178: Fixed Income for Dummies!

Buck: Welcome back to show everyone. Today my guest on Wealth Formula Podcast is Russell Wild. Russell Wild is the principal of Global Portfolios, an investment advisory firm based in Philadelphia. In addition to the fun he has with his financial calculator, Wild is also an accomplished writer who helps readers understand, and make wise choices about their money. Amongst numerous publications, Russell is the author of Investing in Bonds for Dummies, which is what caught my eye, and Investing in ETFs for Dummies, which we’ll also cover as well. Russell, welcome to Wealth Formula Podcast.

Russell: Thanks Buck. Pleasure to be here.

Buck: So give us a little bit of background on yourself, I mean obviously you do this professionally as an advisor, but also you know how did you get into writing in all this?

Russell: Well I’ve been a fee-only advisor with clients only for clients. I take no commissions. I’ve been a fee-only advisor since 2003 and before that I had spent a few decades as a writer, writing primarily about finance way back when I got an MBA in finance and I worked as a credit analyst for a large bank that’s now out of business. But I didn’t really like working in a large bank. Quit when I was 28 and got into writing and I guess after writing about finance for more than a decade or so I got to a point where I felt I knew at least as much if not more as the people I was interviewing. So I went back and got a graduate certificate in financial planning. this was 2001/2002 and I spent about six months working for another advisor and in 2003, hung out my shingle and I’ve been doing that ever since, both the writing and the financial planning

Buck: Got it. Now I know you have a background in what’s not necessarily alternative investing which is what we typically focus on here, but you wrote this book on investing in bonds for dummies and again, I’m thinking to myself that pretty much describes me when it comes to investing in bonds. So what I’d like to do is talk a little bit about bonds and the bond market. So very broadly speaking and understanding that this is an audience of very smart people, but we’ve not really necessarily been educated on this, you know the role of the bond market and equity markets, what exactly is the bond market? Let’s go with that basic.

Russell: Well let me start off by saying when you talk about alternative investments, I think of hedges, hedges to the stock market, and as far as I’m concerned, although bonds are not an alternative investment by any means they are in my mind the only really time-proven hedge to investing in stocks. We’re talking when I’m talking time, I’m talking literally thousands of years. A bond is basically an IOU, okay, you give your money to a government such as the US government, which issues Treasuries, that’s what the US government bonds or IOUs are called, or you give your money to a corporation or to a municipality and they take your money and they pay you back a fixed interest rate. What’s what bonds are alternatively called fixed income. If you buy a thousand dollar bond paying five percent you’ll get 50 dollars a year for as long as you hold that the bond, the price may go up and down but you’re gonna get 50 dollars a year regardless. And that’s really all about this. The bond market is enormous right, much larger than the stock market. Here in the United State, the world bond market is about a hundred trillion dollars. One trillion is a million million or a thousand billion. To put that in relation to the stock market of that 100 trillion the u.s. bond market is about 40 trillion. That compares to the US stock market, the value of all stocks all American stocks adds up to 30 trillion. So the bond market is very very important both to the issuers of the bonds the corporations, municipalities, government and of course to the lenders to us those of us who invest in bonds.

Buck: So let’s talk about the role of bonds in traditional investing portfolios. So presumably it is the hedge against the equities, right? I mean is that is there more to it than that?

Russell: Well I have to ask you, are we talking about the role as it is or the role as it should be?

Buck: Both.

Russell: Ok. In my mind, the role as it should be, I think bonds serve two purposes in a portfolio or should serve two purposes in a portfolio. One is this ballast. Typically when the stock market goes down people rushed to safety safe bonds we assume Treasuries are safe we assume the government is not going bankrupt safe bonds when the stock market goes down usually go up in price, in part because of simple supply and demand it’s a little more complicated than that. But there is there tends to be an inverse relationship between safe bonds such as Treasuries and the stock market. Doesn’t always work that way, usually it does. In 2008 for instance when everything went to hell, every kind of stock every stock of every nation reads everything went down in 2008 except for Treasuries. Treasuries went up. The second reason to hold bonds and a portfolio is as dry powder. So if you’re holding a portfolio let’s say a 50% stock 50% bonds and you have a crash like 2008, suddenly without touching your portfolio at all you have 25% stock, because the stock market at one point went down 50%, now stocks are presumably selling a bargain-basement prices. You want something to be able to turn into cash so you can buy the stocks. So those are the two purposes bonds should serve in a portfolio. Unfortunately when interest rates drop as low as they have and they are one pundit said the other day they’re as low as they’ve been since Sumerian times and I thought he was kidding but he was serious, maybe right on interest rates worldwide are extremely low and at times like this people get desperate for yield. So people start investing in junk bonds: high-yield otherwise known as junk bonds and those do not serve as a hedge, junk bonds tend to go up with the stock market and down with the stock market, they are not ballasts they are not dry powder and in the long run they don’t turn they don’t return nearly as much as stocks. So I rarely rarely use junk bonds in any of my portfolios.

Buck: So you know you brought up a good you brought up something I think is interesting the idea that you know the bond market and the interest rates continuing to go down, you know that that the yield on the bonds may not be quite what they were in the past. One of the things that and I recently read was the idea of you know how the often cited 4% rule, and that the 4% rule being that you know the idea being that if you know if you want to retire and you can safely take out 4% per year out of your you know your portfolio and live on it forever, but that that was based on data from another time that the data was compiled about 20 years ago so it’s missed all of what we’ve seen and certainly has missed these crazy negative interest rates and these environments. How does that affect and and maybe you don’t agree with the assessment maybe it doesn’t affect it, but how did that affect this whole 4% rule paradigm that I think a lot of people still use?

Russell: Well the 4% rule does not say you can live. The 4% rule is based on someone of average retirement age, mid-sixties living an average lifespan, maybe 20-25 years. So what the 4% rule says is if you have a diverse portfolio and you would draw 4% a year adjusted for inflation, that is you take 4% of your first year’s portfolio balance and each year you bump it up for inflation you have a good chance or a very good chance of not outliving your money if you live 20-25 years. Does the 4% rule now hold in times of very low interest rates that’s a very good question. The 4% rule has looked at time frames over history and initially it looked at what if you retired in 1929 and 1930 in 1931. From 1929 up until you say about 20 years ago the 4% rule held tight. There was never a 20-25 year period where you would have run out of money had you limited your withdrawals to 4%. With interest rates so low, I am suggesting that people in their mid sixties might want some limit their withdrawals to three and a half percent a year. I don’t think today’s low interest rates are extremely low by historical standards, yes perhaps they’re the lowest nominal interest rate since Sumerian times, however inflation is very low. Your real return on bonds right now is lower than the historical average, but not that much lower.

Buck: Got it, got it. So you know I’m particularly interested in the role of bonds as they relate to the global economy and because of that I think it’s a good idea for us to understand the market better than I think most people do. Can you give us a high level, obviously the secure size of the bond market is a big reason for that but why is it important to follow the bond market if you want to know what’s going on with the global economy?

Russell: Gosh the road you drove on to get to work today was probably built on money that your municipality raised by issuing bonds. So bonds are really the great real greaser of modern society, when governments want you to run a deficit, as almost all Western governments are these days, they give it by issuing bonds there’s no other way they could do it if they’re spending more than they’re raising in taxes. Municipalities often run with deficits they want to build the tunnel, they want to build a new street, put in train tracks, they almost always will still bonds to raise the money. Corporations the same way usually a lot cheaper in the long run for government for corporations to issue bonds than to issue stocks and give away a piece of the corporation. So corporations that have a good credit rating generally will prefer to raise cash to expand by selling bonds rather than issuing stock.

Buck: So let’s talk about for example US Treasuries and US Treasury notes are basically you know bonds the US government right you’re lending money to us go yeah they what can we look at in terms of the correlation between the price of US Treasury notes and an inflation?

Russell: Well the general thought, and empirically we have seen, when interest rates are lowered it tends to pump Prime the economy. People will tend to spend more because it’s easier to borrow. Companies will attend to it will tend to expand more and hire more because their borrowing costs are lower. So when people are spending more, inflation rises. There are many correlates between the two but I would say that that’s the main one. And conversely when interest rates rise, it tends to contract the economy and that tends to lower inflation. Right now we have very low interest rates and very low inflation because strange things start to happen when interest rates get too low and they’re getting to that point in the United States and they are beyond that point in Europe and Japan, where you mentioned negative interest rates we don’t we don’t have that now we could get to that point in Europe and Japan right now if you want to buy Treasuries, although it flux from day to day, you may have to actually pay the government to keep your money stored you’re going to get a negative rate of return. And we could talk about negative interest rates and what they mean if you wish but even in what we have now in the United States, ten-year Treasuries last I look we’re paying about 1.6 percent just keep eating them even with inflation. So funny things start to happen when interest rates get that low because the the most rapidly rising demographic growing demographic in America it’s the older look we’re gonna have way more retired people in 20 years than we do now. So these people historically my parents are very likely your parents, they had fixed pensions and any other money they needed usually came from their Treasury portfolio and they may be getting eight nine ten or twelve percent. Nowadays people be moving into retirement are very nervous because if they buy a bond portfolio they’re gonna get swat they’re going to keep even with inflation. Now and chances are for the next for quite some years to come because current yields are a good predictor of future stock market returns over the next several years. So when you get interest rates that low, retirees start to freak and they start to spend less so instead of expanding the economy, the lower interest rates can actually backfire at this point and start shrinking the economy. And I think that’s what we’re seeing now in Europe. So when you go to the extreme those lower than negative interest rates even in Japan and Europe have not felt through the economy which is one reason…

Buck: More is that part of it the reason, because it is curious to me that that has been so for the most part completely ineffective in Europe but that it’s a psychological element of the fear that comes with an economy that requires a negative interest rate?

Russell: Well there’s that too sure you know that’s what I find so fascinating about economics which is my major at college, I just love there’s so many interactions. Yes interest rates, well actually there are two interesting things here we should talk about the inverse yield curve. So right now you can get as much on cash and very short term bonds as you can and long on long term bonds and that’s all the flat or an inverse yield curve because hey today it fluxes but you can actually sometimes get more these days on short term bonds. So that reflects a certain nervousness. People are taking money and putting them in long-term boss for fear that interest meets trial may drop lower. And why do they fear that interest meets many drop lower? They are cautious about the state of the economy.

Buck: And that is the that’s the inversion curve everybody is kind of freaking out about when it happened?

Russell: Inverted Yield Curve

Buck: Yeah the inverted yield curve.

Russell: Well I don’t know people are freaking out I mean you know it’s the way that you can keep short-term bonds and earn as much as if you weren’t having wrong is if you had long-term bonds. So some people are saying well why should I have any long-term bonds because long-term bonds,they’re not as volatile stocks but they can be volatile. Well my answer to that is you want both because in frustrates may in fact go down in which case as we’ve seen over the last month bond prices will go up.

Buck: Right. When that inversion has happened it’s been predictive of recessions, typically, is that not true?

Russell: Yeah there’s a correlation there but there are many correlations and I wouldn’t by any means say that the universe yield curve is a sure sign that we’re going to have a recession by no means.

Buck: Let’s talk about a little bit you know our audience is pretty real estate focused in general and we’re concerned about mortgage rates which are you know they’re different obviously than Fed Funds rate. Mortgage rates might be better correlated with the 10-year Treasury price is that true?

Russell: They’re correlated to Treasury prices. When we talk about Treasuries we often use ten-year Treasury as a proxy for Treasuries because Treasuries are issued in weeks months two years five years up to 2030 years they’re talking about creating a longer-term Treasury so that the average is more or less 10 years so to when you talk about the Treasury rate, perforce you’re talking about the ten-year Treasury rate. Is there correlation between the ten-year Treasury rate and mortgage rates? Absolutely. Generally all interest rates tend to move up and down together, there are many reasons why there’s so much connectivity, but in a way Treasuries compete with the bonds that are issued that hold mortgages. So mortgage-backed securities are a large part of the of the total bond market. Those mortgage-backed securities compete with Treasuries when Treasuries are paying low yields, the mortgage-backed securities like the Ginnie Mae’s and Freddie Mae’s those can then sell on the market for lower interest and therefore the banks can lend you money for less because they can borrow the money for less.

Buck: So there was this recent, just popped in my head I’d be good to get your thoughts on this there’s recent event in the repo markets where you know basically there was an emergency injection of capital by the Federal Reserve. Wondering if it makes sense for you to talk a little bit about that and tell us what that was all about and you were reading about it in the newspaper and a lot of people don’t know what that is, I don’t really understand you know what if any significance there is to it. Could you address that a little bit?

Russell: Well there are two ways that the government generally can prime an economy or if inflation is running hight to slow an economy. And one is called fiscal policy that’s what you’re talking about actually well which talking to us a combination of monetary and fiscal policy. Fiscal policy refers to government spending. When the government spends money people get hired when roads are being built and tunnels are being built it boosts the economy. So when the government spends more it tends to boost the economy the government spends less it tends to slow the economy. Then there’s monetary policy and that is largely for a manipulation of interest rates government has a lot of power over. The government can either speed the economy up by lowering interest rates or slow the economy down that is slow inflation down by raising interest rates. So again things now are not working the way they should so be the government is taking so much free measures at times to keep things in balance, there’s a lot of fear of recession, we’re not in a recession and I don’t want to hear into politics that I it’s a big mistake right now for the government to continue lowering interest rates because we will wind up in a trap like Europe and there will be no place left to go and the government will stop having the tools, the ammunition will be taken away from the government to help the economy in times of real need now is not such a time.

Buck: Yeah. You know what well I noticed in addition to the bonds book, there was another book that you had written regarding ETFs and thought it’d be a good chance to ask you about this you know there was a hedge fund manager Dr. Burry who was kind of famous for that you know the big what was it the big I know everybody’s like come on you know what it is, anyway, The Big Short movie where he basically called the housing market Dr. Burry was you know sort of the star of the show there, he’s come out and talked about an ETF bubble, basically the idea these you know all these ETFs that are sort of people consider this sort of a type of passive investing just buying the market, I want to know if you would talk a little bit about you know Dr. Burray’s assessment of the ETF space and if you agree disagree.

Russell: There was a fun article and I talked to a bunch of my colleagues about it. The general consensus is there’s some small truth to what he was saying but it’s nothing that should keep people up at night, but let me back up. Exchange-traded funds, ETFs are at least they started off as basically index funds that trade like stocks on an exchange. For all intents and purposes they’re very similar to mutual index mutual funds that have existed for for a long time. Jack Bogle just died he was I think 100 years old and he was the father of index funds. So for 40 years or so we’ve had index funds. Index funds tracked indexes. So an index fund might pick up an index like the S&P 500 buy up all the stocks in the S&P 500 which is not necessarily 500 but close to it stocks, and it’s been well known for a long time that an index was originally created as a way of tracking investments. It wasn’t meant as an investment vehicle. so why would you want to invest in the S&P 500 there’s really no good reason. But the S&P 500 when you turn on CNBC when you look at the Wall Street Journal the stock market is often lists the S&P 500 it’s a very popular index and it’s been known for some time that if you invest in the S&P; 500 to a certain extent not a great extent you’re shooting yourself in the foot because companies that become part of the S&P 500, on the day they become a member of the S&P 500 their stock tends to go up a little bit . The manager of the index fund whether it’s a mutual fund or an ETF has to buy that stock as soon as it enters the S&P 500 so he’s buying it a slightly inflated price. And then the converse, if a stock goes down becomes ejected from the S&P 500 the index fund manager has to sell. And so he’s selling and usually the price goes down at that point a little bit and the stock manager has to sell. So those of us in the know are not great fans of buying ETFs or stock mutual funds that track very popular indexes. So to that extent what he’s saying is true, maybe. it depends.

Buck: If I can interrupt for a second, the idea is just to kind of put this in perspective the idea is that like effectively that if you’re saying if you’re buying an ETF an S&P 500 ETF if you’re buying into that, because these stocks sort of get lumped together, in many cases their earning your price-to-earnings ratios are maybe artificially elevated, is that fair?

Russell: To a small degree yeah. I mean entering the S&P you’re stock’s not going to double

Buck: So what is the, maybe you’re getting to this, but what’s the danger specifically that Dr. Burry is is referring to?

Russell: Well if everybody invested in SPY, the most popular S&P 500 ETF which I believe holds more assets than any other ETFs, if everybody in America suddenly bought SPY, then this effect we’re talking about would become more significant. However, there are thousands of ETFs out there, not everybody is buying SPY, a certain number of people who buy SPY are coming from S&P 500 mutual funds so there’s not going to be any any real bubble creation there. Generally I would say if you’re gonna buy an ETF and you’re afraid of a bubble they just don’t buy any ETF that’s tracking one of the most popular indexes, there are plenty of them out there. But conversely as I said earlier indexes were meant to track investments not to be investments and there are some ETFs right now where the purveyors are creating their own indexes and you want to make sure if you’re buying into a created index that it’s an index that makes sense and an index that belongs in your portfolio.

Buck: Got it. So what is, I guess just in in terms of your personal recommendations right now, how are you looking at you know the economy as it is right now, you know what are you telling your clients and you know obviously we’re we’re just gonna look for a little bit of free advice from you at this point and mostly get your perspective on where we are in the economy, what’s going on, and how you know generally speaking that that you have been guiding your client’s behavior.

Russell: Well I’d say my number one finance guru is Yogi Berra he said he said “Predictions are very hard to make especially when they involve the future,” and I refuse to do it. When you turn on CNBC, when you look at any financial magazine, money magazine you name it, most of the pages are devoted to trying to predict the future. And you know it doesn’t work any better in stocks, it doesn’t work any better in bonds, than it does in trying to predict you name it the weather a year from now, it really doesn’t and this has been very well studied. So I always recommend that my clients build very diversified portfolios with many stocks in many industries in many countries and a diversified portfolio of bonds with long term short term bonds of different countries and Treasuries corporates and municipals. With that being said, right now, the outlook on bonds, I’m gonna correct what I said. Bonds, unlike stocks there is some predictability. And that is you look at the current yield which I said is about Treasuries that’s probably gonna be your girl return on bonds over the next five six years. Because if interest rates go up, bond prices drop, interest rates go down, bond prices go up. So you know you’re you’re probably gonna break even with inflation on your bond portfolio in the near intermediate future. And therefore a lot of people as we talked about are buying junk bonds trying to get higher yield, I think that’s a mistake, or they’re going more into stocks than they should and I think that’s a big mistake. Stocks have always been risky, they always will be risky, and retirees just have to or people who want to sleep well at night, you just gotta bite the bullet and you got to deal with these low interest rates, perhaps you need to spend less, perhaps you need to extend your retirement a few months. Don’t shoot me I’m just a messenger, but i think going into stocks especially for people at the cusp of retirement are just starting retirement is not a good idea.

Buck: Got it. So tell us a little bit more about your practice and how people can get a hold of you if they’re interested. I’m here at beautiful Philadelphia. My firm name is Global Portfolios. My website is Globalportfolios.net and I am again strictly fee-only. I take no Commission’s. I work directly with clients and only for clients. I am a fiduciary, that’s the way I’ve always run my business and always well.

Buck: Russell thanks so much for being on Wealth Formula Podcast.

Russell: It was a pleasure, thank you.

Buck: We’ll be right back.