My 1st Million At 33 – yes, you can do it too

There are a couple of ways that you can invest in bonds:

1. Buying and own bonds directly:

   This strategy exposes you most to the credit quality of the bond. If you have a lot of money, you can buy a diversified portfolio of bonds, and reduce a lot of the credit quality risk. Or you can buy very high quality bonds (ASSUMING that credit ratings are correct. How many times they downgrade the credit rating only after-the-fact?).

   But owning bonds directly give you one of the best things that are not available in mutul funds, except closed ended funds. When you own a bond directly, it’s like investing in the mutual bond fund, with a free put option. The “free put option” allows you to eventually sell your bond to redeem all of your money from the issuer without any loss (in the number, but not in buying power). The “free put option” also grows in value through time. Because as the bond approaches the time of maturity, your long term bond will gradually transform into an intermediate term bond, and then a short term bond at the end. Since normally, the yield curve is not inverted, and that short term bond has a lower effective interest rate than long term bonds, it means that eventually you can benefit from the gradual transition of higher interest rates going towards lower interest rates (which equals gain in the bond prices). Now, of course, the foremost assumption of buying individual bonds is that you don’t need that money any time soon (and I mean years, if not decades). Well, of course, you can always sell your bond when you need money, but your “free put option” will not mean anything for a short term trade. For people with a lot of money that they think they will never need in the short term, this is a good strategy to make up a portfolio with individual bonds instead of buying bond mutual funds.

2. Buying a bond mutual fund:

   You can research for your bond mutual funds using the mutual fund screener at Yahoo’s finance. Vanguard mutual funds are usually pretty good and close to the lowest costs. In terms of specifics, I only want to say that you can enter any bond mutual fund symbols in Yahoo’s quote, clicked on Holdings at the left column, and scroll all the way down to the bottom. There are 3 MOST IMPORTANT numbers there: Maturity, Duration, Credit Quality. The average maturity is the capital weighted average time to maturity. The average duration is a better number that gives you an idea of how much the fund may lose when the interest rate goes up by 1% at the comparable length of bond yields. Here is an example on VWEHX.The meanings of each are explained here. I use the maturity & duration to evaluate my interst rate risk, and I usually prefer a relatively higher credit quality compared to industry average.

3. Buying a bond ETF:

   Here are some bond ETF that you can buy: TLT (for long term US bonds, 20+ years), TIP (TIPS bond), LQD (investment grade corporate bonds), IEF (intermediate term US bonds, 7-10 years), SHY (short term US bonds, 1-3 years). All of these ETF bonds pay monthly interest. My only minor problem with these ETFs is that these interests are supposedly to be state tax-exempt (except LQD), but your brokerage houses may report them incorrectly as un-qualified dividends instead. So you may get a little state tax bite, unless you get the brokerage house to change their 1099 form.

4. Buying TIPS treasury:

   TIPS stands for Treasury Inflation-Protected Securities. These bonds pay an interest rate of CPI + a small interest premium. TIPS are offered starting in 1997, and you can buy them directly from TreasuryDirect. While it is claimed as having protection against inflation, I think it’s more of a government bond to pay you cheaper yields under a hedonically adjusted CPI. Most of the time the CPI reported is lower than the real inflation rate. BankRate.com has a really good article on TIPS. You should check it out if you want to invest in TIPS.

5. Buying a closed end fund:

   One of the disadvantage of buying a closed end fund is that liquidity volume is rather poor. Because of that, you tend to pay a little more due to bid/ask spread. But the biggest advantage with buying a closed end fund is that there are many funds that structure their bond investments such that they will return the original cash back to the fund holder at a certain date. This makes them to be like an actual bond with the “free put option” that I mentioned above. Instead of perpetually investing back to the same type of bonds, they will make sure that all bonds will return cash by such date. Normally these funds are called “Limited Duration”, instead of “Perpetual”. BlackRock has a lot of offering for these types of investments. For example, BFO, BlackRock Florida Municipal 2020 term trust is designed to return $15 per share back to investor at about year 2020. There are so many offerings from BlackRock, Merill Lynch, Nuveen, Eaton Vance, and Colonial that I won’t list them all here. You can use closed-endfunds.com website to search through all these bond fund information.
   These closed end funds trade like stock shares. You can simply buy them from any brokerage houses.

6. Buying a floating rate fund:

   A floating rate fund is good when the short term interest rates are rising. This is a good investment in a rising rate environment in which most other bonds will have a tough time preserving capitals. This kind of fund invest in short term securities and manage to have the fund yield to go along with the prevailing short-term interest rate. Keeping their money farily liquid, they can easily re-invest the returned capital quickly to another higher yield short-term bond. However, because Fed is probably done with rate hike, I don’t think floating rate fund is a good idea. You don’t want to float down your interest rate. Rather you should lock in your rate in a bank CD.

Here are all the posts in the same bond investing series:

1. Intro to Investing in Bonds: Fundamentals
2. Intro to Investing in Bonds: How-to
3. Intro to Investing in Bonds: Risk Factors
4. Reasons for (Not) Investing in Bonds