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More Praise for Bonds, second edition
“There’s no such thing as risk-free investing, but Bonds, second edi-tion, gives investors practical advice on ways to minimize risk while growing their assets.”
—Bill D’Alonzo, Chief Executive Offi cer of Friess Associates, manager of the Brandywine
Funds family of growth-stock mutual funds
“Over the past decade, the “truth” that investment in equities is a sound, and perhaps the surest path, to long term portfolio success has been severely tested. The Richelsons make a persuasive case for taking a path less travelled—that of investing in individual bonds. With historical examples comparing the stock and bond markets, risk-reward analyses, and exploring of the “magic” of compound-ing, the book is, at a minimum, a fascinating read that for many will be a blue-print for a revolutionary new portfolio design.”
—Victor Keen, Of Counsel, Duane Morris LLP
“Hildy and Stan have written the ‘Everything You Always Wanted to Know About Bonds But Were Afraid to Ask’ book. This book pro-vides clear and concise insights into bond investing.”
—Alan Schapire, CFP®, CPA/PFS, Principal, Libra Financial Planning
“Stocks are always risky, no matter the long-run. Bonds should always have a place in investment portfolios. Stan and Hildy have been saying this correctly for years. Bonds: The Unbeaten Path to Secure Investment Growth, now in its second edition, is one of the best in-depth reviews of wisely navigating the bond markets and how to practically implement thoughtful strategies for fi nancial advisors and advisor-clients alike. Fellow colleagues, this is a must read.”
—Michael Dubis, CFP®, President, Michael A. Dubis Financial Planning; Adjunct Lecturer, University of Wisconsin Graaskamp Center for Real Estate; past
NAPFA National Conference Chair
“Bonds still aren’t part of the nation’s fi nancial culture, years after this book’s fi rst edition and through the stock market’s ups and downs. Don’t blame the Richelsons. Better yet, leaf through their book for a detailed examination of the only investment where income is king.”
—Joe Mysak, editor of Bloomberg Brief’s daily Municipal Market
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“Bonds, Second Edition explains the reality of today’s complex world of investing. It shows how bonds can be more predictable and more profi table for somebody’s fi nancial future. The Richelsons take the facts of investing and they explain how to make it safe. What could be better than that?”
—Paul H. Frankel, Partner, Morrison & Foerster
“The Richelsons have advocated the virtue of bonds long before they became in vogue when the stock market tsunami hit every American in 2008/2009. The second edition of their book about bonds is a must read for anyone who hasn’t invested in bonds because they don’t understand them, or, who wants to understand what they already own. Stan and Hildy’s passion for bond investing is contagious.”
—Kent R. Addis, Jr., President, Addis & Hill, Inc.
“With every conceivable bond topic discussed in plain English, this book is the most useful and practical guide to bond investing. If you’re looking for the “how to” and “why” of prudent bond invest-ing, this book is for you. In thoughtful refl ection, the 2nd Edition will enhance your understanding of the 2009 credit crisis, and will help you steer clear of bond investing mistakes.”
—Jeffery B. Broadhurst, MBA, CFA, CFP, President of Broadhurst Financial Advisors, Inc.
“Finally an up-to-date practical book on fi xed income vehicles as well as strategy in using them. A must-have resource for all levels of investors as well as advisors interested in growing their assets as securely as possible. Readers will truly benefi t from Hildy and Stan Richelson’s independent thinking and experience on effectively using this major asset class.”
—Harry Scheyer, CPA/PFS, CFP, Pinnacle Financial Advisors
“A great insight on understanding bond portfolios. It is an area of investing that is often overlooked and not understood.”
—Fred Amrein, Founder & Principal, Amrein Financial
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BondsSecond Edit ion
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Since 1996, Bloomberg Press has published books for fi nancial professionals, as well as books of general interest in investing, economics, current affairs, and policy affecting investors and business people. Titles are written by well-known practitioners, BLOOMBERG NEWS® reporters and columnists, and other leading authorities and journalists. Bloomberg Press books have been translated into more than 20 languages.
For a list of available titles, please visit our web site at www.wiley.com/go/bloombergpress.
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BondsSecond Edit ion
THE UNBEATEN PATH TO SECURE INVESTMENT
GROWTH
Hildy Richelsonand
Stan Richelson
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Copyright © 2011 by Hildy Richelson and Stan Richelson. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.
TreasuryDirect® and SmartExchange® are registered trademarks of the U.S. Department of the Treasury.
For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.
Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.
Library of Congress Cataloging-in-Publication Data:
Richelson, Hildy. Bonds : the unbeaten path to secure investment growth / Hildy Richelson and Stan Richelson. —- 2nd ed. p. cm. Includes index. ISBN 978-1-118-00446-3 (hardback); 978-1-118-10654-9 (ebk.); 978-1-118-10655-6 (ebk.); 978-1-118-10656-3 (ebk.) 1. Bonds. I. Richelson, Stan. II. Title. HG4651.R528 2011 332.63'23—dc22
2011010980
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To the youngest members of our family, Maya and Emily Carpenter, and to our newest family member, Kate Williams, who have expanded the possibilities
for our future.
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ix
Contents
Foreword xxiii
Preface xxvii
Acknowledgments xxxvii
Introduction xxxix
PART I Clearing the Cobwebs 1
Chapter 1 Bonds: The Better Investment 3 Examining the Myths 5
Historical Annual Return 5
Unhappy Returns: Uncovering the True Returns
on Stock Investments 6
Taxes, Costs, and Risks of Investing in Bonds 9
Past Performance 10
Risk 14
Growth and Income 18
A Second Look at Risks and Returns 19
Stock Market Volatility: The Impact on Retirement Planning 21
Why Bonds Are a Better Investment than Stocks 23
Individual and Institutional Investors: How They Differ 24
Institutional Bond Investors 25
Key Questions to Ask about Whether You Should
Invest in Stocks rather than Bonds 27
Notes 27
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x Contents
Chapter 2 The All-Bond Portfolio 29 Advantages of the All-Bond Portfolio 30
Financial Planning 31
Designing the All-Bond Portfolio 33
Plain Vanilla Bonds 33
Plain Vanilla Exclusions 34
A Word about Other Bonds 36
High-Yield Debt 36
The All-Bond Antidote to Greed and Fear 37
Notes 38
Chapter 3 Adopting the All-Bond Portfolio: A Case Study 39 A Poor-Fitting Portfolio 39
Peter’s Financial Objectives 40
Peter’s Concerns about His Portfolio 41
A Consultation with Stan Richelson 43
A Financial Plan Aligned with Objectives 44
Step 1: Peter’s Objectives and Financial Needs 45
Step 2: Allocation Between Safe Bonds and All Other Assets 45
Step 3: Tax Review 45
Step 4: A Goal-Directed Portfolio 46
Reaching a Comfort Level 48
Note 48
PART II Bond Basics 49
Chapter 4 The Evolution of a Bond: From Verbal IOU to Electronic Entry 51
Learning the Language 51
The Early Years 52
A Colonial Debut 55
After the American Revolution 56
Entering the Twentieth Century 59
Changes in the Twentieth Century 62
A Modern Metamorphosis 64
Great Recession of 2007–2009 67
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Contents xi
Basel III—International Securities Standards 68
Derivative Regulation 70
The Internet’s Impact on Bond Buying 70
Notes 71
Chapter 5 The Life of a Bond: How it’s Created, Issued, Priced, and Traded 75
By Way of Background 76
Preparing a Bond Issue 78
Rating a Bond 81
Setting a Coupon Rate 84
Launching a Bond 85
Understanding Risk 86
A Bond’s Cost and Yield 88
Determining a Bond’s Yield 88
Current Yield 89
Simple and Compound Interest 90
Yield-to-Maturity 91
Yield-to-Call and Yield-to-Worst 92
Yield-to-Average Life 92
After-Tax Yield 93
The Call Option 93
Duration 94
Total Return 96
Cash Flow upon Death: The Estate Feature 97
Mind Mr. Market 98
Pricing a Secondary Market Bond 100
Key Questions to Ask When Purchasing a Bond 101
Notes 101
PART III Bond Categories 103
Chapter 6 U.S. Treasury Securities 105 The Big Picture 105
U.S. Treasury Notes and Bonds 108
Advantages 108
Risks 109
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xii Contents
Tax Implications 109
Pricing Information 110
Special Features and Tips 110
U.S. Treasury Bills 111
Advantages 111
Risks 111
Tax Implications 112
Pricing Information 112
STRIPS 112
Advantages 113
Risks 114
Tax Implications 114
Pricing Information 114
TIPS 114
Advantages 117
Risks 117
Tax Implications 118
Special Features and Tips 118
Key Questions to Ask about All Treasury Securities 120
Notes 120
Chapter 7 U.S. Savings Bonds 121 Simple Investments with a Few Complexities 121
Purchasing a Savings Bond 122
Series EE Savings Bonds 123
EE Bond Purchases on or after May 1, 2005 123
Special Rules for Old EE Bonds 124
Advantages 125
Risks 125
Tax Implications 125
Special Features 127
Recommendations and Tips 129
Series HH Savings Bonds 130
Advantages 130
Risks 131
Tax Implications 131
Series I Savings Bonds 131
Advantages 133
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Contents xiii
Risks 134
Tax Implications 134
Recommendations and Tips 134
Key Questions to Ask about Savings Bonds 135
Chapter 8 U.S. Agency Debt 137 Major Debt-Issuing Agencies 138
Fannie Mae and Freddie Mac 139
Federal Agricultural Mortgage Corporation 142
Federal Farm Credit Bank System 142
Federal Home Loan Bank System 142
Financing Corporation 143
Resolution Funding Corporation 143
Student Loan Marketing Association 144
Tennessee Valley Authority 144
Advantages 145
Risks 145
Tax Implications 147
Special Features and Tips 147
Key Questions to Ask about Agency Bonds 148
Notes 149
Chapter 9 U.S. Agency Mortgage-Backed Securities and Collateralized Mortgage Obligations 151
Mortgage Securities Guaranteed by the Agencies (Agency MBSs) 152
MBSs: A Complex Structure 153
The Agencies 155
Agency Mortgage-Backed Securities 157
Advantages 158
Risks 159
Tax Implications 160
Special Features and Tips 160
Key Questions to Ask about Mortgage-Backed Securities 161
Collateralized Mortgage Obligations 161
CMOs: A Closer Look 162
Advantages 164
Risks 165
Tax Implications 165
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xiv Contents
Pricing Information 166
Key Questions to Ask about CMOs 166
Chapter 10 Municipal Bonds: Overview 167 Why Buy Munis? 168
Munis: The Opaque Market 169
Default Risk Considered 172
Risks in Common Bring about Change 174
Ratings and Municipal Bond Insurance 177
Downfall of the Muni Bond Insurers 180
Phoenix Rising 182
Purchasing New Issue Municipal Bonds 182
Municipal Notes 183
Prerefunded and Escrowed Bonds 184
Advantages of Prerefunded Bonds 185
Advantages of Escrowed Bonds 185
Risks 185
Tax Implications 185
Protect Your Muni Bond Portfolio? 185
Taxes on Municipal Bonds 186
Key Questions to Ask about Muni Bonds 187
Notes 188
Chapter 11 Municipal Bonds: Types 191 Tax-Exempt or Taxable Bonds? How to Decide 191
Taxable Municipal Bonds 194
Advantages 195
Risks 195
Tax Implications 196
Special Features and Tips 196
Private Activity Bonds 196
Advantages 197
Risks 197
Tax Implications 198
Tax-Exempt Municipal Bonds 198
General Obligation Bonds 199
Revenue Bonds 202
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Contents xv
Types of Revenue Bonds 205
Checking Prices on Municipal Bonds 220
Key Questions to Ask about Types of
Municipal Bonds 222
Notes 223
Chapter 12 U.S. Corporate Bonds 225 The Big Picture 225
Ratings 225
Types of Corporate Bond Coupons 227
Taxation 228
Key Categories of Corporate Bonds 229
Advantages 230
Risks 230
Pricing Information 232
Special Features and Tips 232
Corporate Medium-Term Notes 234
Advantages 235
Risks 235
Pricing Information 236
Special Features and Tips 236
Corporate Retail Notes 236
Advantages 237
Risks 238
Pricing Information 238
Information Sources 238
Special Features and Tips 239
Step-Up Bonds, Notes, and Debentures 239
Advantages 240
Risks 240
Tax Implications 241
Special Features and Tips 241
Corporate High-Yield Junk Bonds 241
A Rose by Any Other Name 241
The Track Record 242
Brave Buyers 244
Advantages 245
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xvi Contents
Risks 246
Pricing Information 246
Special Features and Tips 247
Corporate Convertible Bonds 247
Advantages 248
Risks 248
Pricing Information 249
Special Features and Tips 249
Price-Checking Corporate Bonds 250
Key Questions to Ask about Corporate Bonds 251
Notes 252
Chapter 13 International Bond Markets: Foreign and Offshore 255
Defi nition of Terms 256
Types of International Bonds 257
Trading Blocs 260
European Bloc in the European Union 260
Emerging Market Bloc 261
Dollar-Denominated Foreign Debt 263
Foreign Bonds 265
Currency Considerations 265
Tax Implications 266
Advantages 266
Risks 267
Special Features and Tips 268
Key Questions to Ask about International Bonds 269
Notes 270
Chapter 14 Bond Look-Alikes 273 Certifi cates of Deposit 274
Ratings 274
Yields 274
Bank Certifi cates of Deposit 275
Broker-Sold Bank Certifi cates of Deposit 277
Key Questions to Ask about Certifi cates of Deposit 281
Single-Premium Immediate Fixed Annuities 281
Advantages 283
Risks 284
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Contents xvii
Tax Implications 284
Pricing Information 285
Information Sources 285
Special Features and Tips 285
Key Questions to Ask about an Immediate Fixed Annuity 287
Deferred Fixed Annuities 287
Investment Phase 287
Accumulation Phase 287
Nonfi xed Distribution Phase 288
Fixed Distribution Phase 289
Advantages 289
Risks 289
Tax Implications 290
Pricing Information 291
Special Features and Tips 291
Key Questions to Ask about a Fixed Deferred Annuity 292
Nonconvertible Fixed Rate Preferred Stock 292
Advantages 295
Risks 295
Pricing 296
Tax Implications 296
Information Sources 297
Special Features and Tips 297
Key Questions to Ask about Preferred Stock 298
Dividend-Paying Common Stock 298
Advantages 299
Risks 299
Special Features and Tips 299
Key Questions to Ask about Common Stock 300
Notes 300
PART IV Options for Purchasing Bonds 301
Chapter 15 How to Buy Individual Bonds: A Tool Kit 303 Buying Online 304
Pricing Information 305
Pricing a New Issue 308
Real-Time Prices 308
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xviii Contents
Key Questions to Ask about Buying Bonds Online 310
Choosing a Broker 310
What’s Wrong with This Ad? 310
Choosing the Right Brokerage Firm 314
Criteria to Consider 315
Establishing a Relationship 316
Using a Stockbroker 316
The Managed Account 317
Evaluating Bond Prices 319
Nature of the Marketplace 320
Wholesale versus Retail 320
New-Issue Order and Confi rmation Details 321
Key Questions at the Point of Purchase 322
Notes 324
Chapter 16 Bond Funds: The Good, the Bad, and the Worst 325
Common Ground 326
Maturity 327
Yield 327
Duration 328
Derivatives 329
Advantages 330
Disadvantages 330
Checking the Costs: Hidden and Unhidden 331
Load 331
Other Changes 332
More about Fees 335
Buying for Total Return 336
Fund Categories 337
Unit Investment Trusts (UITs) 337
Closed-End Funds 338
Exchange-Traded Bond Funds 340
Open-End Mutual Funds 342
Key Questions to Ask about Types of Bond
Funds 346
Notes 347
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Contents xix
Chapter 17 Bond Funds: A Taxing Matter 349 Money Market Mutual Funds: Taxable and
Tax-Exempt 349
Breaking the Buck 350
Municipal Bond Funds: Tax-Exempt 352
Municipal Bond Funds: High Yield
(Junk Bonds) 352
Municipal Bond Funds: National 353
Municipal Bond Funds: State Specifi c 354
Taxable Funds 354
Municipal Bond Funds: Taxable 355
Build America Bond (BAB) Funds 355
Corporate Bond Funds 355
Convertible Bond Funds 356
Corporate Bond Funds: High Yield (Junk) 356
Corporate Bond Funds: Investment Grade 357
Floating Rate Loan Participation Funds
(Bank Loan) 358
International Bond Funds 360
Index Funds 360
Inverse Bond Funds 361
Long-Short Bond Fund 361
Stable-Value Funds 361
Ultrashort Bond Funds 363
Government Bond Funds 363
GNMA Funds 364
Infl ation-Protected Securities Funds 364
Treasury Bond Funds 365
Strategic or MultiSector Bond Funds 365
Target-Date Funds: Zero-Coupon 365
Target Date Funds: Life Cycle/Asset-Allocation
Funds 366
Key Questions to Ask about Choosing a Bond Mutual
Fund or ETF 367
Notes 367
Chapter 18 Choosing a Bond Mutual Fund or ETF 369 Bond Fund Fees 370
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xx Contents
Understanding Yield 370
The Search Begins 372
Morningstar 375
Long-Term Thinking 377
Strategies for Bond Fund Buyers 377
Key Questions to Ask When Exploring Bond Fund
and ETF Search Engines 380
Notes 381
PART V Bond Investment Strategies and Richelson Investment Rules 383
Chapter 19 Financial Planning Framework for Bond Investing 387
Create Cash Flow with Bonds 388
Focus on Cash Flow Not Performance 388
Buy Cash Flow, Not Diversifi cation 389
Get Cash Flow, Not Hoped for Returns 390
Infl ation and Cash Flow 390
Cash Flow in Retirement 391
The Basics of Creating Your Financial Plan:
The Four-Step Financial Planning Process 393
Step 1. Determine Your Life Objectives and Financial Needs 394
Step 2. Divide Your Investment Portfolio into Two Categories 396
Step 3. Plan for Taxes 398
Step 4. Select Bonds to Support Your Life Objectives and
Financial Needs 401
Should You Add Risk to Your Portfolio? 406
Reevaluating Your Portfolio 409
Key Questions to Ask about Financial Planning with Bonds 410
Chapter 20 Financial Planning with Bonds: Case Studies 411 Baby Boomers Design a New Financial Plan 411
Every Family Has a Different View of What Lifestyle
Is Appropriate for Them 412
Summary of Key Takeaway Points 415
You Are Rich! Why Are You Worried? 415
Summary of Key Takeaway Points 418
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Contents xxi
Changing Course 418
Summary of Key Takeaway Points 419
Meeting a Need for Safety 420
Summary of Key Takeaway Points 420
An Unanticipated Transition 421
Summary of Key Takeaway Points 422
Ownership of Stock in a Private Company 423
Postscript 424
Summary of Key Takeaway Points 424
Stock Options Pay Off Big 424
Postscript 426
Summary of Key Takeaway Points 426
Planning for College Expenses 427
Summary of Key Takeaway Points 428
Invest a Large Amount of Cash at One Time 428
Summary of Key Takeaway Points 431
Socially Responsible Investing 432
Ill-Advised Advisers 433
Mikala’s Bond Portfolio 435
Charitable Lending and Personal Growth 437
Church Bonds 438
Mikala’s Life Plan 439
Summary of Key Takeaway Points 439
Notes 440
Chapter 21 How to Make the Most Money from Bonds 441 Knowing When to Buy and Sell 441
The Yield Curve 443
Strategies for Deciding When to Sell 447
Strategies for Finding Bargain Bonds 448
Strategies for Avoiding Overvalued Bonds 450
Strategies for When Interest Rates Are
High or Rising 451
When Interest Rates Are Rising 451
Strategies for When Interest Rates Are Low or Falling 453
Investing for the Highest After-Tax Yield 455
A Reminder about Taxes on Investments 456
Strategy for Placing Bonds in Tax-Effective Accounts 457
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xxii Contents
Strategies for Individuals in High Tax Brackets 458
Strategies for Tax-Deferred Retirement Accounts
and Individuals in Low Tax Brackets 458
Investing and Risk Tolerance 460
Practical Considerations for Assessing Risk Tolerance:
Know Yourself 460
Strategies for Reducing the Risk of Default 462
Strategies for Safe Investing 463
Strategies for Reducing Market Risk 464
Strategies for Reducing Liquidity Risk 469
Strategies for Reducing Call Risk 469
Investing for Income Needs and Financial Goals 470
Strategies for Short-Term Goals 470
Strategies for Long-Term Goals 471
Strategies for Life Events 473
Strategies for Increasing Income 473
Strategies for the Socially Responsible Investor 475
If You Are Starting Out With Less Than $25,000 to Invest 475
Obstacles to Committing to an All-Bond Portfolio 475
Notes 477
Appendix: Useful Web Sites 479
About the Authors 483
Index 485
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xxiii
Foreword
When Rob Arnott revealed in 2009 that bonds had outperformed stocks over the preceding 40 years, most people were shocked. Arnott, founder and chairman of the California money manager Research Affi liates, showed that an investor buying a constant-maturity, 20-year bond in 1968 enjoyed a higher total return than he would from an S&P 500 portfolio.
Stan and Hildy Richelson, though, were not in the least surprised. For the last 25 years, they have steadfastly advocated the all-bond portfolio, arguing, among other things, that bonds offer better risk-adjusted returns than stocks.
History proved them right.This second edition of their book contains substantial new
material, including a history of bonds, a chapter devoted to fi nan-cial planning with bonds, and numerous case studies that explain the powerful role bonds can play in your investment strategy. The Richelsons show how these concepts can be employed in their hallmark All-Bond Portfolio.
Today, many fear that the bull market in bonds has run its course, that interest rates will rise and the history of the last 40 years will reverse itself. Municipal bond mutual funds, for example, suffered record outfl ows at the end of 2010 and the fi rst quarter of 2011. Infl ation is inevitable, the herd contends, and bonds will be the victims.
There is no crystal ball through which we can see into the future. Our economy may face infl ation down the road, but the timing is highly uncertain. More likely, we will experience a period of slow growth and high unemployment—what the global bond manager PIMCO has called the “new normal”—because of continued deleveraging in the private and public sectors. Infl ation has historically correlated highly with wage growth, and without strong and consistent economic expansion that creates jobs, defl ation will be more likely than infl ation.
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xxiv Foreword
The capital markets concur with this forecast. The break-even infl ation rate over the next 30 years (the yield on fi xed-rate 30-year bonds minus that of 30-year Treasury Infl ation Protected Bonds, known as TIPS) is 2.6 percent—below the average infl ation rate of 3 percent during the last century.
Defl ation, or even moderate infl ation, will be a boon to bond investors.
As the Richelsons explain in the pages that follow, even if infl ation were to unfold, it is not the all-powerful menace that many bond investors fear. By constructing a portfolio of lad-dered fi xed-rate bonds and reinvesting coupons at progressively higher interest rates, investors can insulate themselves from adverse interest rate movements. If they have a bond ladder in place before infl ation begins, higher interest rates will be the investors’ upside case. Moreover, the yield-to-maturity calculation assumes that you will reinvest the interest payments at the same rate. Insofar as you can reinvest them at a higher rate, you will have a higher overall return.
If you truly fear infl ation, TIPS provide a near-perfect hedge. Individual TIPS bonds offer real (after-infl ation) interest income that precisely matches the government’s reported consumer price index (CPI). Only to the extent that the reported CPI does not match one’s individual infl ation profi le are TIPS an imperfect hedge.
A laddered portfolio and individual TIPS are examples of an important theme the Richelsons present in this book: The advantage of individual bonds over bond funds. Retirement portfolios are con-structed to match assets with liabilities. Those liabilities consist of living expenses, tuition payments, health care costs, planned bequests, and other items; some we can forecast, and some we can’t. Funding those liabilities with individual bonds assures investors of highly predictable cash fl ows timed to meet their obligations.
Bond funds, by contrast, typically have a constant maturity that does not adjust to an investor’s dynamic liability profi le. Moreover, fund investors must pay management expenses, which for active portfolios may comprise a large percentage of bond fund yields. Add to that the tax ineffi ciencies arising from portfolio turnover, and the Richelsons argument for individual bonds is eminently compelling.
The central question facing all retirement investors is how much money they need to retire. I am honored that the Richelsons have
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Foreword xxv
chosen to present research that I have conducted in the fi eld of safe withdrawal rates (SWRs), an area of study that offers important insight into this problem. Previously, virtually all research on SWRs used an equity-centric portfolio, relying on the hoped-for good for-tunes of the stock market to provide suffi cient returns to fund one’s retirement. The risks of this approach were made painfully clear in 2000 and 2008, as retirees with equity-centric portfolios were forced to make major lifestyle sacrifi ces in the wake of market collapses.
As the Richelsons illustrate, a safer approach is to construct a de-accumulation portfolio of high-quality bonds that include TIPS and municipal bonds, which, depending on market conditions, offers SWRs of 4 to 5 percent with far less downside risk than the equity-centric approach.
Zvi Bodie, a fi nance professor at Boston University, has encapsu-lated the essence of retirement investment in a succinct and profound statement: One’s goal should be not to burden one’s children. Spend your life giving your children the education and love they need to live independently, and don’t saddle them with the burden of taking care of you in your old age.
But that is the risk that many take in an equity-based approach to retirement investing, whether in the accumulation or de- accumulation phase. Investing is about positioning a portfolio for the appropriate risk-adjusted return. Too many retirement investors focus on return and ignore risk. Stan and Hildy’s important book will help the investment world understand that bonds should play a central role in retirement investing, and that bonds offer attractive returns with far less risk than stocks.
Here’s to the next 40 years proving as profi table for bond investors as the last 40. If they come anywhere close, this book will be your guide to a safe and comfortable retirement.
Robert Huebscher
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xxvii
Preface
The fi rst edition of Bonds: The Unbeaten Path to Secure Investment Growth (2007) took the untraditional stand that high-quality bonds are a better investment than stocks for individual investors. We supported our thesis by concluding that stocks historically didn’t outperform bonds when an individual investor’s taxes, transaction fees, expenses, and bad timing are all taken into consideration.
Furthermore, we put forth the heresy that asset allocation to multiple asset classes is not required for investment success. Instead, we proposed the wisdom and logic of the All-Bond Portfolio as the safest and surest way to investment success. We concluded that allocating your assets in the traditional way to many asset classes would actually increase your investment risk rather than decrease it, when compared to the strategy of the All-Bond Portfolio.
The wisdom and logic of the All-Bond Portfolio was certifi ed as correct by the dot-com Crash of 2000 to 2003 and, fi ve years later, by the epic Crash of 2008 that shook the investing world. In the Crash of 2008, all asset classes went down together—all, that is, except high-quality individual bonds. Stocks declined by almost 57 percent peak to trough. Looking back on the decade of 2000 to 2009, during which U.S. large company stocks returned an average of –0.95 percent,1 it is clear that bonds have been a better investment no matter how you evaluate the facts or measure performance.
The stock market roller-coaster ride from 2000 to 2009 resulted in much sound and fury but no net gain (apologies to Shakespeare). Despite this decade producing no stock market gain, there were the added indignities of taxes and fees to be paid, which further reduced performance. In addition, many investors sustained substantial losses due to trading in and out of the stock market at inappropri-ate times. Our view that the asset classes of stocks and bonds must be risk adjusted as part of every investor’s analysis was demonstrated in spades.
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xxviii Preface
In the Introduction to the fi rst edition in 2007, we made the following predictions for the future:
High-quality bonds can free investors from the fear of investing.High-quality tax exempt bonds will protect your principal and generate substantial after-tax income.High-quality bonds will provide as good or better returns than stocks without substantial volatility.High-quality bonds will provide growth through the magic of compound interest if the interest income is reinvested.
All these predictions proved to be true in the years following 2007, but to a greater extent than anyone anticipated. Those who invested in high-quality individual bonds were saved from the fear and destruction of volatile markets. High-quality individual bonds proved to be safe and continued to provide all the income they promised and growth if the interest income were reinvested in addi-tional bonds. High-quality bonds substantially outperformed stocks without substantial volatility.
A typical portfolio of high- quality individual tax-free bonds returned about 5 percent per year from 2000 to 2009. Thus, a bond portfolio of $100,000, compounding at 5 percent tax-free over a 10-year period, would be worth over $162,000 (a 62 percent appre-ciation after tax). Moreover, this 5 percent tax-free return would be equivalent to a 7.7 percent taxable return for an individual investor in the 35 percent marginal federal income tax bracket.
A Short History of the Causes of the Crash of 2008
There has been much written about the Crash of 2008 and the effects of the Great Recession that is still with us at the beginning of 2011. The Great Recession is the most serious global fi nancial crisis since the Great Depression of the 1930s. Financial bubbles and pan-ics have been with us throughout history. The most recent history of these fi nancial crises over the last 800 years has been brilliantly researched and recorded by Carmen M. Reinhart and Kenneth S. Rogoff in their book This Time Its Different, Eight Centuries of Financial Folly (Princeton University Press, 2009).
During the 20-year period that comprises the 1980s and ‘90s, declining infl ation and declining interest rates stoked a massive stock
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