James Mayo keeps meeting the same new client. Most of the bond money sits in high-yield funds, and the client has no idea those funds hold low-rated junk. “They just see the high yield,” the Lakewood, Colo., planner told the Journal's Ashlea Ebeling. Her Wednesday guide to buying bonds, with the 10-year Treasury near multidecade highs, lists five risks. The yield isn't one of them. It's what the risks pay you for.
Credit risk comes first. A bond is a loan you make, and a weaker borrower pays you more because it's more likely to stiff you. Investment-grade bonds carry lower yields and lower default risk. Junk carries the opposite. Allan Roth, a Colorado Springs planner, notes the Bloomberg U.S. Aggregate index used to be the Lehman Brothers Aggregate. Big names go under.
How long, and who can end it early
Duration risk is next. The longer you lend, the more the bond's price drops when rates rise. Schwab's Cooper Howard says an individual bond lets you look past that, since you know what it pays at maturity. Picture a 20-year bond you bought at 4%. A similar new one now pays 5%. You still earn your 4%, and if rates fall to 3% you'll be glad you locked it in. If you'll have to sell along the way, hold shorter and intermediate bonds, and ladder them so something matures every year. Then call risk. Many corporate and most muni bonds let the issuer repay you early if rates fall, exactly when you'd want to keep them. Noncallable bonds, or 5 to 10 years of call protection, fix that, usually at a little less yield. Mortgage bonds carry a cousin, prepayment risk, since homeowners refinance when rates drop.
Last, taxes. The IRS taxes bond interest like wages, so an IRA or 401(k) is usually the right shelf. Muni interest skips federal tax, and Treasury interest skips state tax. TIPS, the inflation-linked Treasurys, create “phantom income” in a taxable account, since you owe tax each year on an inflation bump you don't collect until maturity. They belong in a tax-deferred account, unless you're a high earner in a high-tax state. Roth adds the risk he calls the biggest. Skipping bonds and letting cash sit in a checking or sweep account that pays almost nothing.
Our read
Fixed Income IN02, and this is the house's own checklist, written by someone else. We keep safe money in Treasury bills and floating-rate Treasury paper. SGOV is held at weight in 49 books and USFR in 14; nothing added. Long Treasurys sit in only 4 older books, nothing added there either. That handles duration risk and credit risk the plain way, by not taking them with money that has a job. Mayo's clients shopped the yield column. A 5% yield on a junk fund and a 5% yield on a Treasury bill are different products, and only one is safe money. General principles, not advice for anyone in particular.
Here's the connection to your own plan. Open the 401(k) app or the brokerage statement and find your safe money line. The bond fund, the stable value, the sweep. This week's check is its fact sheet, for two things. The credit quality box, and the words 'high yield' or any rating below BBB, the lowest investment grade. And the duration number, in years. If your safe money is junk, or the duration runs past ten years, we wouldn't call it safe, whatever the yield says. Then look at the cash in the sweep, which Roth says is the biggest risk of all. That's the umbrella you already own, so check it for holes before the weather turns.