremely safe, dependable, easy-to-understand investment product which frugal investors should not disdain. Using CD's in combination with stock investments can help you preserve what you accumulate. If you have future obligations which you must meet, CD's guarantee that the principal will be there when you need it.

If you have a brokerage account, you can probably buy CD's there. The process is typically very convenient. Rates will be reasonably competitive and you should get a rate exceeding the brokerage's money market rate if you want to park cash and stay out of the stock market for a few months. On top of that, paperwork is very easy.

For the best rates, shop around at your local banks to see what kind of "Manager Specials" they offer! These specials can have rates considerably higher than the normal CD rates. Also check Bankrate.com or other sources for the best rates available on the internet.

It's a pain to constantly search for better rates and roll over your money from bank to bank, especially when you are emotionally attached to an institution. Be ruthless! The end results make the effort worthwhile!

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