Bonds

The Unbeaten Path to Secure Investment Growth

Hildy Richelson, Stan Richelson

• Publisher: Bloomberg Press
• Year: 2011
• Print ISBN: 9781118004463
• eBook ISBN: 9781118106549
• Edition: 2
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Updated edition of the established classic on investing in bonds

In Bonds: The Unbeaten Path to Secure Investment Growth, Second Edition, the fully revised and updated edition of the classic guide to demystifying the bonds market, veteran investor husband and wife team Hildy and Stan Richelson expose the myth of stocks' superior investment returns and propose an all-bond portfolio as a sure-footed strategy that will ensure positive returns. Designed to educate novice and sophisticated investors alike, as well as to serve as a tool for financial advisers, the book explains why and when bonds can be the right choice. Case studies, detailed bond strategies, and a financial planning overview bring home the value of bonds in achieving financial goals.

Presenting a broad spectrum of bond-investment options, and describing how to purchase bonds at the best prices, the book shows how to make real money by investing in bonds. The strategies presented here are designed to help the reader determine how to use bonds to take control of their own financial destiny.

• New edition includes information on corporate bonds, emerging market bonds, municipal bonds, the new global ratings, and how to protect against municipal defaults
• Looks at how bond portfolios protected against market volatility in the 2007-2008 crash and how they can do the same in the future
• Includes information on how the bond market has changed
• The wealthiest investors and financial advisers use the bond strategies outlined in this book to maximize the return on their portfolios while providing security of principal

With more bond options available than ever before, Bonds continues to be a must-have for anyone looking to understand the investment opportunities available to them.

PART I

CLEARING THE COBWEBS

The main purpose of this book is to debunk the many myths surrounding investing in stocks and bonds and to provide new thinking for you to consider when developing and carrying out your financial plan. In Part I, we take you on an unusual journey and encourage you to look at the financial world through our eyes and examine the proposition that, for individual investors, individual bonds are a better investment than stocks or any other asset class.

In Chapter 1, we compare stocks and bonds and describe the powerful case for investing in bonds. When we refer to “bonds,” we only mean individual bonds and not bond funds. Bond funds are quasi-equities because they do not have a due date. Our case for bonds has always existed. However, it has been made more persuasive by the dot-com crash of 2000 to 2002, the crash of 2008, and the Great Recession beginning in 2009. If you find that bonds make sense for you, we describe in Chapter 2 how to carry out the strategy of the All-Bond Portfolio, including the specific kinds of bonds to buy (we call them plain vanilla bonds). Plain vanilla bonds are high-quality individual bonds, easy to buy and sell at low or no cost, and easy to understand. In Chapter 3, we provide a case study illustrating why and how a family used the All-Bond Portfolio to support their life objectives and their financial goals using our four-step financial planning procedure.

Come with us as we look at the financial world in an unbiased way, challenge the traditional thinking found in articles and books on investing, and offer strong evidence to support our belief in bond investments. Financial plans based on the traditional thinking that emphasizes stock investing have not worked out well for many individual investors. They have taken substantial risks with their nest eggs and endured severe and upsetting market declines and financial uncertainty. Indeed, many individuals lost their retirement savings. We believe that the All-Bond Portfolio is a better way to plan and secure your financial future. This book will show you how to build one. We hope that this book will change the way you view the world of investing.

CHAPTER 1

Bonds

THE BETTER INVESTMENT

Watching your stocks all day long is amusing up to a point, but income is the thing if you’re shopping for anything from pajamas to pastrami sandwiches.

—Joe Mysak, Bloomberg columnist

For generations, stocks have gotten top billing over bonds. Stocks, many insist, have outperformed bonds in the past, will outperform bonds in the future, and are not risky if held for 10 years or more. We believe these assertions are myths. In fact, this thinking is now being called into question by sophisticated market players such as Citigroup. Citigroup Global Markets published an article dated September 1, 2010, entitled “The End of a Cult.”1 The article points out that from 1950 to 1999 global pension funds and individual investors substantially increased their asset allocation to stocks and substantially decreased their asset allocation to bonds. “Back in 1952, U.S. private sector pension funds held just 17 percent of their assets in equities compared to 67 percent in fixed interest. Over the next 50 years, these weightings reversed.”2 Japanese pension funds in 1998 held 55 percent of their portfolios in equities. By 2010, that percentage dropped to 36 percent.3

This movement from bonds to stocks is referred to as the “cult of equities.” However, in the 10-year period from 2000 to 2009, as a result of two 50 percent bear markets and brutal volatility, the cult of equities has reversed as a result of a reassessment by investors of the merits of stocks and bonds. Bonds enable investors to match their needs in retirement with their assets. Aging populations favor bonds over equities. Most importantly, the cult of equities has been severely questioned because bonds have outperformed equities from 2000 to 2009, annual performance of 0.3 percent for equities and 6.9 percent for bonds.4 The article concludes that an immediate reincarnation of the equity cult seems unlikely.

This chapter makes the case that the stated historical return of 9.8 percent for stocks5 is merely theoretical because this return is not reduced by taxes, fees, expenses, and investors’ bad timing. It is uncertain that stocks will outperform bonds in the future, and the risk of a severe stock market decline increases as the investment period increases. Stocks are riskier and less predictable than bonds. Ultimately, they are not as good an investment as bonds.

In the holy name of diversification, investors are told to balance the bulk of their investment portfolio between stocks and bonds. We think that’s a mistake. For individual investors, we believe that bonds are a better investment than stocks. Indeed, we believe that the ideal portfolio for individual investors would contain only plain vanilla bonds. That’s because after paying taxes, fees, expenses and factoring in the risk of bad timing, the return on stocks is not likely to exceed the return on bonds, particularly when the risks associated with stocks are taken into account. These risks have been clearly demonstrated as a result of the two stock market crashes that occurred from 2000 to 2009.

Even if you believe that stocks will outperform bonds in the future, consider our view that dependable and predictable cash flow from your portfolio is the best solution to your retirement problem. The bonds that we recommend are the safest investments available. If you can achieve your financial goals without taking on substantial risk, why not do so? If you cannot achieve your financial goals without taking on substantial risks, should you do so? Are there alternatives to consider?

We developed the All-Bond Portfolio as a strategy that individuals can use to achieve their financial goals, taking into account their capabilities and limitations. Individual investors can’t use the advanced techniques or participate in big institutional deals, but they can and do invest in stocks and stock funds, and that puts them at risk. The All-Bond Portfolio does not include investments in stock, stock funds, commodities, real estate, or bond funds. It’s a strategy that individuals can use to keep their assets safe and growing.

This chapter examines the myths surrounding the historical returns on stocks and bonds—without equity-colored glasses—in a noninstitutional portfolio. The results will show you why we believe that the All-Bond Portfolio is the best strategy for individual investors. Keep in mind that when we refer to bonds, we mean individual bonds and not bond funds.

Examining the Myths

To compare historical and potential returns from stocks and bonds, some important questions have to be addressed:

• Is it accurate to say that stocks had an historical return of 9.8 percent?
• If stocks outperformed bonds in the past, why can’t we assume that stocks will outperform bonds in the future?
• Does the historical return on bonds compare favorably with the historical return on stocks?
• How can a portfolio of bonds provide both income and growth?
• Are bonds a better investment than stocks?

Our answers to these questions cast doubt on the old assumptions of investing, which the media and most financial advisers accept as gospel. We’ve developed some new thinking that reflects decades of observing and investing in the financial markets. Let’s evaluate stocks and bonds in light of the new thinking we propose and see if you are persuaded that bonds are a better investment than stocks. If you are and you are willing to change your approach to investing, the All-Bond Portfolio can maximize your investment returns with the highest degree of safety.

Historical Annual Return

Old Assumption

The historical annual return of stocks is around 9.8 percent.

New Thinking

The actual annual historical return of stocks is much less than 9.8 percent when taxes, transaction costs, fees and bad timing of the stock market are taken into account.

Morningstar’s Ibbotson SBBI 2010 Classic Yearbook—SBBI standing for stocks, bonds, bills, and inflation—provides one of the staples for obtaining historical data to compare the returns of stocks and bonds.6 However, the Ibbotson data are misleading when applied to individual investors. The Ibbotson data reflect a 9.8 percent return on stocks. However, these data are merely theoretical because they do not take into account the actual frictions of real-life investing. You cannot measure the actual performance of a stock portfolio or stock fund for individual investors without taking into account the burden of income taxes, transaction costs, investment management fees, and the possibility of an individual investor’s poor timing when he buys and sells stock based on emotion. Because of these real-life costs, it is impossible for individual investors to have realized the stock market returns reported by Ibbotson.

Unhappy Returns: Uncovering the True Returns on Stock Investments

To find the actual historical performance of stocks, we must reduce the theoretical Ibbotson stock returns by three elements: taxes, transaction costs, and bad timing:

1. Taxes. Individuals are subject to federal and often state and local taxes on income as well as on dividends and capital gains. If stock is held in a stock fund and the fund trades its stock portfolio a great deal, some or all of the reportable gains may be treated as short-term capital gains, which may be taxed at ordinary income rates. The outcome is the same if an individual holds his stock for one year or less before its sale.

2. Transaction costs. Individuals must pay transaction costs to buy and sell stocks including commissions on individual stocks, managed account fees, and management fees and other expenses on stock funds. “It’s fair to estimate that the all-in annual costs of equity fund ownership now run in the range of 2.5 percent to 3 percent of assets,” says John Bogle, founder of the Vanguard Group of mutual funds.7

William Bernstein examined fund management fees and reported the following in the April 2001 issue of Financial Planning:

• The average actively managed large-cap fund has annual fees and expenses of about 2 percent.
• The average small-cap and foreign fund has annual fees and expenses of about 4 percent.
• The average microcap and emerging market fund has annual fees and expenses of almost 10 percent.8

3. Bad timing. The most costly element of all is the buying and selling habits of individual investors. Investors are generally emotional in their investment choices...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Dedication
• Foreword
• Preface
• Acknowledgments
• Introduction
• Part I: Clearing the Cobwebs
• Part II: Bond Basics
• Part III: Bond Categories
• Part IV: Options for Purchasing Bonds
• Part V: Bond Investment Strategies and Richelson Investment Rules
• Appendix: Useful Web Sites
• About the Authors
• Index
• End User License Agreement