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How Do Investors Buy Fixed Income?

Individual securities, bond funds, ladders—approaches to buying fixed income are varied. Blerina Hysi explains the options and the pros and cons of each.

Transcript

Tim Maurer
Hello, Tim Maurer back with another episode of Ask Buckingham. A new video podcast designed to bring clarity in the midst of confusion by connecting your great personal finance questions with straightforward answers from industry thought leaders. Today’s question will be answered by Blerina Hysi, Fixed Income Trading Manager at Buckingham Wealth Partners.

Tim Maurer
Blerina, how exactly do investors buy fixed income?

Blerina Hysi
So there is a couple of ways that you can do that. You could either buy individual bonds or you can buy them in a bond fund form.

Tim Maurer
Okay and let’s talk a little bit about the mechanics of each of those. What is an advantage and a disadvantage per se of buying them directly? Buying individual fixed income.

Blerina Hysi
So typically with fixed income, there is some risk associated with it. The main risks with fixed income are credit quality, reinvestment risk and interest rate risk.

Blerina Hysi
So whether you’re an individual investor or a fund manager, you are trying to minimize these risks. Credit quality is easy in the sense of you buy highly rated bonds and you are somewhat minimizing that risk. Interest rate risks and reinvestment risk get a little bit tricky because reinvestment risk is essentially the risk that once you’ve locked in a high rate, when you get ready to reinvest, the going rate is a lot lower than what you have.

Blerina Hysi
On the other hand, interest rate risk is the volatility that a bond will go through with interest rates going up and down. So the way to minimize reinvestment risk is by locking up that rate, as long as you can. On the other hand though interest rate risk increases with longer duration. So minimizing one only amplifies the other. The perfect way to sort of get in front of these conflicting risks is by building a ladder. So whether you’re an individual investor or a fund manager, what you do is you have a ladder in place. The short maturities allow you to reinvest if interest rates are rising, the longer maturities allow you to lock in higher rates if you do run into low interest rate environment.

Tim Maurer
So in other words, Blerina, if we are in a period of time where interest rates are abnormally high, that might be a time where you’d want to lock those rates in for a longer period of time?

Blerina Hysi
Not necessarily because who’s to say that, that is the highest interest rates that fixed income will ever be. What you want to try to avoid is making any predictions of what interest rates will do. We could have a general idea just based on how the market is behaving on which direction interest rates are going to go. But the question and the most important part of that is when is that to happen and by how much and that is truly going to make a difference on how you manage your fixed income.

Blerina Hysi
To leave that guessing out of the game, what you do is you have a ladder in place and as bonds mature, you start investing in the backend of the ladder and assuming there’s a steep yield curve, meaning interest rates are higher the longer you go into a maturity schedule, then you’re picking up higher rates.

Blerina Hysi
In the same sense. Let’s say, if you have built a 10 year ladder, which means you have bonds maturing each year from year one to year ten. As you keep rolling these bonds, when they mature, your maturity schedule does not change because next year, when year one comes due, your year 10 becomes only a nine year maturity. So as you add to the backend of it, you’re adding another 10 years. So you keep rolling that same duration without adding any maturity risk to it. Yet you have the ability to pick up higher rates on the longer end.

Blerina Hysi
So by having this ladder in place, you have the ability to do that and you take that guessing game out of the equation, because you’re constantly rolling in bonds at whatever the going rate is.

Tim Maurer
Interesting. So how many rungs do we want on this bond ladder? How many different interest rate varieties would you prefer to see in a typical interest rate environment?

Blerina Hysi
So typically you want to have something maturing each year. As to how far you want to go in the ladder, it strictly depends on where interest rates are at that point and how steep the curve is. There’s times that you might build a 10 year ladder. There’s times that you might build a five year ladder. The way we determine is let’s look at how much you’re picking up for each additional maturity, because anytime you add that maturity, you’re adding duration risk, are you getting compensated for adding the duration risk? That’s when that difference between a year to year comes into play. If you’re getting compensated enough for taking that additional maturity risk and you keep extending in the ladder, and if you’re not, then you keep shortening the duration.

Blerina Hysi
So having flexibility on what you want your duration to be allows you to take advantage of a flat yield curve or a steep yield curve.

Tim Maurer
So again, it’s going to be situational based on what the interest rate scenario is and based on what the individual investors plan is, is that correct?

Blerina Hysi
Absolutely. So you want to take into account the client’s goal with fixed income, but you also don’t want to just invest for the sake of investing. You want to make investments in a smart way, meaning you are awarded for any additional year you extend your ladder.

Tim Maurer
Okay. So we’ve been talking a lot about building a bond ladder with individual fixed income instruments. We haven’t talked much about bond mutual funds. Blerina as a fixed income pro what is your preference to the utilization of individual bonds or fixed income instruments versus bond mutual funds?

Blerina Hysi
So typically we prefer individual bond ladders versus bond funds. There are scenarios where we recommend that a client goes into a mutual bond fund versus an individual bond ladder. The main reason there is how much money is being invested into fixed income. We need to have the ability to have enough money to protect against the risks that we are facing in fixed income. So when you have too little to work with, it really ties up your hands on how much you can do with it. A fund because they have millions and millions invested in it. They have the ability to diversify in a way that makes sense.

Blerina Hysi
If you do have enough funds to build a fixed income ladder, that is our preference and there’s a few reasons for that. When you’re building a fixed income ladder, there’s greater transparency, you know exactly what is in your fixed income ladder. You can control credit quality. You can control duration. You can control the way you’re investing this ladder. As I mentioned earlier, because you want to adjust things based on what the yield curve is doing you have more flexibility.

Blerina Hysi
Versus in a mutual bond fund, they have to hit a certain target duration. So if interest rates are not indicating that that’s the route you should go, they still have to abide by that duration restriction that they have.

Blerina Hysi
As far as having greater transparency and knowing exactly what’s on your account. One of the biggest benefits there is the ability to construct a ladder based on each individual client’s situation. One of the main things to consider there is their taxability. What’s their federal tax bracket. What’s their state tax bracket. We take those into account when we’re buying bonds.

Blerina Hysi
Typically when you go to a mutual fund, it’s a one size fits all. So everybody’s buying the same types of bonds. So if you’re buying a tax-free mutual fund, you’re going to see munis throughout that mutual fund. When we’re building a ladder for our clients, we’re considering the tax bracket, as well as the break-even between a taxable product versus a tax-free product. What that means is that there are times that a CD, for example, which is fully taxable, will make a lot more sense than the municipal bond even if you’re in the highest tax bracket. What we are buying on is based on the best after tax yield. So this part of what that product is, we’re not just buying munis, let’s say on a taxable account, just because it is a taxable account. We’re doing that calculation to buy on a best after tax deal.

Blerina Hysi
Another nuance to that is treasuries, and some agencies are state tax free. If you live in California, for example, you’re paying about a 13% state tax. There are times that treasuries might make sense, even over munis, even though you’re paying that high federal tax bracket, you’re still picking up some benefit on the state tax and that is going to make a more sense on an after-tax basis.

Tim Maurer
Blerina, it sounds like a 3D game of chess or something. There are a lot of different factors associated with this and so you certainly make the case effectively for individual bonds due to the customization over bond funds but you mentioned that it’s not appropriate for everyone. About how much money do you think one needs to be investing in just the fixed income portion of their portfolio to make individual bonds make sense?

Blerina Hysi
So typically we require an individual client to have at least $500,000. We feel that that’s a good number to allow us to have enough bonds to build a well-structured ladder, as well as worry about credit quality and well diversified in that sense. Although we’re buying very high quality municipal bonds, for example, we do not want to cross certain thresholds. We do not want to have more than what we feel comfortable with a client being exposed to either a certain state or a certain municipality. So just having $500,000 allows us to diversify well enough to where we’re comfortable with it.

Tim Maurer
Again, this is vitally important because we believe the primary purpose of fixed income is to stabilize the portfolio and therefore we don’t want to extend ourselves when it comes to risk. Is that correct?

Blerina Hysi
That is correct. Yeah, absolutely. You want to structure it in a way that it’s going to minimize any risk that will allow the overall portfolio to perform better.

Tim Maurer
Well Blerina, you find a way to make a fixed income investment sound a lot less boring than they did in my finance 101 course. Thank you so much. And thank you for tuning into this episode of Ask Buckingham.

Tim Maurer
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Tim Maurer
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