Linden Thomas - How Bonds Work
Linden Thomas

Linden Thomas & Company

How Bonds Work

Bonds are critical for generating income during retirement. Building a bond portfolio that creates strong net cash flow means you don’t have to rely as much on other assets for your living costs.
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Investors often do not understand the importance of fixed-income portfolios.

They build a portfolio tilted toward growth up to retirement, thinking they will move more toward bonds when they retire. The challenge occurs when the markets move down before retirement or fixed-income yields are low, or even worse, both occur in tandem. As investors set out to build a portfolio all too often, we think in terms of short-term rather than long-term goals. To create an efficient portfolio that meets your long-term goals, one must consider the what-ifs of investing! What if there is a market correction before you retire? What if rates are low at retirement?

In understanding how bonds work and their benefits, we at Linden Thomas & Co. know what not to do, what to do, and the pros and cons. Balance and perspective will allow you as an investor to have insight into why building a private bond portfolio can and will benefit your portfolio both pre-retirement and post-retirement. In this review, we will cover 15 subjects.

Why bonds are essential

Building an efficient bond portfolio can often be your saving grace if you don't have a steady income at retirement. Building an efficient bond portfolio usually takes years and is frequently done with the help of a professional. Much like having a portfolio of rental income or rental houses, bonds can offer investors a steady flow of net income. With a proper fixed income portfolio, cash flow is staggered by spreading out coupon payment dates. This allows investors to avoid relying solely on stockmarket performance. The benefit is that when markets are down, the bond income produces cash flow, so investors can avoid selling at low prices, giving portfolios the ability to recover. Likewise, an efficient bond portfolio in good markets allows equities to be left alone, enhancing growth. Substantial income from a bond portfolio will enable investors to let equities grow.

Pre-retirement benefits of bonds

Investors' pre-retirement accumulation period can often be 20-40 years. Building a bond portfolio before retirement provides another avenue for saving and reinvesting. This long-term approach, similar to investing in rental homes, can lead to a steady increase in income and buying power. The more income you have, the more buying power. The income the bonds pay allow you to buy more bonds. (The more you earn, the more you buy). Ideally, one wants to build an efficient bond portfolio before retiring.

Over the years, Linden Thomas & Co. Has helped hundreds of investors build bond portfolios before retirement, so once you cross over to retirement, your income needs have are already been addressed established.

Post-retirement benefits

Over the last 30 years, the equity markets have had countless -10% down markets and -20% down markets can be expected every few years. The challenge is that if investors rely on equities for income, when markets move down, the % of assets required to fund distributions increases. What may have been a portfolio distribution rate of 5% can become an unsustainable 7% rate in the face of a large 30% - 40% pullback in the stock market. If a portfolio is down -30 yet has another 7% annual distributions over several years, then portfolio recovery is long-gated and sometimes impossible.

Conclusion: Whether you're an affluent investor or not, building an efficient bond portfolio can greatly relieve the uncertainty of relying solely on equities.

Direct bond ownership is essential

If you're an affluent investor with a net worth between $2 and $100 million, you should own only bonds directly. Why? All too often, investors or retail advisors put their clients in bond funds or ETFs due to convenience. Simply, it's easy! While this may be a viable option for small investors due to the size of investable assets, this should never be considered for affluent investors. As a wealthy investor, building a bond portfolio directly through a skilled professional can be invaluable over long periods. Direct ownership gives you control to tailor the portfolio to your specific income needs, and the benefits do not just end there. Direct ownership gives both control and transparency that is seldom available in pooled bonds. Direct ownership also helps investors avoid small investor herding impact and hidden and high investment advisor fees. All of these factors negatively impact investors' net income and results. Lastly, direct ownership means that the direct outcome to maturity doesn't change if the markets move down. Yes, the current value may be down, but the maturity price and yield don't change when you own the bonds directly. When bond funds go down, because you don't own the bonds directly, you are subject to small investors selling the fund, forcing fund managers to sell bonds prematurely at discounted prices.

Downmarket benefits

One significant benefit of building a tailored bond portfolio is the net cash flow that allows investors to add to equities or more bonds when markets move down. Because bond income doesn't fluctuate, but markets do. Having cash flow during challenging markets gives investors purchasing power! When equities are selling at discounts, the steady cash flow of bonds can be directed to buy discounted shares. Equally, when bonds go down, buying more bonds at significant discounts means taking advantage of the pullback.

What happens when interest rates go up?

When rates move up, bond prices move down. This can impact investors' current market value. For bond owners with direct ownership, the maturity date, maturity price, and yield don't change. The reason you initially bought the bond based on the income and maturity date stays the same. If you invest in a bond at $15k with a 6% yield and a 10-year maturity, and interest rates move up while your bond is down at $14k, that won't change the maturity of $15k in 10 years. One benefit of owning bonds directly when rates go up is that it allows investors to take the income and buy more bonds at deeper discounts. In the case of the $15k at 6%, the $900. Annual income gives the investor more buying power to buy more bonds.

How does rating and yield impact results?

The highest rating on bonds is AAA. An AAA rating is often associated with government bonds. While rating is essential, bonds are nothing like stocks. The higher the rating, the less the yield. One example was GE years ago; their bonds carried a high rating yet a low yield. Investors were willing to have low results due to perceived safety. Yet when GE was downgraded, the bonds sold off due to the benefits of safety had failed. Spreading risk between different issues focusing on yield and quality are all important. Genuinely, the higher the quality, the less the yield!

One risk associated with high rated bonds, like AAA or AA, is that if they get downgraded to a lower rating like an A-, the perception of safety can disappear and cause a deeper selloff in the market.

What to do if bonds go down

As an affluent investor, you should always own your bonds directly. This way, when bonds go down, you can add more bonds with the cash flow of the current bonds. Remember, as a direct owner, you have a maturity date. That maturity date and the income give you control to add more new bonds at better prices and higher yields while you wait for the current bonds to mature!

Why affluent investors should avoid bond funds and ETFs

If you're a wealthy investor with $2 million plus in assets, you should never consider pooled bond funds for a few reasons. First, no direct ownership means no control. You are buying a portfolio of pre-existing bonds that are subject to low yield! Second, you have no maturity benefits because you don't own the bonds directly. Third, nothing is tailored to your income needs! Fourth, you are subject to small investors selling in down markets, forcing the bond manager to sell bonds at discounted prices before maturity. Fifth, hidden fees like expense rations, trading costs, spreads on trades, and high advisor costs can sometimes cut your net income in half. Lastly, you have no transparency.

What happens if rising interest rates and small investors collide?

When rates move up, bonds go down. The challenge of a bond fund is that investors don’t own the bonds directly, so when the fund they own goes down, they often panic and sell. The challenge is when whole groups of fund investors sell the fund they own; it forces the fund manager to dump bonds at discounts into the open market! Commonly known as small investor herding impact, this does further the fund value. It hurts both the one selling and the more patient investor.

What impacts net income when bond fund investing?

Six factors can impact the cash flow of bond fund investors--clearly fees. The expense ratio, trading cost, trading cost, and investment advisor fees are the most commonly known. Other items seldom discussed are cash held in the fund for redemptions and spreads on trades between the bid and ask. Because bonds are not as liquid as equities, the spread can widen when selling takes place in a bond fund, further impacting results.

Why investors should avoid high-income drawdown.

When investors draw out more than they earn, an environment where shares have to be sold is created. The higher the drawdown over and above the realized cash flow, the more significant the negative impact on compounding. As this takes place, the effect on the principal increases. One of the many reasons Linden Thomas & Co. build private bond portfolios and establish high net cash flow is because it minimizes the need to draw down principal. Tailored, direct ownership gives investors control to build a portfolio based on their needs, not someone else.

Three hidden factors that kill investor income.

Low yield to maturity, trading costs, and forced liquidation all impact bond funds' ability to offer what investors need. When investors buy pooled bond funds, they are immediately subject to the current portfolio's low yield to maturity. That low yield, along with additional trading costs and forced redemptions, creates a vacuum in investors' cash flow.

Warning of relying on portfolio growth for net income.

All too often, investors rely on equity results to offset net income where bond funds fail to provide reliable cash flow. While this may work during bull markets, this approach can come crashing down when markets retreat or move flat. The higher the net income needed, combined with lousy equity markets, the more challenging the outcome.
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