Understanding Bonds for Retirement: Basics, Market Insights, and How Brokers Get Paid

Bond investing or fixed-income investing tends to be one of the most misunderstood aspects of the financial industry. They’re definitely one of the most misunderstood financial tools. In today’s video, we’re going to start with the basics, then we’re going to go a little bit deeper. We’re even going to give you some inside baseball here and make sure you understand how brokers get paid and the difference between investment advisors and brokers. The goal is to help you have a much deeper understanding of the bond market in totality, but also help you make better decisions for your retirement.

Bond Basics: Types, Markets, and Discounts

We’re starting with the basics here. A bond is nothing more than a note. As you can see here, we have an individual that loans money to either a government or a corporation, and in exchange, they receive a bond. This is essentially a note. It’s a note for a certain amount of debt that was invested. Bonds typically issue at $1,000. They have an interest rate and they have a specified number of years. Could be 2%, 3%, 6%. Could be one year, two years, 10 years, 20, 30 years. This is what a bond is, nothing more than someone loaning their money to a government or a corporation, in exchange receiving a note or a bond that has an interest rate, a par value, this $1,000, this is called your par value, and then a number of years before it matures.

Once this bond matures, the $1,000 that was originally loaned is paid back as long as the government or the corporation is financially solvent. That was called the primary market, but when you invest in bonds or when you buy bonds from your broker or online yourself, you’re typically investing in what’s known as the secondary market. Once bonds are issued and that original note is provided, then they trade on a daily basis. Bond values fluctuate every single day based on economic circumstances, corporate profitability, supply and demand. This is the secondary market, and we have two types of bonds here in the secondary market.

We have discount bonds that are selling at a discount to the original $1,000 issue price, or premium bonds that sell at a premium to the original $1,000 issue price. Working off our example from the primary issue, let’s say that bond now has been in the secondary market for two years, someone decides to sell it. The price could have went down from $1,000 to $900, but the interest rate never changes. As time progresses, of course, the amount of time left goes down, the value changes every single day. The interest rate, whereas at issue it was 4% of $1,000 per bond, which is $40, and that’s typically paid semi-annually, so twice a year.

If you buy this for $900, that 4% yield, now you take the $40, you divide it by $900. Effectively, you’re earning 4.4% on this bond that is only paying 4%. That’s because you buy it at a discount. Conversely, if a bond goes up in value, and it’s a premium bond now, it still pays the 4% based off the original issue price of $1,000. $40 divided by your purchase price, now effectively you’re earning 3.64%. In both of these instances, if you hold it for the eight years, the bond matures and you will receive $1,000 back.

Here, you’ll also have a capital gain because you purchased it at $900, but here you’ll have a loss because you purchased it at $1,100. That needs to be taken into consideration as well. This is what’s known as the Yield to Maturity when you buy it at a discount or a premium, and also taking into consideration the time and the interest rate that you’re earning. Now, I want to cover the two types of bonds that are primarily issued, government bonds and corporate bonds. Government bonds can either be from the federal government, known as treasuries, if they’re short-term, they’re known as T-bills or municipal bonds. Municipal bonds are issued from cities and states.

Bonds from a Retirement Planning Perspective

From a retirement planning perspective here, it’s important to understand that government bonds, federal government bonds, treasuries, are taxable when they pay interest. Now, of course, if you have it inside your retirement account, then that tax is deferred, but treasuries, T-bills, that’s taxable interest. Municipal bonds, they pay tax-free interest. There’s a caveat here. If you live in a state with an income tax and you buy a municipal bond from out of state, it is possible that your state will still subject that municipal bond to the state income tax. I recommend you talk with your tax advisor, but if you buy municipal bonds from the state you live in, typically they are going to be 100% income tax-free. Now, municipal bonds, we have two general types. We have what are known as General Obligation Bonds, and then also Revenue Bonds. General obligation bonds are when a city issues a bond to raise capital for some project and your repayment is based solely on the city’s financial solvency. It’s a general obligation on the balance sheet of that municipality. Revenue bonds are issued, for example, when a city or a state wants to, let’s say, build a stadium, like a sports stadium. They’ll issue the bonds to raise cash to fund the construction of that stadium and then the sales or receipts from that project itself are the revenue that’s used to pay the interest on that debt and also to repay the principal when the bond matures.

Now, a big financial planning mistake that we often see is that when people purchase municipal bonds, just because they’re income tax-free. That doesn’t mean that they do not increase your modified adjusted gross income. Your modified adjusted gross income is a calculation that adds back in your tax-free income from municipal bonds to determine multiple different things throughout the tax code. Primarily for you in retirement or approaching retirement, that’s going to be how much of your social security is subject to taxation, Medicare premiums, if you’ll pay an excise tax on your Medicare premiums, and also your investment income.

All of those are essentially means tested based on how much income that you have. Municipal bonds will be federally income tax-free, but the amount of income you generate from those municipal bonds will be added back into the calculable amount to determine if your social security is subject to more income tax, your Medicare premiums, and also your investment income.

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Roth IRA Advantages: Tax-Free Income and Strategic Planning

Now, here’s the cool planning thing. For those of you who follow a lot of these videos, we talk about Roth IRAs. We talk about Roth conversions. We talk a lot about the planning aspect of getting money out of that tax-infested retirement account for a multitude of reasons. Roth IRA distributions, one, they’re always income tax-free as long as you satisfy the five-year rule. Your treasuries inside your Roth IRA, of course, 100% tax-free. Really no reason to put municipal bonds inside of a Roth IRA.

I guess you could, because here’s the point, when you distribute from a Roth IRA, that tax-free income does not add back into your modified adjusted gross income. That’s the only source of tax-free income where you can make a distribution or receive income from that Roth IRA and it does not increase at all the potential for you to pay more taxes on your social security, Medicare premiums, or investment income. A huge advantage for the Roth IRA when we’re talking about generating tax-free income versus municipal bonds.

Corporate Bonds: Credit Ratings, Risks, and Returns

Now on to corporate bonds. Corporate bonds typically are considered more risky than government bonds. They’re usually going to pay a higher rate of interest. There’s credit quality concerns that you have to be aware of, because just as consumers have credit scores, essentially corporations also have credit scores. As a matter of fact, the United States government and all governments also have a credit score. When we look at– This is the Standard & Poor’s rating system.

A couple of things here, first, ratings are nothing more than opinions of those respective agencies. It’s important that you do your own due diligence as an individual. When we talk about credit quality, this just means how financially stable is that particular corporation, what’s its outlook, and based on those factors, these agencies give their opinion, whether they’re AAA, AA, single A, or BBB. These ratings are all known as Investment-grade Bonds. Once you get below there, this is where the term Junk Bonds comes into play. BB, B, CCC, CC, single C, and D, these are junk bonds, otherwise also known as High-yield Bonds.

As you go down the credit quality spectrum, interest rates are typically going to get higher and higher because you’re taking on more risk. Now if you buy one of these bonds on the lower end of the credit quality spectrum that pays a higher level of interest, you are assuming the risk that corporation may not be in business to repay you either the interest while you’re holding the bond or your principal upon maturity.

How Interest Rates Impact the Value of Short, Intermediate, and Long-Term Bonds

Now, I want to transition to short-term, intermediate-term, and long-term bonds and discuss how interest rates impact the prices of the various bonds that you have to choose from. Short-term is generally considered less than five years. Intermediate-term, seven to ten years. Long-term, 10+ years. These are just general ranges here. I don’t have a six-year number on here, but I would consider that probably intermediate-term.

It’s important to understand that as interest rates go up, the value of your bonds typically goes down, but short-term bonds will be less impacted than intermediate or long-term bonds. These are going to lose value a lot more, as I’m going to show you in just a few minutes, when interest rates rise, than your short-term bonds.

Additionally, when interest rates drop, theoretically, long-term bonds and intermediate-term bonds should go up in value more than your short-term bonds. Now, I know what a lot of you are thinking, “Troy, interest rates are probably going down, why don’t I just go buy a bunch of long-term bonds?” The simple answer there is you’re not being compensated currently for the risk of owning long-term bonds, because when you lock yourself into a long-term bond, you have to plan on holding that for 10, 20, 30 years.

If interest rates stay where they are or go up for a little bit, you could see some massive declines in value to your portfolio. Just because the Federal Reserve is raising rates, that’s more directly tied to short-term bonds and government bonds. It doesn’t necessarily translate immediately into the long-term bond market. The market is more responsible for controlling what long-term rates are, more so than the Federal Reserve.

Real World Examples

Disclaimer: These securities are used for demonstration purposes only and do not constitute purchase or allocation recommendation.

Now, I want to give you some real-world examples. We’re going to look at corporate and government bonds in the short-term, intermediate-term, and also long-term range, and see how they’ve performed over the past five years, and also look at their current interest rates. In order to do this, we’re going to look at Vanguard short-term bonds. Here’s the short-term corporate bond fund. Then, we’re going to look at intermediate and long-term, and then we’re going to look at the iShares version of government treasuries.

I have this on the five-year chart, short-term bonds over the past five years have declined in value 3.43%. This is this specific ETF. Now, when we look at the intermediate term, we see they’ve lost 11% of their value over the past five years, and the long-term has lost 23% of its value over the past five years. If you invested $100,000, your principal would be down 23% investing in longer-term corporate bonds. Because interest rates have gone up over the past five years, the value of that corporate bond ETF has come down.

Now when we look at the interest rates being paid on these, the current yield is 4.95% for the long-term corporate bond fund. If we go back here, 4.22% for the intermediate-term corporate bond. The short-term corporate bond is 3.75%. The question is, if the long-term is paying 4.95%, the short-term is paying 3.75%, are you really being rewarded for taking that extra risk of investing, instead of over one, two, three, four years, of potentially holding that bond fund for 30 years? It’s only about a 1% difference there.

The contrast we’ll see in the government bond market, it’s much closer. There’s not as big of a difference in the yield. The yield curve is actually what we call inverted, and I’ll show you what that means. The question is, are you being compensated for taking the risk of potentially losing a lot more principal in the short term if interest rates don’t go in the direction that you’re assuming?

Here, we have the iShares short-term bond ETF. Over the past five years, it’s only lost -0.19%. If we look at the interest rate, right now it’s paying 5.14%. We look at the intermediate term here over the past five years, this is a government bond ETF from iShares, lost 16% of its value, yield 3.42%. Hold on a second. If this is a longer-term bond, shouldn’t we be earning more interest for taking more risk in terms of the duration or how long it takes us to get our money back?

Normally, yes, you should, but right now, the yield curve is inverted. Again, we’re going to go through what that means in simple terms in a minute. First, let’s look at the long-term bond here. This is the 20-year TLT, and we have a yield of 3.95%. More importantly, it’s lost almost 35% of its value over the last five years. The point I’m trying to make here is, when we go out longer in time frame, we take more risk because they’re more interest-rate sensitive.

Current Yield Curve

 

Here’s a good chart that shows you what the current yield curve is. First, we’re going to show it in numbers, and then we’ll draw the chart. Right now, you can buy a one-month treasury bond, or T-bill is what it’s called, and earn 4.567% annualized interest. Now, you’d have to buy them 12 different times for 12 months to earn the 4.567%. We see here the one-year yield is 4.366%. We come down here for the 30-year, only 4.596%. Between the one-year and the 30-year, you’re only being compensated 0.02% more roughly to hold something for 30 years and take on a tremendous amount of more risk. You’re not being rewarded for that incremental increase to the interest rate. Just a little bit longer on this yield curve, because if you watch any of the finance show or any of the pundits, you’ll hear them talk about the yield curve. You’ll also hear them talk about it being inverted. A lot of times, it may sound like gobbledygook to you. I just went through what it looks like as far as the actual interest rates that are being paid over various time frames, but I want you to visually see it as well.

In a normal, healthy environment, from an interest rate and inflation standpoint, and also economic growth standpoint, as we see down here, we have time frames. Over here, we have interest rates. A normal, healthy yield curve should look something like that. As you increase the length of time that you are required to hold that bond before it matures, you should be rewarded higher and higher interest rates. When they talk about the yield curve being inverted, this is what it looks like. It’s going the opposite direction.

We’re actually being paid more interest for shorter time frames than what a normal, healthy market would look like.

Understanding Bond Pricing: Bids, Asks, Spreads, and Hidden Commissions

I want to talk now about bond pricing, bond spreads, and also commissions, how your broker gets paid, or how the brokerage firm that is selling bonds gets paid. What we have here, if you do this yourself and you’re buying and selling bonds, when you open up the trading platform, any of the online discount brokerages, you’re going to see a bid and you’re going to see an ask.

Now, the bid is what somebody is offering to buy that bond that is trading currently on this secondary market. The ask is what somebody is asking that already owns that bond but wants to sell it. The difference between these two is the spread. Now, let’s say this is what the true market is out there, meaning this is your highest bid from a non-institution, and then usually these are going to be institutions that they’re asking. When you open up your platform, if you’re buying or selling these yourself, even though that may be the true spread, you may see a much smaller spread here.

You may see it at $958 and $960. What’s going on here is this extra $8, that’s a commission. If you wanted to buy this bond, let’s say it’s paying 5% and you can buy it at $958, you buy it at $958. The brokerage firm typically may already own it and they have it at $950, or they have access to different exchanges and they can go buy it at $950. They list it on their website for $958, so they pocket that $8 commission. This also happens when you deal with your broker.

The bond market is very opaque, and most people simply don’t understand the bond market. Your broker may come to you and say, “Hey, I have–” You want to buy $250,000 worth of bonds, 250 of these, because each bond issues at $1,000. Your broker may come to you and say, “Hey, we have this opportunity. It’s trading at $958. You’re going to make 5% interest, plus if it goes up in value, you can have a capital gain or when it matures, if we hold it that long, you’ll get $1,000 back per each bond.”

Really, they’re able, again, to go buy it at $950. They have access to this different market exchange where they see, “Hey, I can go buy this thing for $950, call my client, sell it to them for $958, and then–” From my experience of working with thousands of clients over the years, many of them come to us from other firms, especially brokerage firms, consumers aren’t simply aware of how bond commissions work and the difference between what the real market is and the market that oftentimes is quoted to you.

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Transparency in Bond Transactions: Understanding Fees, Roles, and Consumer Protections

Very important that you understand that this is the spread and a lot of times, or most of the time, I should say, the true price that you’re paying is actually more, sometimes significantly more, than what the fair market value of that bond actually is. I want to be clear here. I’m not saying that commissions are bad. Sometimes commissions could be more advantageous to the consumer. What I am saying is that the opaqueness that people operate within the bond industry as it relates to transparency with the consumer and what they’re actually paying for it, it’s something that needs to change. It’s been going on for forever.

In my experience, I’ve never met a consumer that understood this and this level of compensation was disclosed to them. I want to talk now a little bit about an investment advisor, like us here at Oak Harvest Investment Services, versus a broker, versus someone who wears both hats. Investment advisors, we’re fiduciaries. We do not make commissions on investments. We don’t make commissions on stocks. We don’t make commissions on bonds.

We charge a management fee for the overall assets that we’re managing. Brokers typically make commissions, but they can also charge a management fee. What you’ll see a lot of times, especially at the big banks and brokerage firms, is they’ll have an investment advisor license. They’ll have a broker license. When they’re making these recommendations to you, they’re technically wearing both hats. You as the consumer don’t know a lot of times what you’re actually paying whenever these bond purchases are made on your behalf. What you should do, and you should always do this in writing, is you simply ask, “Are you a broker or are you an investment advisor or are you both? Do you make a commission for buying or selling these bonds? Are you also charging me a management fee? What’s the spread? What is your commission? What is the total compensation for making this purchase for me?”

I recommend you always do this in writing and then you require the responses to be in writing as well. This is the best way that I found to keep your advisor or broker operating in a very transparent manner. This is best for you. This is best for the industry and it’s the right thing to do. Okay. This was a pretty detailed and in-depth explanation of bonds. I hope you’ve learned more. I hope you understand better. Let me know what you think in the comments. If you have questions, jot them down. If you have comments, if you buy individual bonds, if you just buy bond funds, let me know what you think and we look forward to seeing you on the next video.

 

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