Managing Risk With Fixed Income: How to Buy Zero Coupon Bonds

 
Today’s guest post on the mechanics of selecting and purchasing U.S. Treasury bonds comes courtesy of the man behind Reaching the Crest.

His blog has been dormant for quite some time now. I think he’s been too busy taking a deep dive into the investing world to create new content of his own!

As you will read several times, he is a member of my fatFIRE Facebook group, a community I created for readers interested in a bigger budget style of FIRE. It started as a place to direct non-physicians who asked to join Physicians on FIRE, but it has since taken on a personality all its own and is growing at a rapid pace.

Personally, I have kept my fixed income investing simple (Vanguard Total Bond Fund), but those who correctly predicted the fall in rates have done quite well with the Treasury portion of their portfolios.

 

Managing Risk With Fixed Income: How to Buy Zero Coupon Bonds

 

Today’s topic of U.S. Treasuries was inspired by a small group of individuals on Physician on FIRE’s Facebook group called FatFIRE. If you are a frequent reader of Physician on Fire and not a member of this Facebook group, you are passing up some real value.

Sometime over the holidays, I felt like I had been smacked in the face.  Not literally of course, but after reading a line of thought that was so counter to what the majority of people were doing financially, my eyes were opened.  In some ways, this new perspective had turned my financial planning world upside down. Or at least a part of it.

This new perspective had to do with using individual Treasury Bonds as a way to hedge risk. Looking back, I couldn’t remember a single article from the blogs I commonly read that spoke specifically to using Treasuries. There were references to bonds but mostly bond funds. I, too, was a holder of bond funds.

As I continued to explore the topic, I came to realize that there seems to be a glaring hole in the word of personal finance. This topic of owning individual bonds has been discarded for portfolio holdings that are easier to understand, i.e. just buy the index.

 

But First, What is FatFIRE?

 

Physician on Fire describes it well:

“The average American household spends somewhere between $50,000 and $60,000 in 2018. A leanFIRE budget is at most half of that. I’d say fatFIRE is somewhere in the neighborhood of double. Since we like round, even numbers, let’s call a fatFIRE budget $100,000 a year.”

 

If you are a high income earner and saving a large percentage of your income, chances are you are on your way to a FatFIRE type of retirement without even knowing it.

[PoF: I have since refined that definition, since it varies so much from person to person based on where they live, single versus married with children, etc… but I stick with the assertion that it includes a level of spending well above average compared to others who share your demographics.

For a solid discussion on the topic, have a listen to an episode devoted to fatFIRE on the What’s Up Next podcast.]

 

The Basics Don’t Include Treasuries

 

I suspect that many people reading this today might feel like you have a good handle on the basics of personal financial topics.  Everything from what type of funds you prefer to a understanding of withdrawal rates.  If you are super fancy you might even be able to execute a backdoor Roth conversion.

And even if you are just starting your financial journey and learning some of the basics.  That’s ok, too.

Personally, I have felt for some time that I have a good handle on most of these types of topics and strategies. But from time to time, we get presented with a counter argument that is so good that you have to take a pause and reevaluate.

If you were like me, your view of bonds was owning shares of some type of bond mutual fund – mainly focused on getting a decent yield and hoping it was ‘safer’ than your equity positions. In all my years with Fidelity I had rarely – or maybe even never – ventured over to the fixed income side of Fidelity’s brokerage website.

The Case For Treasuries

 

As a community of individual investors, I believe many of us are missing out by not spending more time thinking about the bond market. There simply isn’t enough dialogue on bonds.  The bond market is a good indicator of the overall economy. And now with rates moving up from historic lows, it is a good time to take a look. But there is more to it than simply chasing yield.

 

[PoF: When this post was written several months ago, this was true! Now, we’re seeing falling rates and high-interest savings accounts offering less than they did in the spring.]

 

The use of Treasuries was made very clear by a few 9-figure Net Worth types who are members of the FatFIRE group.  There have been many times when their ideas have run counter to the group. Some like to argue back, but me, I’m literally taking notes from some of their comments.

Money is not always a good indicator of intelligence, but I feel like in this case, these individuals are pretty smart. And no early retirement for some of these folks – they are hard at work, earning, saving, and investing.  Passing on to the next generation.

That type of wealth seems to provide a perspective that most do not have.  Even those with a ‘two-comma’ net worth are most likely not doing the same thing as someone with that type of wealth.

 

What The Heck Is A 30-Year Zero?!?

 

How many people do you know buying large positions of 30-year Zeros in anticipation of future rate reductions by the Federal Reserve once this business cycle comes to an end?  This idea, of course, led to lots of discussion within the pages of the FatFIRE group.

Some people were trying to understand the business cycle, some were disputing that rates would be lowered any time soon, some were on the set-it-and-forget-it index path, but many of us were simply asking, “What the heck is a 30-year zero!?”

 

Time To Get Smart (or at least smarter)

 

The first book I picked up was Bonds: The Unbeaten Path to Secure Investment Growth, by Hildy Richelson.

This book makes the case for owning only bonds.  Although, I’m not planning to sell all my equity shares just yet, it is an excellent book for learning the fundamentals of bonds and bond investing.

After reading this book, you will better understood many of the basics of bonds. The timing was perfect as there was much discussion in the financial world about whether the Federal Reserve was going to raise rates back in December 2018.

From the early Fall, through the very volatile stock market month of December, my view of the fixed income world started taking form. I suspect it will continue to evolve. There is a strong case to be made for a larger focus on the fixed income world.

And, frankly, if you are a high-income earner with a high savings rate, there is a case to be made for an overall larger percentage of your holdings being placed into a fixed Income Portfolio.

 

Below are some of my key takeaways from discussions and readings:

 

  1. You should view your portfolio in two distinct parts: the equity side, and the fixed income side.  Both are equally important.
  2. Many of us are taking way too much risk with our hard-earned money.
  3. When seeking safety, investing in a bond fund is not hedging against risk the way we really need it to.
  4. The ultra-wealthy are managing risk better than the rest of us.  While we talk about diversification of stocks, they are looking outside of that pool of assets.
  5. Within an equity-focused portfolio, you need to create an uncorrelated asset base to reduce your overall risk from market down turns (think: financial crisis). This is paraphrased from one of those smart folks in the FatFIRE Group!
  6. Don’t make bad investment choices or take on excess risk for the sake of saving on taxes.  Although the stock index fund may be more tax friendly, that’s not always a good reason to invest in it.  Speaking of taxes, Treasury income is exempt from state income tax but not Federal.
  7. During the economic crisis of 2008, there were many people who made a fortune in Treasury Bonds.  Their long-term Treasury position became very valuable as the Federal Reserve lowered rates down to zero. As interest rates go down, the value of those bonds go up!  When will the Federal Reserve begin to lower rates?  Have you watched the Ray Dalio video yet? No? Keep reading.

 

The Economic Cycle and Reduction of Risk

 

Ray Dalio, founder of BlackRock, arguably created one of the most successful hedge-funds in the world.   In recent years Ray has started to do more public speaking and sharing his views.

I would strongly encourage everyone who wants to have a better understanding of the economic cycle to watch the below video.  It is well worth the time.  It helped me understand the role of the Federal Reserve, interest rates, and why a Treasury Bond position is so important.

 

 

At a time when many think we are towards the end of the current business cycle that often leads to a recession, the use of Treasury Bonds is a good way to create that uncorrelated asset base to reduce your overall risk from market downturns.

As I’ve learned more about bonds, I’ve come to realize that when I chose to own a bond fund, I was in many ways defeating the whole purpose of the intended use of that money.  A bond fund does not secure your principle as you don’t actually own any bonds. You don’t control when bonds are bought or sold. Your principal is at risk the entire time.

Buying individual bonds across the yield curve provides for a much more stable fixed income position.  If rates go up and bond prices fall, you can simply hold your bonds until maturity, collecting coupons along the way and receive your principal back at the end.

If rates go down, your bond positions at the far end of the yield curve (longer maturity dates) will go up in value – potentially offering you a capital gain. You could choose to sell or hold and collect the coupons until maturity.

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Where To Buy U.S. Treasuries

 

Many of the larger brokerage firms have direct access to the Treasury Market.  You can also buy them directly through the Government at www.TreasuryDirect.Gov.  I have been buying Treasury positions through Fidelity. I’ve had a Fidelity brokerage account since I was about 16 years old.  If you are lucky, you may also have an employer-sponsored retirement plan that has the option of Treasuries.

I’m currently limited by the funds I have in a Taxable account, Roth IRA, and a Rollover IRA.  Funny enough, I work for the Federal Government and don’t have the ability to buy Treasuries through my retirement account.  I only have access to a bond fund and something called the G-Fund which is a unique Treasury instrument only provided to Federal Employees, but it doesn’t act exactly like a bond.

 

How to Buy U.S. Treasuries

 

One thing that really helped my understanding of how to buy a Treasury bond was to actually go buy one. On the Fidelity website, you have to go to the News and Research section and click on Fixed Income Bonds & CDs.  The Landing page is below.

 

 

It’s important to note that most bonds are purchased on the secondary market.  You can certainly buy New Issue Bonds, but there is no reason to worry about buying on the secondary market.  This is how the majority of bonds are bought and sold.

U.S. Treasuries are considered to be very liquid, meaning there are enough buyers for your bonds if and when you desire or need to sell. This is not the case for all types of bonds, but it is for Treasuries. As a result, most of the my orders are executed within seconds.  There have only been two times when orders weren’t fulfilled.  And honestly, I’m not sure why.

A strong secondary market makes buying a long term bond a little less, well, scary. If you buy a 10-year bond, it can easily be sold prior to it maturing. The value may have changed, but it can still be sold if absolutely needed.

Notice on the screenshot above that the cost to trade is $1 per bond.  To me, this is a fairly affordable trading cost.

 

 

The next step is to take a look at the yield page (next picture below). Fidelity does a really nice job here. One simple page to see all the current yields across all fixed income types.

When looking at the U.S. Treasury row, you are essentially looking at the yield curve. You can see the small inversion between the 2- and 3-year treasury. Meaning the 2-year has a higher rate at 2.62 than the 3-year at 2.60. Small but still its inverted. The 3-year should yield more than a 2-year if the yield curve was steeper. The curve is very flat right now.

 

Each percentage on the table is a hyperlink to available bonds within that maturity range. It’s also worth noting that you can do a more detailed search for Treasuries that don’t fit within these durations. If you want a 7-year bond, you just have to search for the proper month and year you desire the bond to mature. The yield will be calculated by market demand.

If we click on the 10-Year U. S Treasury 2.79 it brings you to the below table.

A few quick basics: A bond’s trading price at Par (100) has a value of $1,000. A New Issue bond or a bond closer to maturing will be closer to its original par value. The below options are not new issue bonds, so the par value will not be exactly 100.

 

 

There were 5 options on this day with maturity dates ranging from 2028 to 2029.

 

 

The first option is the highest yield. Note the coupon at 5.25 that was the original yield at the time of issuance. However, the price of this bond is 121 which means you will pay over $1,000 for this bond. This is sometimes referred to as buying at a premium – essentially paying for the higher coupon, which lowers the yield to maturity down to 2.8%.

As this bond gets closer to its maturity date, the price will slowly drop down closer to 100. Final coupon will be paid along with the $1,000 worth of principal.

The bottom option that I circled shows a coupon at 2.87 and a yield of 2.78, but notice that the price is nearly at Par or 100.

There are arguments for and against buying bonds over par. Some in favor argue that you are essentially paying for the higher cash flow and make up the difference over time by collecting higher coupons. Some argue they don’t like to see the value go back down to 100. There are also some tax implications. At this point, I need further study and remain undecided.

The deviation from par is less noticeable for shorter duration bonds or notes. Below are what the one-year bond options look like. There are a lot of choices and nearly all at or under par. Bonds with shorter maturity are less prone to interest rate risk and will remain closer to their par value.

 

 

When you decide which bond you want, simply click on “Buy” and it takes you to the order screen. I’ve only used market orders. The few times I have tried to adjust the price, the order hasn’t gone through.

Also, there is a small notification on price adjustment to account for not buying minimums you see next to the bonds in the table above. Some have minimum quantities of 25, and some are as high as 3,000 or more. Remember each bond is worth roughly $1,000.

For this example, as you can see pictured below, I have placed an order for five bonds. The Limit Price was auto-populated. Once you hit “Preview Order,” it will confirm one more time that you want to make the trade.

 

 

One important note: bonds are traded when the market is open – not when closed. Unlike stocks, where you can place orders after the markets close, you will have to find a time during the day to place your bond orders.

Examples of prior trades I’ve made show the transaction of buying either above or below par.

 

Over Par Under Par

 

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Below, for reference, is one example of the relationship between changes in interest rate and bond value for a 10-year bond issued at a 9% coupon.

 

 

Once you have purchased some bonds, Fidelity has a great Fixed Income Analysis Tool that will allow you to see your positions, principal maturity, and cash flow. I can really see how useful this tool will become.

 

As you build your portfolio, seeing the averages is very useful. It is also helpful to better understand the relationships between price, yield, and coupon.

Below are a few of my positions in one of my Fidelity accounts. My wife and I both have accounts. Once the 2019 positions mature I will likely continue to buy into the 10-year and beyond. Although I now know what a 30-year zero is, I’m not sure I will be entering into that position just yet.