Easy Income Strategy – Bonds and Bond Funds

Lots of Bonds to Pick From

If you buy a bond, you are loaning money to someone. “A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer.” – Investopedia

Generally speaking, it is not prudent for most investors to buy individual bonds. However, there are many different ETFs that contain bonds. There are Treasury Bond ETFs (SCHO, PLW), Corporate Bond ETFs (AGG, LKOR, SPLB), Junk Bond ETFs (JNK, HYG), International Bond ETFs (BNDX, IYH), Floating Rate Bond ETFs (FLTR), Convertible Bond ETFs (ICVT), and Leveraged Bond ETFs (TMF).

Four Cautions Regarding Bonds

The cautions are inflation, value, income, and expenses. Investors buy bonds because they are “safe” and “reduce risk.” That is utter nonsense.

1) If annual inflation is 3% and the ten-year return of a bond or bond fund is 1-2% you are losing money. Your purchasing power is dropping. 2) Secondly, bonds can become worthless. That is right. A bond that costs $1,000 can become worth zero dollars. This is especially true of junk bonds, corporate bonds (remember General Motors?), and international bonds. 3) Bonds tend to pay the same amount month-after-month. There is generally little hope that your bond will be paying you more five or ten years from now. 4) Finally, to add insult to injury, you are paying the fund manager an expense ratio to help you underperform the market and lose money in the long run.

EIS Investment Number Ten

This is the tenth in the series. My goal is to present arguments in favor of a simplified and uncomplicated way to have income before and in retirement that grows even if we do nothing.

The format of this post will be different. I want to present a story in pictures to help you realize that having 40% or 60% of your investment assets in bonds or bond funds is a very questionable practice.

Comparing Two Bond Closed End Funds

A participant in the Fidelity Investor Community asked a question about two bond funds. The ticker symbols of the funds were DHY and CIK. I recommended that the investor sell those funds. Here is a comparison of the two. But you ask, “Aren’t there better bond funds?” Yes, there are. So you ask, “which ones are good ones and how many can I pick from?” Let’s use Fidelity’s tool to find them.

Fidelity Find Bonds

If I specify that I want funds with Five Stars (Morningstar), with at least average returns and low expenses, I find that there are two funds out of 2,839 that fit the bill if I don’t want to pay a transaction fee. (Don’t pay transaction fees for ETFs!)

Comparing Ten-Year Bond Returns

If you look at the major bond indices you will discover that they have underperformed inflation in one-year, three-year, five-year, and ten-year returns. It is time to ask yourself: “Do I understand percentages? Do I understand the Rule of 72?” If you do, then run away from bonds.

The Alternative Is…

“But Wayne, I need income in retirement. Where can I get growing income?” Take a look at the income we have received over the past five years from dividend growth stocks and ETFs. Not only was the income growing (which bonds would not do), but the value of the assets has increased over the last five years. The value of bonds has decreased. So ask yourself one more question: “Are bonds really safe?”

Full Disclosure

Cindie and I own stocks and stock ETFs. We don’t own bonds.