Suze Orman says no bond funds

[clifp]

4 things Suze doesn't tell you about Muni bonds

The more I think about her advice the more awful it sounds. Here is my experience with muni bonds.

I started buying individual bonds about 1997, when income+stock option was pushing me into the top bracket (39.6%) some years . The California rate was I believe 9.3% so the combined marginal rate was just under 50%. I first bought CA muni fund, then individual CA bonds, eventually when I moved to Hawaii I bought some Puerto Rico (tax exempt all states) and finally bought some Hawaii muni bonds in 2000.

My primary retirement analysis was hey I can take $2 million buy muni bonds that yield 5% that gives me $100K a year to live which is plenty. Plus I have my IRAs to help me keep up with inflation. I kinda of wonder if a similar mindset isn't why Suze is recommending them.

So here are the 4 things that Suze doesn't say about Muni bonds.

#1 Muni bonds got called, a lot. Of the 8 or so individual issue I bought everyone has been partially or total called before maturity. When bond gets called you are then left with having to find an income replacement in lower interest rate environment. Now of course bonds get called when interest rates go down (muni bonds unlike corporate are typically called par instead of a premium). But Muni bonds will get called even if interest rates stay flat.

Imagine you buy a fairly low rated 10 year with a coupon of 3%. Fast forward to 2018 and say interest rates are the same as they are today. You no longer have a 10 year bond you have a 5 year bond. But 5 year muni rates are only 1%. So the City, or state will call the bond and reissue it as a 5 year and save the state 2% a year.

The only environment were Muni bonds work out some what well is where interest rates raise slowly.

#2 Bonds are illiquid which means high commission. If you buy $10,000 worth of stock you pay maybe $10 for commission plus a spread of about $.01 or $.02 cent or <$20 total. For a muni bonds if you are lucky to the commission plus spread will run $100 and $200 is not uncommon. Not a big deal if you buy 10 to 30 year bonds and hold them to maturity but it adds up if of they get called every 3 to 5 years..

Now #1, #2 have always been true but I didn't know when I started buying the bonds these next two are because the muni bond market changed after the crisis.

#3 Muni bond insurance is pretty much worthless. One of the side effects of the 2008 crisis is that pretty much all of the muni bond insurers, also wrote insurance policy on the junk mortgage bonds. Lawsuits and paying of claims for things like credit default swaps has severely weakened the financial situation of most muni bond insurances. If a large city goes broke I wouldn't count get a lot of money from the insurers they just don't have it.

#4 Many local and state finances are in mess and it is virtually impossible for the average investor to really understand what is going on. Historically rating agencies have been too hard on muni bonds. A medium rated A- muni bond has historically been much safer than an A- rated corporate bond. I am not sure this is going be true in the future.

The net effect of #3, and #4 is that individual investor has to be much more sophisticated than in the past. 10-15 years ago there wasn't much risk buying individuals muni, they didn't default and if they did the insurance company would pay you. So all I worried about was interest rates and maturities. This has all changed.

One example in 1999 about $50,000 worth of Puerto Rico general obligations with coupon rate of 5.5% (not exceptional at the time.) and they were insured. A while ago I mentioned the forum on own some and Brewer said you should be really careful with this bond PR finances are in mess. Now I pay attention when Brewer says stuff like this, but because $35,000 of the $50,000 were already called leaving me with a small $15,000 position I put off doing something about. A month ago I awake to article in the WSJ about the horrible pension and budget problems of Puerto Rico. Now the bonds are trading at $.90, but since the mature in 3 years, I will probably just tough it out. But if was a bigger position it would cause some sleepless night. Now mind you this is a bond that has been dutifully paying 5.5% interest for almost 14 years.. My grandfather held muni bonds for decade and he never had worry about them, that is no longer and option.

TL; DR if you are in a high tax bracket a muni fund may makes sense. But buying individual muni bonds the hassle/risk isn't worth it.

 

[perrytime]

I guess I take things too literally, when some says don't buy bond funds, with no further expination, I take it they mean something like TEGBX, very stable, or any fund with the word bond in it.

 

[HFWR]

Probably coincidence, but the when looking at the FIRE and Money sub-forum, directly after the Suze topic was "Stupid things finance people say"...

 

[2B]

Suze argues that bond funds lose value because they have no defined maturity date, whereas individual bonds can be held until maturity and then give you the principal back in full. This is an overly simplistic argument.

Not really. I don't want to be noted as a Suze fan since I generally think most of her advice is too generalized.

If I buy a bond for $100.00 that pays 5% interest for 20 years, and interest rates go up, I will have to sell the bond at a discount to liquidate it. The bond will only hold its value if I keep it for 20 years. However, doing so means I will be accepting a lower return than what current bonds are paying, and doing so for 20 years will cost me a substantial amount of lost opportunity to earn a higher yield. I believe Suze focuses on the psychological aspect here that as long as you hold the bond for 20 years it will always return your $100.00, where the bond funds can lose money each day, thus resulting in a lower net asset value. In reality, the individual bond is losing money every day too in an environment where interest rates are rising. You are just not paying attention to it because it's not as easy to determine the current market value of an individual bond as it is a bond fund, which has an ending value each day the market is open.

I buy CDs and have them laddered. My original ladder had 5 yr maturities but 2008 caused me to swing to a 2 yr ladder. The manipulated low interest rates have gone on far longer than I thought possible but I still see no reason to go out further on the yield curve for pennies.

I used to have a bond fund but learned a lesson back in the 1970's when LT bond yields went from around 6-8% to over 15%. I got absolutely destroyed in my NAV. Until yields fell, this was a permanent loss in principle. A $100 investment that had been returning $7/yr was still returning $7 but I would only be able to sell it for ~$50. Yes, dividends were reinvested at the higher rates.

Let's assume I have $100,000 in a 20 yr bond/CD ladder originally purchased with an interest rate of 3%. If you have a bond fund with a 20 yr maturity purchased with an interest rate of 3%, we would typically get the same $3,000 in return. To make life simple, let's spend our interest so as to not complicate this with reinvestment.

Interest rates rise suddenly to a little over 8%, that would effectively reduce the bond fund value to ~$50,000. If you owned the individual bonds, the full $100,000 would be recovered after 20 yrs but the bond fund typically maintains its maturity by selling 18 yr bonds and buying 22 yr bonds. This maintains the NAV pretty close to the same level over the following 20 yr (and longer) period unless interest rates change. Interest continues to come in at $3,000/yr for infinity if you live that long.

My bond/CD ladder has a similar drop in value although not as much since the maturities are staggered but that is now irrelevant since no selling is contemplated. It still generates $3,000/yr in interest. The difference is that every year $5,000 in bonds mature at par, this is then reinvested at ~8% which increases the interest income by $250/yr. After 20 years, the ladder has regained its orginal value of $100,000 and is now generating ~$8,000/yr income.

For small sums I think that bond funds are fine especially if the investor is continuously adding to the fund as the overall portfolio grows. As one is nearing FIRE with substantial bond fund holdings, I think the fund represents an unnecessary risk.

 

[derekc]

Suze would be right about not buying bond funds if she meant long term bond funds ( i doubt too many would disagree) but short term bond funds rarely stay down for long. Intermediate term bond funds ( or total bond funds) nearly always have returns better than short term bond funds within 3-5 years. So for any money you may need to withdraw within say 3-5 years :that money is probably best in short term bond funds, but money you will not need for more than that amount of time probably should be in intermediate or total bond funds. Yes , they may go down as they have this year again next year: as inflation rises/ yields rise, but this should be only for a relatively short time. Hang on to them and in 3-5 years they almost certainly will be worth more than if you had all your bond in short term funds