Do all Millionaires have trouble sleeping, wondered Moish Motechin? The Motechins had accumulated $1,000,000 in retirement savings to fund their “Back to Kollel” goal. Moish loved being back in the Bais Medrash but found that he was now stressing about money more than ever. With his paycheck gone, their needs would be met by combining income from this nest egg, Social Security, and Devorah’s part-time job. They needed $50,000 of investment income to keep up a comfortable lifestyle, and also help their married kids pay for Yom Tov and simchas. Moish had invested the entire $1,000,000 into a few bond mutual funds and thus began his surprising nightly twisting and turning.
Although interest rates were very low, Moish had figured that earning a secure 5% return was reasonable ($1,000,000 x 5%= $50,000). Bonds were supposedly safe investments, and using an online brokerage firm, he’d identified three bond mutual funds, which had returned about 5% annually. Diversifying into these investments seemed quite conservative, so he was shocked when the value of one fund or another occasionally dropped dramatically: as much as 10% sometimes. While interest payments did come in steadily and the portfolio regained its value, the volatility was unnerving. He needed this portfolio to last for a very long time and was unprepared for ups and downs. Is investing in bonds a lot riskier than he’d thought?
Not All Bonds Are Created Equal
Rules of thumb such as “Bonds are low-risk investments,” “Exercise is good for you” and” “Natural foods are healthy” usually contain a kernel of truth but lack details and application. Is any exercise beneficial and how safe is working out for someone with a heart condition? Salt and sugar are natural foods too. Are they healthy and in what amounts? The standard expectation that bonds are low-risk investments is also oversimplified. While most bonds are indeed safer than stocks, not all are. In extreme cases, bond investments can fail completely and some of the Motechin’s bond investments are indeed quite risky and inappropriate for conservative retirees. What was in these funds and causing these occasional losses?
Investing in Junk Bonds
A bond is a loan to a company or government entity which commits (i.e., makes a bond) to pay interest on the loan until the principal is repaid at a future date. While most bonds perform as negotiated, the risk of such an arrangement is that the borrower may be financially unable or unwilling to pay up (I.e., they default). Companies go bankrupt all the time, wiping out their debts partially or entirely, and some do so multiple times (ahem, Mr. President). While rarer, governments may also go bankrupt, as Detroit did in 2013 in the costliest such bankruptcy in US history. And whereas the United States has never defaulted on its debt (yet!), many countries have in recent decades including Ireland, Mexico, Russia, Argentina and dozens of others. Unbeknownst to Moish, some of his money was now loaned to these dodgy debtors, leading to occasional losses.
The first line of defense against default risk is sticking to bonds borrowers with high credit ratings. Every bond is categorized into grades ranging from AAA to D with the high-grade bonds defaulting very rarely. The lower tiers, known as high yield also known as junk bonds, do offer higher interest rates, but even with the promise of extra reward, junk bonds are often a bad bet. Income investors, desperate for additional interest, sometimes lend their money to very shady borrowers for a bit of added compensation. For example, in June 2017, Argentina, which has defaulted many times in the past, borrowed $2.75 Billion at a rate of 7.9% locked in for 100 years! The extra interest will provided little comfort to lenders as within just a few months Argentina’s economic was in a tailspin and the bonds lost 15% of their value. And this turmoil is just year one out of one hundred!! To keep financial and mental stability defensive investors like the Motechins must avoid investing in these “high yield” bonds.
Research Is Always Required
Because buying just one or a few individual junk bonds creates the possibility of a bankruptcy causing significant portfolio losses, high yield mutual funds usually buy into in dozens or even hundreds of them. Diversification spreads the risk around, supposedly enabling investors to enjoy the higher interest of junk bonds without the added risk. But as you expect, this is often too good to be true. In times of economic downturns, many weak borrowers tend to default, causing panic selling and substantial bond fund losses. In 2008, these funds lost about 35% of their values!! Also, even the pros are sometimes tempted by an unusually juicy interest rate and don’t diversify enough. Some well-known funds had 40% of its assets in bonds from Puerto Rico which sustained heavy losses when it became clear that they would not have the tax revenue to repay its debts. While mutual funds can be beneficial, it is the investor’s job always to know where his money is going.
Not all bonds are safe, and not all mutual funds are diversified. Moish was bearing a lot more risk than he expected and could tolerate, so he’d better use bain hasedarim to do his financial homework.