Generating Income in Retirement through Bonds and Bond Ladders

The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney

Share this article:

Listen every other Wed. on KQV 1410 AM, at kqv.com or click below for our archives. Gain FREE access to the best information available from the country's leading IRA experts including Ed Slott, Bob Keebler, Natalie Choate, Barry Picker & Jane Bryant Quinn.

 

 

Generating Income in Retirement through Bonds and Bond Ladders
Jim Lange, CPA/Attorney
Guest: Dan Henderson
Episode 70

Please note: Some of the events referenced in our audio archives have already passed. Please check www.retiresecure.com for an updated event schedule.

Click to hear MP3 of this show

TOPICS COVERED:

  1. Introduction of Guest – Dan Henderson
  2. Basics of a Bond
  3. Individual Bonds Vs. Other Fixed Income Classes
  4. Commissions Vs. Fees
  5. Risks With Bonds
  6. What are Bond Ladders?
  7. Investing Strategy With Bonds
  8. Do Not Break a Certificate of Deposit Early

The Roth Revolution - Now Available!

Jim's book The Roth Revolution: Pay Taxes Once and Never Again is a one-of-a-kind guide that offers step-by-step instructions on how you can create a tax-free dynasty for you and your family for generations to come. This material is so powerful that "America’s IRA Expert" Ed Slott, wrote the foreword and dozens of other national IRA experts including Natalie Choate and Bob Keebler have offered their praise. The Roth IRA conversion is truly an unprecedented opportunity for all retirement plan owners - get the facts, get them now - Buy The Roth Revolution: Pay Taxes Once and Never Again.



Welcome to The Lange Money Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh-based CPA, attorney, and retirement and estate planning expert. Jim is also the author of Retire Secure! Pay Taxes Later. To find out more about his book, his practice, Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at paytaxeslater.com. Now get ready to talk smart money.


1. Introduction of Guest Dan Henderson

Hana:  Hello, and welcome to The Lange Money Hour: Where Smart Money Talks.  I’m your host, Hana Haatainen Caye, and of course, I’m here with Jim Lange, CPA/Attorney and best-selling author of the first and second edition of “Retire Secure!” and “The Roth Revolution: Pay Taxes Once and Never Again.”  One small change for 2012 is that the show will start at 7:05 instead of 7:00 pm to allow for KQV to provide the news at the top of every hour.  Jim’s guest tonight is Dan Henderson, CHFC President of Cookson Peirce, a Pittsburgh-based money management firm.  We don’t know of a firm that does a better job with bond ladders than Cookson Peirce.  In addition to an excellent bond department, they specialize in quantitative investment style, which relies on mathematical and statistical-based modeling that is devoid of emotion and has clearly defined rules for when to sell an investment.  When a bond matures, unless there is a default, you are guaranteed to get your entire principle back.  However, it makes sense to have a diversified portfolio of individual bonds with different maturation dates to meet with your cash flow and investment needs.  That is what individual bond ladder investing is all about.  We will dig more deeply into the concept of bond ladders and answer some more basic questions about bonds, such as what is a bond and how does it work?  What are the different types of bonds, and why would you use one type over another?  But before I turn it over to Jim, I want to remind our listeners that the show is live, so please feel free to call in with your questions for Dan.  The number is (412) 333-9385.  Good evening, Jim, and welcome to the show, Dan.

Dan Henderson:  Thank you.

Jim Lange:  And welcome, Dan.  And I should mention to our audience that I do have a strategic alliance with Dan Henderson from Cookson Peirce, and therefore, I am not 100% independent of him.  Our alliance is of the nature that if I bring business to Cookson Peirce, they actually do the investing, whether it be on the bond side or on the stock side.  We have an agreement where we are sharing fees.  Our firm does things like Roth IRA analysis, how much you can spend, retirement and estate planning and let’s call it non-investment issues, and Cookson Peirce actually does the investments and we share fees of 1% or less, depending on how much is invested.  So, I should begin by saying I am not independent.  I have that same arrangement with several other money managers, but I do want to be fair.  But tonight, we’re going to be talking about fixed income, and on the fixed income side, and particularly on the bond and bond ladder side, I don’t know a better firm than Cookson Peirce, both from our own practical experience and working with clients and they way they do things.  So, I was just very pleased to have Dan be willing to come and share an hour of his time in talking about bonds and bond ladders and fixed incomes.  So, Dan, how about if we start with the beginning?  What is a bond?  How does it work?


2. Basics of a Bond

Dan Henderson:  Probably, the easiest way to think about what a bond is, Jim, is it is a vehicle that you, or a piece of paper that you derive either from your municipality if it’s a local company, or if it’s a local municipality, or it’s a corporation that you are, in fact, lending money to them.  So, you are basically receiving a mortgage, more or less.  They’re issuing debt.  You become the bank for them, and you give them your capital in return for a payment.  That payment is defined in our world as what’s called a coupon payment, and that determines what the rate of return is.  The fixed rate of return is going to be on that particular investment. 

Jim Lange:  Okay, and now, distinguish that from a stock, with a stock, you actually own a piece of that company.  With a bond, you’re actually lending that company money.

Dan Henderson:  Correct.  So, if you look at it from an equity versus fixed income standpoint, with a stock or a piece of real estate, you actually have ownership of some type of property whether it be the corporation that you’re investing into or whether it be a piece of real estate.  With a bond, you actually are loaning your money to another entity and they are giving you back some rate of return relative to the money that they’re borrowing from you. 

Jim Lange:  Okay.  Now, historically, over a long period of time, stocks have done a little better than bonds.  Is that right?

Dan Henderson:  That’s correct. 

Jim Lange:  All right.  But, if you’re, let’s say, a little bit nervous about today’s market, or you’re like in most of our cases, including my own, where you want to have some money in stocks and some money in bonds, or some money in, let’s call it, the fixed income category, and then we’ll talk about the various fixed income categories, then it might be very prudent to have at least some of our money in bonds.  Is that right?

Dan Henderson:  That’s correct.  I mean, if you look at it historically, bonds normally act inversely to the stock market.  That’s not necessarily always the case.  There have been times that they act in similar fashion to one another.  The biggest year, in fact, the worst year in the bond market was 1994 right after I started in the business.  So, you do have periods of time where they act in conjunction with one another, but normally, you’re going to have a situation where bonds do well, stocks do poorly, and vice versa. 

Jim Lange:  All right.  So, in that case, is it fair to say that for most investors, that they should have at least some stocks and some bonds in their portfolio?

Dan Henderson:  Yeah.  I think the advantage of having some type of balance in a portfolio, which is really what we get to is, I think the biggest advantage there is it forces you to do what’s the correct action over time, and that’s really selling high in one asset class and buying low in another asset class.  So, having some type of strategic allocation, a portion of your, you know, overall investments to fixed income and a portion of your overall investments to stocks, that allows you to cause that rebalancing to happen on a regular basis, and it takes the emotion out of the process because a normal human being is not going to necessarily take money from something that’s going well and place it into an investment that’s doing poorly, and having that type of rebalancing allows you to do that on a regular basis.

Jim Lange:  All right, and that can be distinguished by timing because you’re not trying to time when you get in and out of the market.  What you’re doing is you’re just moving back to your original asset allocation model. 

Dan Henderson:  That’s correct, and the way that we run the portfolio is if you’re more than 5% out of balance, that’s considered to be out of compliance, and at that point in time, we take a corrective action to put the portfolio back into compliance.

Jim Lange:  Yeah.  It’s really interesting about rebalancing and how important that is.  Jonathan Clemens came on the show and he said that whatever your asset allocation strategy is, whether it’s 60% equity and 40% bonds, or the inverse, or whatever it is, he said that one of the most important things is to pick a strategy and then stick with that strategy with annual rebalancing.  Is that how you usually handle most situations?

Dan Henderson:  Yes.  That’s exactly how you want to handle the situation, and the overall allocation in a portfolio should, historically, meet the goals of the investor.  So, as an example where somebody needs to derive a 5% draw rate from a portfolio, then in order to take into consideration taxation and inflation, they’re going to have to have a gross return somewhere in the neighborhood of 8% to 9%.  So, knowing what the historical averages are for each of those asset classes, you want to create a mixture that, historically, produces that type of return.


3. Individual Bonds Vs. Other Fixed Income Classes

Jim Lange:  Okay, all right.  So, why would an investor use individual bonds as opposed to some of the other fixed income classes?  Like, why not say, why don’t I just go to Vanguard and get the Vanguard All Fixed Income Fund, or some other type of fixed income mutual fund?

Dan Henderson:  The difference between a mutual fund and an individual bond investment is with an individual bond investment, you have absolute control over both how the maturity of the bond’s going to take place.  You also control cash flow from it.  With a mutual fund, any mutual fund, and we run our own mutual fund, obviously, with a mutual fund, you do not have that type of control.  That’s dictated by the pool of investors that you’ve placed your money with.  So if, as an example, if the equity market begins to take off, as it has in the beginning of the year and it continues to run, and investor sentiment shifts away from fixed income and back into equities, then there could be a large movement in mass of money from one type of asset class to the other.  When that occurs, the bond manager, the fund manager has no choice but to generate the liquidity that’s required by its shareholders in order to disperse that money out.  So that can cause unnecessary taxation.  That can cause the fund to sell bonds at a price you’re not willing to sell them at because they have to meet liquidity requirements.  So, if you have, you know, for lack of a better description, if you have at least a quarter of a million dollars that you want to have in a fixed income portfolio, you gain a lot more control having it in individual bonds than you do having it in some type of mutual fund.

Jim Lange:  All right.  Now, you said that your company itself runs mutual funds.  Isn’t it true that your company’s mutual funds are basically stock-based and not bond-based?

Dan Henderson:  That’s correct.

Jim Lange:  And the reason for that is because you’re not a great fan of bond funds.  You actually prefer individual bonds.

Dan Henderson:  That’s correct.

Jim Lange:  All right.  Now, if I understand what you’re saying right, is if you have a bond fund and you don’t have control, and let’s just say for some reason, whether it’s liquidity needs or even if, let’s say, the interest rates go up, you can actually lose money on a bond fund.  Is that right?

Dan Henderson:  Absolutely.  If you look back ’94 as a striking example, a bond, in particular, acts inversely to interest rates.  So in a rising interest rate environment, bond prices are going to be depressed, and it’s easy to think about how that works because if I issue a bond, let’s just pick an interest rate of 3%.  If interest rates then go up to 4%, on average, for me to sell the bond that I already own that has a 3% interest rate or coupon, I must discount it because if I don’t discount it, I cannot sell that bond because if another investor comes into the marketplace, they can just go out and buy a new bond at 4%, so why would they buy mine at 3%?  And that’s basically what occurs in interest rate environments when they change.  Now, the Fed has made it very clear recently with the FOMC meeting that just occurred that they have no intention whatsoever of raising interest rates, at least as it relates to the government, until the end of 2014 now. 

Jim Lange:  Right, but let’s say you’re like a lot of our cynical clients who might not have perfect trust in our Congress or our President, and they might think that there is some inflation or, perhaps, a change in taxation coming, and let’s assume, for discussion’s sake, that they are right and that interest rates do go up. 

Dan Henderson:  Right.

Jim Lange:  Let’s say you have a ten-year bond at 3% and two years from now, or three years from now, interest goes back up to 5% and you say, “Hey, now I need that money to live.”

Dan Henderson:  Right.

Jim Lange:  If you go to sell that bond, you can’t get the face value.  Is that right?

Dan Henderson:  That’s correct.  I mean to tell you, it’s one of the worst situations we see now.  The ten-year treasury today closed at an interest rate of 1.846%.  So, using that same thinking, if you take that interest rate on the ten-year treasury, which is by far one of the most sought-after fixed income pieces in the world, you know that you’re paying taxes on that interest rate, and let’s just argue that net of taxes, you’re pocketing 1.5%. 

Jim Lange:  Okay.

Dan Henderson:  Okay?  Historically, and as of last year, inflationary rate, you know, the amount the pricing is going up’s about three.

Jim Lange:  All right.

Dan Henderson:  So, you are basically guaranteed by buying a ten-year treasury for the next decade, you’re purposely losing 1.5% of your purchasing power annually because you want to feel safe about the investment you’re buying into. 

Jim Lange:  All right, and would a similar thing be true of a CD?

Dan Henderson:  CDs are exactly the same way, depending upon the length of time that you own them.  So, a certificate of deposit, you get a guaranteed rate of return, no different from, like, a fixed annuity contract, which is another type of fixed income.  You get a guaranteed rate of return for a certain period of time.  The longer you lock yourself into that period of time, the less flexibility you have, which is why a bond ladder, which has a issue coming due every six months, eliminates that type of risk.

Jim Lange:  All right.  We’ll get to bond ladders in a minute.  You said 1994 was the worst year for bonds.

Dan Henderson:  Right.

Jim Lange:  And I don’t want to single out any one particular bond fund, but let’s say that you had purchased a bond fund with an investment of $100,000.  What would’ve happened to your investment had you wanted to get out within a certain period of time?

Dan Henderson:  Well, you know, if you’d held it for the entire year, you would’ve lost about 10% of your principle, and today, things are not much different.  So, if you look at most mature bond ladders or mature bond portfolios, because interest rates have dropped so much, pricing has continued to increase, so a lot of those portfolios are trading at a premium of 9 or 10% right now.  Eventually, they’ll revert back to the mean, and as a result of that, you have a 9 or 10% potential drop in principle. 

Jim Lange:  All right.  So what you’re saying is I know that there are a lot of conservative investors that have perhaps a higher percentage of fixed income in their portfolios than I might recommend, but let’s even say that you understand it, you know, particularly some older clients and they don’t want to have as much money in the market and they’re a little risk-averse and they might have a shorter time horizon because they’re older.  On the other hand, they sure don’t want to lose 10% of their holdings, but you’re saying that that could happen.  In fact, it has happened already and we have the kind of environment where that could easily happen again.  Is that right?

Dan Henderson:  Absolutely.  I mean, if the beginning of this year continues and equities continue to run and problems result in Europe, and we start to see consumer sentiment, investor sentiment, pick back up on the equity side of the house, then as quickly as money flowed into the bond funds, it can quickly flow in the other direction.  So if that occurs, and it’s compounded by the fact that you have interest rates rise, then it has a compounding effect and you can actually see a decrease in principle where you thought there would be none.

Hana:  Okay, we’re going to take a quick break, and when we come back, we will continue this conversation.  I want to remind our listeners out there that we are live tonight, so if you have any questions for Dan, you can give us a call at (412) 333-9385.  We’ll be right back with Dan Henderson, president of Cookson Peirce, and Jim Lange on The Lange Money Hour.

4. Commissions Vs. Fees

BREAK ONE

Hana:  Hello there, and welcome back to The Lange Money Hour.  This is Hana Haatainen Caye, and I’m here with Jim Lange and Dan Henderson, president of Cookson Peirce. 

Jim Lange:  Thanks, Hana.  The reason I asked Dan to come on the show is I think there’s a high demand for information for bonds and bond ladders, and sometimes I get a best-selling author, in this case, I got somebody who actually does this work, and I think does this as well as anybody I know in the Pittsburgh area.  Dan is the president of Cookson Peirce, and his company does, among other things, invest client’s money for bonds and bond ladders and I think I’d mentioned earlier that in full disclosure requires that I tell people I do have a strategic alliance with Cookson Peirce, in which case, we share fees and Cookson Peirce does the actual investment work, and our firm does some of the strategic work, including annual reviews for issues like should you do a Roth IRA conversion, do you have enough money for retirement, should you be giving money away, what should you do for your grandchildren’s education and whatever comes up.  But anyway, during the first portion of the show, we talked about some of the potential disadvantages of having bond funds that could substantially go down in value.  So, why don’t we talk about some of the alternatives, which would actually be bond themselves, and so why don’t you talk a little bit about individual bonds and what you do in practice when people actually need a portion of their portfolio as fixed income?

Dan Henderson:  Okay.  One of the things that I want to bring to light, which most investors don’t realize, is that the bond world operates in what’s called a secondary market.  So, the amount of money that you can get, as far as purchasing a bond or selling a bond, is determined by the brokers who basically interact with that transaction.  A lot of people believe that when they go to a broker, in particular, that they’re not paying any money in order to purchase a bond.  However, commissions can be built into, they call them points, into those purchases without really the acknowledgement of the investor and user.  So, one of the differences between trying to do it on your own and buying a $5,000 bond or a $10,000 bond versus working with a professional that will charge a fee for it is that when we go out and purchase bonds, we’re buying, you know, hundreds of thousands if not millions of dollars worth of one issue.  So, the pricing power that we get and the reduction of costs associated with commissions for that transaction are basically negated.  They’re not eliminated completely, but where you might be having a broker pay, you know, built in a 1 or 2% commission, in a lot of cases, we’re able to transact a nominal fee of $15 or $25.

Jim Lange:  Well, actually, you brought up a good point.  At one point, you used the word ‘commission,’ and at another point, you used the word ‘fee.’  Could you distinguish the two and tell us how your firm in particular works?

Dan Henderson:  Well, we work on a fee basis, so our game plan or what we’re trying to do is line ourselves with the investors so that the more money we can make them, the more fees that we can achieve.  So, basically, all boats rise at the same rate and therefore, both parties profit.  A commission is more of a transaction-based payment.

Jim Lange:  All right, so you don’t make anything on buying and selling a bond?

Dan Henderson:  No, we don’t.  We make nothing.  In fact, we actually go out to multiple bond brokers for very large firms that sell bonds and actually have them compete against each other so that we can get the lowest price.  That’s one of the advantages that we have because of the, you know, we basically run well over a hundred million dollars in individual bonds.  So, we’re obviously trying to buy them on a regular basis.  If you go to a retail place, or you go to a retail broker, in a lot of cases, then you’re going to pay a built-in commission.  It doesn’t have to be disclosed to you, by the way, like you would if you buy a stock.  They build in a pricing mechanism so that the transaction person is getting paid for that, but it’s not really disclosed to the client because it’s transacted on a secondary market. 

Jim Lange:  Well, by the way, you used the word ‘disclosure.’  I am a big fan, whether you’re working with Cookson Peirce or anybody else, that you should know exactly how the financial advisor or broker that you are working with is getting paid, and the other thing that I will mention about both the way Cookson Peirce and I and I believe most ethical…well, that’s not fair, most of the people that I prefer to do business with are what are called fiduciaries and have a fiduciary standard of care, meaning that if you go to Dan, Dan is not only morally required but he is legally required to do what he thinks is in your best interest, not in his.  If you go to (and I don’t want to mention any names), but I will just say to many of the retail outlets, and particularly when somebody is charging a commission, they are working for their company and they are not under a legal obligation to do what is best for you.  Is that fair, Dan?

Dan Henderson:  Yeah, that’s fair.  I mean, there should be full disclosure, I believe, as we continue to move forward with some of the rules and regulations that are coming out.  It should be very apparent to every investor what they’re paying a professional to manage their money for, rather than dealing in percentages, dealing in actual dollars is a lot more awakening than it is, you know, saying well I’m only paying 99 basis points, which is almost 1% for a bond portfolio, while the yield might be only 2 or 3, so a third of your earnings is going to pay for the bond manager to run that particular bond fund.


5. Risks With Bonds

Jim Lange:  Well, maybe we’ll get to some of your fees in a minute.  I think that you have established that you can lose money in a bond fund.  Now, for an individual bond, so let’s say that a client comes to you, and we’ll do the ladder part later, but let’s just say one simple bond, and let’s say that they buy a $50,000 bond of XYZ Company for three years or five years or whatever it is, and it pays a certain interest rate, and what happens if the interest rates go up and the value of that bond goes down, so if they wanted to sell it in a year or two, and what would happen if they said, “Well, I don’t care what happens to the value of it.  I want to hold it for the full three years.”  Do they always get their money back?

Dan Henderson:  Yeah, that’s a good question, and that’s called what we refer to as interest rate risk.  So, when you purchase a bond, knowing what the maturity’s going to be on it, if your intention is to hold it to maturity, you receive back what’s called par.  So, if you buy, as an example, that you had a set $50,000 bond, you may buy it at a premium or discount at the outset, depending on what the current interest rates are, but as long as you hold it to maturity, you receive back the par value, which is the $50,000.  The only risk that you have associated with that particular issue is if there’s a default.  A default occurs when a company goes bankrupt or when the municipality can no longer meet its payments.  If that happens, then you have what’s referred to as a default.  In the current world, on March 22nd this year, the big question is Greece, as an example, going to default on the bonds that they’ve issued to keep their government afloat?  So, if they go bankrupt and they cannot meet those payments, then those bonds will be basically in default. 

Jim Lange:  Well, I have quite a few older clients, and I know some of them, and I don’t want to characterize any group of people, but I think in terms of, specifically, little old ladies, if you will, who go from bank to bank looking for the best CD rate, and they say well, this is federally guaranteed, and the bonds that you’re talking about are not.

Dan Henderson:  That’s correct.

Jim Lange:  All right.  So, there is a true risk of default.  Do you have any historical knowledge, or is there anything that you do to reduce that risk, and in the big scheme of things, is it worth taking that risk to have a bond, and presumably, the higher interest rates that you’re going to get with a bond, or are you just better off saying “Hey, I just want the money guaranteed.  It’s guaranteed by the United States government.  I’m just going to go to ten banks and get, you know, a whole bunch of CDs that are all federally insured.”

Dan Henderson:  Well, there’s a good rule of investing and it carries through to every asset class, and that is the more risk you’re willing to take, the better return you can achieve.  That’s no different in the bond world.  So, we mitigate risk by buying issues that are of top quality.

Jim Lange:  All right.  So, you’re not a junk bond dealer?

Dan Henderson:  No, no.  We actually avoid that.  We’re actually, the way on the corporate side of the world, the bond issues that we purchase are more conservative than most bank trust departments.  So, we’re buying bonds that have ratings of ‘A’ or higher, so there’s triple A, double A and single A.  A triple B is still considered to be investment grade, and then below that, you drop into what’s referred to as junk bonds, because over the life of a bond, you can have a downgrade, which we’ve become all very too well aware of with the S&P ratings and the Moody’s ratings and Fitch.  Those occur over the life of a bond, so you don’t want to automatically start yourself on the bottom rung because there’s only one place to go if you have a slip, and that’s to the junk status.  If that occurs, then you have a dramatic change in the value of that security because it’s no longer considered investment grade anymore.  It slipped into junk status.  That doesn’t change the fact that as long as a company doesn’t go under, when you hold it to maturity, you’re going to get back your money, but it increases the likelihood a default could occur.  And therefore, those individuals who have such a low rating must pay a higher interest rate.  It’s no different than a consumer who’s out there with a bad credit rating.  If you have a bad credit rating, the credit cards you get are at a much higher rate than your neighbor who has a good credit rating.  They’re getting a credit card at a much lower rate, and that’s because a risk of default, or the risk of non-payment, is much lower if you have a better credit rating.

Jim Lange:  And you’re saying that you would rather own the debt of the good payer with a good history who has a good rating from Moody’s or the S&P than, let’s say, starting with a junk bond that has a higher face?

Dan Henderson:  Correct, because we think you should take the risk on the equity side of the house and not on the fixed income side of the house.  So, the fixed income side of the house is generating a fixed income.  I can’t emphasize that enough.  It’s a certain stream of income that you’re relying on either to pay yourself every month while you’re retired or pay yourself once a year if you take money in a lump sum, but it’s a certain amount of money that you know you’re going to derive from that portfolio regardless of what’s going on in the marketplace or regardless of what’s going on in the environment.  So those are the types of things that you have to take into consideration. 

Jim Lange:  All right.  So, right now, we’ve mainly been talking about individual bonds as if you go and buy one bond, but in the real world, if a client comes in, and let’s say that there’s at least a couple hundred thousand dollars involved, you’re not buying one bond for that client, are you?

Dan Henderson:  No, we’re not.

 


6. What are Bond Ladders?

Jim Lange:  All right.  So, as I understand it, you are buying bond ladders.  Could you tell our listeners what a bond ladder is and why you choose to use bond ladders instead of alternatives?

Dan Henderson:  A bond ladder, and right now, we have a bias towards about a ten-year length of time, but a bond ladder, you’re buying an issue, best case scenario, you’re buying at least two issues per year.  So about every six months, a bond is maturing.  In other words, it’s coming due in the entity from whom you purchased it from is paying you back the principle of that bond, the par value.  At that given period of time, you can either use the money if you need it, use it for the balancing in a portfolio if necessary, but if you don’t, which is in most cases, you simply take the proceeds from that bond and put it to the very end of the ladder, because if you look at interest rates over a ten-year period of time, the short-term interest rates, you should see what’s called a steep yield curve, or a yield curve.  That’s the difference between what the rates are in a short-term, which is a one, two, three-year period of time, and what they look like ten years out into the future.  So, you should get paid a premium to go further out onto the ladder, and over time, that’s exactly what happens.  Right now, we have a relatively flat yield curve, so there’s not a big difference between the short-term rates and the long-term rates, but over time, you start to have a yield curve, which is a little bit more steep.  So, by doing that on a regular basis, which you’re negating is what’s happening in the interest rate environment.  So, as you follow that discipline, whether interest rates are high or low, based upon which you made the original purchase at, it doesn’t matter because every six months, you have another issue coming due, and by having that come due, you can place it at the back of the ladder and over time, negate any interest rate movements.  That’s much, much different, by the way, than a fixed annuity contract, or much different from a certificate of deposit because there, you are blocking yourself into a known rate for six, seven, eight, ten years in time, and you have no way to get any variableness of that return.

Jim Lange:  All right.  So, let’s say, even comparing it to, say, a fixed annuity, which might be comparable, is it fair to say that the fixed annuity rate might have a higher face amount than, let’s say, maybe a three-year bond that you might be selling, or recommending right now, but that at the end of the three years, maybe the interest rates will be higher.  The client can then take the proceeds of the bond, put it in something higher where the person who has the fixed annuity will then continue to be stuck at that same rate.

Dan Henderson:  Well, yeah.  They wouldn’t necessarily be stuck, but I’ll tell you what they’ll incur, which is called a surrender charge.  So, most of those contracts have between a six to nine year surrender charge, and while you place your money into those, sure, you can take it back out, but you’re going to pay a very large penalty for doing so, and a lot of them, unfortunately, are set up with what are called teaser rates, so let’s say the prevalent rate right now is 2%, they may offer an extra percent or two, but only for the first year, and then it goes down to whatever the guaranteed rate is after that period of time, but you’re still locked into it.  So, you have to really take a look, again, I go back to the same premise I always do when I talk about investing, which is if it sounds too good to be true, it normally is.  So, you have to take a look at all the bells and whistles associated with those products. 


7. Investing Strategy With Bonds

Jim Lange:  Okay.  The other thing is, can you give our listeners some idea of mechanically what happens when somebody comes to see you, and I know that you also do equity investing.  I think that you guys have some very interesting ways of doing equity investing, and I happen to like your slogan “We do the math,” and the way that you do it, but since this is about fixed income, what would be a typical thing that would happen?  So, somebody comes in and, let’s just say on the bond side, there’s a couple hundred thousand dollars, and you take a look at what their cash flow needs are, what is typically going to happen?

Dan Henderson:  Well, the first thing is, we have to take a look at what the total portfolio is going to be comprised of, and we have a biased by 25,000 issues or higher, so there is a better pricing model when you have a $25,000 bond or $50,000 or it’s a multiple of a $25,000 bond.  When you go below that amount of money, we call it breaking a bond.  When you go below a $25,000 issue, you usually pay a premium price for that because most retail investors, those are the type of bonds they might buy $5,000 or $10,000 or $15,000 bonds, so our bias is to $25,000.  That’s where you get the best pricing power.  We also start to build a ladder which begins with a six-month maturity from now, because it stretches all the way out to ten years into the future, and over time, it may not happen very quickly, it could take us a couple of weeks, but we try to build a ladder of bonds that have maturities about every six months so that issues coming due every six months and we can continue the passive ladder process.

Jim Lange:  And how do you decide which bonds you want to buy for clients and which ones you don’t?

Dan Henderson:  The primary way we focus on is called yield maturity.  So, when you purchase a bond, at least in the current environment, most of the bonds are selling at a premium, so you are buying a bond that has a coupon rate of, let’s say, 5%, while the yield to maturity on that bond over the lifetime of the bond because you pay a premium might only be about 3%, and while some people may say that’s not acceptable, given what the rates are right now, that’s what’s available right now in the marketplace.  So, we look at yield maturity because that’s the overriding factor.  That’s the amount of money that you’re going to earn, as long as the bond doesn’t default, based upon what you purchased for it and what it’s going to mature at in the future. 

Jim Lange:  All right.  Well, this is pretty interesting because usually, you think, on the radio, people would want to sensationalize things and talk about this 10% guaranteed interest rate and all kinds of things and bells and whistles, and what you’re saying is, really, if you’re a grownup and you’re interested in fixed-income investing, you might not want to go for a junk bond or some other thing that is paying substantially more.  Is that correct?

Dan Henderson:  That’s correct, unless you want to put your principle at risk, and our argument would be that if you’re going to take that route, then you’re better off on the equity side of the house than you are on the fixed income.

Jim Lange:  All right.  So, then it is fair to say that what we’re really talking about is…I mean, 3% doesn’t sound all that great.

Dan Henderson:  That’s correct.

Jim Lange:  On the other hand, for people who are risk-averse and perhaps don’t need such a high return because they’re either older or they have a significant portfolio or perhaps they’re not great spenders like most of my clients, that might be a good solution for at least part of their portfolio.

Dan Henderson:  Correct.

Hana:  Okay.  Sorry about this, but we need to take another break.  When we come back, we’ll continue the conversation about ladder bonds, and I want to remind our listeners that you do have a few minutes yet to call in.  If you have any questions for Dan, it’s (412) 333-9385. 

BREAK TWO

Hana:  Welcome back to The Lange Money Hour.  This is Hana Haatainen Caye, and I’m here with Jim Lange and Dan Henderson, president of Cookson Peirce, and guys, I found it kind of interesting today to hear the news about Facebook in the investment market and wanted to know what your take was on that, Dan.

Dan Henderson:  I’d say Mark Zuckerberg just became the most eligible bachelor in the United States of America.  I think they priced it at $25,000,000,000, so that puts his net worth somewhere around $6 or $7,000,000,000 for the day.  All joking aside, I think it’s a great story.  It’s the American way.  It’s showing a lot of innovation.  It shows you what we can do as Americans, but our general rule of thumb, in all honesty, is we avoid IPOs for at least six months, and the reason is because six months after the initial public offering date is when insiders can become liquid, and that’s when the majority of them will liquidate their holdings in order to take profits from those firms.  So, our rule of thumb for the firm is that we will not participate in those until we get beyond that date.  A statistical fact of the matter is that over 75% of the time, the current price six months from the date of the IPO is usually lower than the IPO price, so we tend not to play in that neighborhood.

Jim Lange:  Poor Mark.  He won’t be happy about that at all.

Hana:  I’m sure he’s listening!

Dan Henderson:  I’m sure he’ll be very happy.


8. Do Not Break a Certificate of Deposit Early

Jim Lange:  All right.  Anyway, getting back to the real world and the purchase of bonds, I have a client, actually very sweet, you might call her a little old lady, and she has basically gone from bank to bank and has a variety of CDs with different maturation dates, and let’s say that she is not happy with the rate that she’s getting, and she recognizes that, particularly in the long run, there’s a significant difference between a half a percent or one percent and three percent, and that she is interested in investing some money in a bond ladder with you.  But she doesn’t have $500,000 cash that she can just say, “Okay, I’m going to write a check from my checkbook.  Go invest this $500,000.”  She has a bunch of CDs coming due at different points, and let’s even say that maybe she has some existing bonds that have different maturity dates.  How do you, as a firm, handle a client like that?

Dan Henderson:  Usually, Jim, we take a look at the portfolio of fixed income she currently has and what the maturity dates are going to be, and work out a contract that they will at least come to our minimum bond portfolio side, which is a quarter of a million dollars, within a reasonable amount of time.  It almost never makes sense to break a certificate of deposit early and suffer a penalty for doing so.

Jim Lange:  By the way, could you repeat that, because there are some, I don’t want to say anything bad about anybody who sells products, but there are product salesmen out there, and I have actually, believe it or not, when I go around the country, I often give workshops on Roth IRAs and Roth IRA conversions, and I’m sometimes part of a sales meeting for some of these product people, and they actually had a whole, I think, ninety-minute session on ‘how to get a client to break a CD to use the money to buy a variable annuity.’ 

Dan Henderson:  Yeah, that’s because the commission rates on a variable annuity are about six times higher than they are on a certificate of deposit.  So, that’s only serving the product salesperson and not the client in any way, shape or form.

Jim Lange:  All right, and again, that comes back to fiduciary duty.  Somebody who does that doesn’t have a legal obligation to do what is best for the client.

Dan Henderson:  Correct.  Well, the reality of it is, in any type of investing, how well you do for an investor is based upon the trust level you’ve been able to develop with that individual.  If your focus is on the short-term and getting paid one time, then commissions become very attractive for that type of transaction, but if your focus is on building a trusted relationship over a very long period of time, we have clients who go back 27 years to the inception of our firm.  Those are the type of clients that we’re most interested in, and you’re not going to serve them well by telling them to take penalties on particular products just to rush into a new product.

Jim Lange:  Well, by the way, I agree with you, and I have that same goal.  Now, my goal’s slightly different than yours because I’m not actually doing the investing, but my goal, when it really comes down to it, is to be the trusted advisor of a limited and not an unlimited number of clients, and it sounds like what you’re saying is, and also with a $250,000 bond minimum, you’re not looking to make a high commission on a $10,000 or a $25,000 bond, you’re looking for people that have more wealth, and you’re looking for a long-term relationship, so hopefully, if they go with you, they’re there for five, ten or twenty years for the duration.

Dan Henderson:  Absolutely.  I mean, we’re looking at it as a business for the long run where it serves us best and it serves the client also as equally or better.  I think it’s kind of shortsighted to take a different approach.  One of the unique things working, you know, that maybe your clientele or people that come through you to understand is that if they hadn’t come through you if they don’t have a million dollars, they’re not talking to us.  So that’s a unique arrangement that we’ve been able to develop, but I think it also serves investors well because not everybody’s ready to hand over the keys to the car in its entirety to one particular person.  They want to try to develop a relationship over time and see through action, not through words, that they do have a trusted relationship, and over time, then both parties can come to what’s in the best interests of both situations.

Jim Lange:  Well, going back to somebody with $250,000 and a whole bunch of CDs, and maybe not even $250,000 in investible assets immediately.  It seems to be, because I know a little bit about your process and how much time and work it takes you to put that together, that if you were to take the number of hours that you and the people on your firm spend on that on an hourly basis, it’s pretty darn low.  Unless that person stays with you for a lot of years, you’re losing money.       

Dan Henderson:  Yeah, I mean, we go into every relationship assuming that the client is going to remain a client of ours for life.  You know, we have some client relationships that are four generations in length, and I think that says a lot about the company and I think that says a lot about the people that we serve.  Everybody should be given the best advice regardless of the amount of assets that they have.  From a mechanical standpoint, it doesn’t make a lot of sense to do individual managed bond ladders below a quarter of a million dollars.  However, when you take a look at an investor that has well more than that but happens to be tied up over some period of time in other products, you know, annuities in general, then you should step back away from that table and say is this a good idea entering this relationship, and if it is, then it makes a lot of sense for both.

Jim Lange:  Now, if somebody really likes annuities, you can sell them annuities, right?

Dan Henderson:  Yeah.  You know, you can go down that route.  I think they have their use for certain things.  I don’t necessarily agree with fixed annuities or variable annuities.  Immediate annuities have a use, especially if you’re rolling out of an old annuity, but there are more flexible and less prohibitive investment vehicles out there that can get you equally good rates of return if not better rates of return over time. 

Jim Lange:  Yeah, and by the way, I should tell people immediate annuities are a completely different beast with a much lower commission structure than, say, either a variable annuity or a fixed annuity, and the immediate annuities are the ones that are trumpeted by the true consumer report people like Jonathan Clemens, who’s been on this show saying that he likes those, and Jane Bryant Quinn and Larry Kotlikoff.  So, that really is a good thing.  I’m afraid we’re not going to have much time, but one of the questions that I would have is, I guess there’s obviously a difference with comfort levels, but how do you usually determine what percentage an exposure should an individual investor have to bonds through fixed income?

Dan Henderson:  Well, I think the biggest thing goes back to asset class.  Right now, the asset classes that are out there, I think, have been distorted by recent evens in the marketplace.  You know, an equity asset normally does not return three or four percent over a decade.  A bond portfolio normally will not return ten percent in a year.  Those are returns we’ve seen in recent times based upon events that we never thought would happen in a lifetime, and they should never be extrapolated.  Just like when I thought in the late nineties with clients, explaining that we were not going to illustrate equity returns at 20% because that’s not reality, and it turns out that it really wasn’t.  I don’t think it makes a lot of sense to show bond returns somewhere north of five or six percent when that’s not going to be reality going forward either.  So, the total rate of return you need to achieve in a portfolio takes an overriding factor, and you have to work backwards from that, and that’s where you come up with a good allocation. 

Hana:  Okay.  Well, this has been really informative tonight.  I want to thank you all for joining us for another Lange Money Hour, Where Smart Money Talks.  A special thank you to you, Dan, and I want to just mention that he joins our growing list of informative guests throughout the years, including Jane Bryan Quinn, Ed Slott, Roger Ibbetson and others.  You can access our vast library of past shows on our website at www.retiresecure.com, and as always, you can catch a rebroadcast of this show on Sunday morning at 9:05 right here on KQV.  Join us at 7:05 pm on February 15th when our special guest will be Larry Kotlikoff, best-selling author and Professor of Economics at Boston University.

END      

 

James Lange, CPA/Attorney

Jim is a nationally-recognized tax, retirement and estate planning attorney with a thriving registered investment advisory practice in Pittsburgh, Pennsylvania.  He is the President and Founder of The Roth IRA Institute™ and the bestselling author of Retire Secure! Pay Taxes Later (first and second editions) and The Roth Revolution: Pay Taxes Once and Never Again.  He offers well-researched, time-tested recommendations focusing on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans.  His plans include tax-savvy advice, will and trust preparation and intricate beneficiary designations for IRAs and other retirement plans.  Jim's advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, his recommendations frequently appear in The Wall Street Journal, and his articles have been published in Financial Planning, Kiplinger's Retirement Reports and The Tax Adviser (AICPA).  Both of Jim’s books have been acclaimed by over 60 industry experts including Charles Schwab, Roger Ibbotson, Natalie Choate, Ed Slott, and Bob Keebler.

Free Bonus!

As a gift, you'll receive a summary of Jim's bestseller, Retire Secure! - acclaimed by Charles Schwab, Ed Slott, Jane Bryant Quinn and 50 other financial professionals! Enter your e-mail address to receive our FREE e-newsletter!

Need a Keynote Speaker?

James Lange, CPA/Attorney Nationally-Acclaimed Roth IRA Expert, Best-Selling Author & Keynote Speaker Training Your Financial Advisors on the Latest, Cutting-Edge Roth IRA Conversion Strategies Jim Lange - Now Available to Train YOUR Team

» Learn More

Follow Us on Facebook