Money Rehab with Nicole Lapin - Which Bonds Should You Bond With?

Episode Date: January 25, 2022

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Well, it doesn't. Charge for wasting our time. I will take a check. Like an old school check. You recognize her from anchoring on CNN, CNBC, and Bloomberg. The only financial expert you don't need a dictionary to understand. Nicole Lappin. In a small indie play called Hamlet, written by a little playwright you may have heard of called Shakespeare,

a character says, neither a borrower nor a lender be. A character says, neither a borrower nor a lender be. Shakespeare obviously didn't have his financial life together because you should absolutely become a lender through buying bonds. Yesterday, we started our deep dive into all things bonds. Bonds are the most common type of debt asset. And before I go any further, I do want to confirm something. Most of us, myself included, have a lot of emotional baggage around the word debt. Debt is such a stressful concept that we don't think we mere mortals can profit on it like credit card companies do from us, but we actually can be in that position. And an important thing to remember is that when you're investing in debt equities, you're not getting into debt because you're not

borrowing money. You're lending someone money through the bond. So you're essentially in the place of the credit card companies or the lenders. As we learned in yesterday's episode, bonds are basically IOUs. When a bond is issued, it's basically like an open call asking to borrow money. The bond itself represents a promise that the bond buyer will be paid back, plus interest, of course, by a certain date. We understand how borrowing money works from the other areas of our life, right? For example, when we buy a house, we take out a loan from a bank, aka a mortgage. As you probably know, if you have a crummy credit score, your lender will view you as risky. Or in other words, they have reason to doubt that you'll make your payments on time

or at all. If you're seen as a risk, your lender is going to hit you harder with a higher interest rate, which gives that a little bonus or incentive for taking a risk on you. Unlike mortgages and some of the other common IOUs we deal with, with bonds, you are not the I that owes, you are the you that is owed. That's a pretty sweet turn of events. When the roles are reversed, you are the lender, aka a badass bond buyer. You get the benefits of this system. If there's more risk involved, you'll get a higher interest rate and earn more. In many ways, as a bond buyer, you have a more predictable rate of return than banks do with their credit card or mortgage loans. With a mortgage, you may not necessarily sit down with a bank and say explicitly,

at a 4% mortgage, you, Miss Big Bank, will be making X amount of dollars from me in interest and get to deposit Y total in profit at the end of my mortgage term. But with bonds, a key part of the bond buying process is getting a commitment on how much money you'll actually get back at the end of your term. The final amount bond buyers get back is called the maturation value or the par value. Let's take a look at this in context before we start spinning from jargon overload. I know, I know. An example might be that you see a bond that has $1,000 par value, a maturation period of two years,

and is offering a 2% discount rate. What the actual fuck does that mean? Well, remember, the par value is not actually what you pay. You pay the discount rate and then get the full par value back at the end of the term. So when we decode this bond jargon, we learn in this example, you would be purchasing the bond at $980 because $980 is the par value at the 2% discount and get back $1,000 by the maturation date. So net net, and you know what that means, you're up $20 total at the end of two years. A more complex but desirable bond structure are bonds that come with coupons.

Thankfully, with bond coupons, there is no newspaper cutting necessary. Coupons are bonuses here. More specifically, coupons are percentages of the par value that are given to bond holders at fixed intervals over the course of the maturation period, typically every six months. Let's use the same example as before. You are buying a bond with a $1,000 par value at a 2% discount. a $1,000 par value at a 2% discount. You're told the maturation period is two years and there's a 2% coupon payment every six months. So how the F is this example different from the last? Well, in addition to the terms of the first example, you're also getting 2% of the par value, or $20, every six months. Because this has a two-year maturation term, you will get four coupon buyouts because there are four six-month periods in two years. So,

net net, between the coupons and receiving the par value, you're up $100 total at the end of two years. Based on this example, you may assume that coupons are basically the bomb.com and you should jump on bonds with coupons every single chance you get. Well, not so fast. You also need to consider the bonds risk factor. Many of the smartest, richest investors out there swear that the safest bonds are U.S. Treasury bonds because they're backed by the U.S. government. And while, sure, there is a chance the U.S. government is going to default, gotta tell you, there are going to be bigger problems than not getting the principal back on your bonds if that happens. So for that reason, investing in treasuries,

that's what you'd call U.S. bonds for short, is a good way to make your overall portfolio more secure. But not all treasuries are the same, and not all of them are even called bonds. Okay, it's time to introduce you to the four members of the T-Crew. And no, that's not a technical term. I did just make that up, but I have to admit it spices things up and that's what I'm here to do. So let's get started. Number one, T-bills.

The reason there are different names for different treasury bonds is to denote the term. Those with the shortest term, shorter than 12 months, are technically called treasury bills, but are more commonly referred to as T-bills. In terms of the cash money value, T-bills are sold in increments of $100. In terms of the maturation timeline, T-bills come in increments of weeks, 4, 8, 13, 26, 52. That's one, two, three-ish months, six-ish months, and a year for those of you who don't have kids and don't speak in weeks. There are also super short-term ones that come due in just a few days called cash management bills. With shorter terms come lower entry points. So if you have a hundred bucks, you're going to get more back with a T-bill than in an average savings account for not much more risk. Number two, treasury notes or T-notes are the

intermediate term for the T-crew and mature between two and 10 years. You can buy them in these increments, two, three, five, seven, 10 years. They offer payments every six months. T-notes are often used as the basis for general long-term interest rates. In bad economic times, the Federal Reserve, the body that sets the interest rates for the entire country, will lower interest rates. That's to incentivize investors to take on riskier investments and for regular folks to buy cars and homes and whatnot, and to stimulate the overall economy. However, in times of higher interest rates, which usually go along with a sluggish stock market, T-notes are actually really good investments because they pay a higher yield than many other investments. Number three, T-bonds. Technically, all of the investment

vehicles we're discussing today are bonds, but the Treasury only calls the ones that mature from 10 to 30 years T-bonds. They pay interest every six months like T-notes. You have to hold on to a T-bond for 45 days at a minimum, but after that you can sell on the secondary market through a brokerage. T-bonds have the highest interest rate of the entire T-crew because of the risk you're taking. Not that the U.S. government's going to go under, but there will be higher interest rate bonds available later on, which, as you remember from the seesaw in yesterday's episode, will lessen the value of your bond. Number four, tips. Treasury inflation protected securities, or tips, are mainly used to protect your money against fluctuations in inflation.

When you buy TIPS, the principal, or again, par value, rises and falls and comes back to you in semi-annual payments as the Consumer Price Index, or CPI, which is an index that tracks inflation, rises and falls. For example, if you buy $1,000 in tips and the interest rate is 1%, you get $10 back in interest payments. If inflation stays the same, then nothing happens. But this is my favorite part. When inflation goes up, say 5%. Your bond is then worth $1,050 and your payment then goes up to $10.50. I know, 50 cents doesn't sound like a lot, but if you own more tips and inflation gets nutso, that's real money. So after meeting each member of the T crew, you might be ready to take your relationship to the next level and actually buy one. Well, there are two ways to purchase treasuries.

The simplest way is through a non-competitive auction process on treasurydirect.gov. By the way, it's called an auction, but the treasuries on offer are pretty much at a fixed price and there are no paddles involved. The second way to purchase treasuries is through a brokerage account like Vanguard or Fidelity. What's cool about helping the government pay for stuff is that you don't have to pay state and local taxes on the money you make. You do have to pay federal taxes, though. Boo. There is no penalty for taking your money out early, although you'll

likely get dinged with some sort of transaction fee by the bank or brokerage you're using. So early withdrawals should still be avoided if possible. Today's tip you can take straight to the bank is simple. Buy some tips. Treasury inflation protected securities. That's it. That's your tip. Money Rehab is a production of iHeartRadio. I'm your host, Nicole Lappin. Our producers are Morgan Lavoie and Mike Coscarelli. Executive producers are Nikki Etor and Will Pearson.

Our mascots are Penny and Mimsy. Huge thanks to OG Money Rehab team, Michelle Lanz for her development work, Catherine Law for her production and writing magic, and Brandon Dickert for his editing, engineering, and sound design. And as always, thanks to you for finally investing in yourself so that you can get it together and get it all.