Rebecca Hotsko (02:16):

Thanks so much for coming back on the show, Brian. So, for today’s discussion I wanted to go over some of the basics of bonds with you, how to invest in them and just some different bond investing strategies and maybe some products that are most suitable for millennials. Recently we’ve had on some guests talking about bonds and suggesting they might be a good investment for millennials right now. But I also had some listeners message me saying they’re not sure how to apply this as the bond universe is so large.

(02:45):

So, I thought it would be good to have you on and go over some of these bond basics. So, I guess just to start off, I think it would be helpful to talk about what are the benefits of investing in bonds to just help our listeners determine if adding some fixed income exposure to their portfolio makes sense, because it won’t make sense for everyone, but I think this could help frame the conversation of who it might be good for.

Brian Martucci (03:10):

Yeah. Bonds do make sense for a lot of millennial, investors, a lot of younger investors. I think the biggest reason you’ll hear people recommend that you invest in bonds is for diversification. Their stocks and bonds aren’t opposite or it’s not like a yin and yang situation, but they do tend to have an inverse relationship historically. Meaning in a good year for stocks, bonds won’t do as well, but in a bad year for stocks, bonds tend to do better. This past year, the post pandemic period has been a counter to that. Historically it’s been an aberration in that stocks and bonds have not done very well, but bonds have still performed better than stocks.

(03:54):

It’s been a really awful year for both and actually it’s been a historically terrible year for bonds. So, this is about the worst bonds I’ve ever done, which is kind of good thing if, again, you’re comparing to how the stock market has done, which is even worse. So, going back to diversification, most younger investors, the recommendation is not that you are all in bonds or even a majority in bonds, depending on your risk tolerance. Maybe it’s 90% stocks, 10% bonds or 80% stocks, 20% bonds if you’re a little bit more conservative. You can have higher allocation over time as you get older, because bonds are generally less risky, the recommendation usually is to increase your bond holdings and decrease your stock holdings proportionally.

(04:39):

But we’re talking as you get into your fifties and sixties. The benefits of bonds, there are several beyond the inverse relationship with stocks. One is capital preservation. So bonds, they’re less risky than stocks overall, they’re less volatile, and that means that even bad years for bonds the price swings tend to be less dynamic than with stocks, which is good if you are risk averse and you don’t want to keep your money in cash, which is even less volatile and has less upside, but you still want to have the benefit of not owning stocks that are going to lose half their value over 18 months.

(05:17):

Another thing some stocks do, but not all, is income generation. Virtually all bonds pay interest and sometimes those interest rates can be pretty attractive, much better than even now than your money is going to do in the bank and certainly higher than stock dividends. Those interest payments are known as coupon payments and they usually come semi-annually, so twice a year. And it’s always predictable, it’s usually fixed. There are some exceptions that we’ll probably talk about. So, that’s really nice. It’s predictable and you can either reinvest those payments if you own a bond fund or if you want income, you can just take those payments. And so that’s another really helpful attribute. And those are actually the two big ones for millennials tends to be cited.

Rebecca Hotsko (06:03):

Yeah, I think that’s really helpful the way you explain that, because when some of our guests come on and they recommend bonds or they say it’s a good investment right now, it doesn’t necessarily mean it’s good for everyone, because their strategy behind that might be shorter term or just might be more tactical. And so I kind of just wanted to go over the basics and go over some of the risks and benefits and then investors can figure out if it does make sense for them. And so I guess I do want to go over the risks of investing in bonds with you, because it’s different than equity. So, can you talk about some of the main risks with bond investing?

Brian Martucci (06:41):

Sure. And there are several. So, the biggest one is, and it kind of gets at a fundamental aspect of bonds, is that interest rates and prices tend to move, the bond prices tend to have an inverse relationship. So, when prevailing interest rates rise, bond prices tend to fall. That’s why bonds have done so poorly this year, because interest rates have gone up really fast. That essentially means that the value of the bonds that you hold is lower. So, if you were to sell them, just like if a stock declines in value and you sell it, you’re going to lose money. Same deal with bonds.

(07:11):

And a lot of, not all, but a lot of the volatility in bond markets can be explained by interest rate movements, what the federal reserve is doing, what other important benchmark rates are doing. The other risk is a little bit more theoretical or not theoretical, but less tangible, is inflation risk. So, right now we’re in a high inflation environment, inflation is at 40 year highs in the US and similarly in a lot of other parts of the world. And if bond rates don’t rise to meet inflation they actually, since they’re fixed, the real return on your bonds is lower in an inflationary environment.

(07:49):

So, if you have a bond that yields 4% annually, which is about where one year US Treasuries are right now, but the inflation rate is eight or 9% where it is right now, your bond is actually losing 4% to 5% per year in real value. So, it’s better than putting your money in a savings account that only yields one or 2% interest, but you’re not keeping pace. And right now most bonds that we call investment grade, which we’ll talk about later, they don’t yield 8% or 9%, they’re more in the mid single digits range.

(08:25):

So, in this kind of environment you’re losing value and that’s part of the reason why bonds haven’t done that well this year. There’s also credit risk in the bond market. So, a bond is basically giving a company, or a government agency or entity, or government itself a loan. Just like any borrowing situation, the borrower has good or bad or in between credit, and your likelihood of getting that bond repaid depends on the credit, the financial stability of that entity or that organization. So, companies that aren’t in a great financial position, they are more likely to default on their bonds, so not be able to repay them.

(09:05):

Interest rates tend to be higher to account for that. You’re still dealing with a very real likelihood, or real possibility I should say, that you’re not going to get all the money back that you put in. With governments, the US government, the credit risk is really just theoretical. And I mean you would get different opinions depending on who you talk to, but personally I think the credit risk of the US government is quite low. So, you can be very confident that you’re going to get repaid on that bond. And same for other developed economies like German bonds. They famously have low interest rates, because the German government is seen as very stable and Swiss bonds and so forth.

(09:45):

But credit risk is still something to keep in mind if you’re investing in bonds from emerging economies or from companies that aren’t maybe in the best financial health. And then there’s also liquidity risk where some bonds, the secondary market is very liquid. For US Treasuries, for example, you’re always going to be able to find a buyer, maybe not at the exact price you want, but those markets don’t really break down. But there are a lot of bonds that they’re thinly issued. There are only a few coupons or bonds that are circulating and if no one wants to sell or no one wants to buy, there’s really no market for them.

(10:21):

So, if you want to get rid of a bond, it’s not as simple as just withdrawing money from it, you might be stuck. So, that’s a big deal and an important reason why you should look at bonds generally, or I should say retail investors should look at bonds generally as more of a long term investment and those are the main drawbacks. All that said, bonds in general carry less risk than stocks.

Rebecca Hotsko (10:44):

So, as you mentioned, one of the biggest factors that influence bonds and one of the major risks is interest rate risk. So, I want to dive into this one a bit deeper, because this one is probably the most important to understand. So, can you just walk us through how interest rates impact bond prices and yields?

Brian Martucci (11:04):

Yeah. As I mentioned, the relationship is basically inverse. When interest rates go up, bond prices tend to go down, but it’s also true that longer term bonds are more sensitive to interest rate risk. Longer term bonds tend to be more influenced by inflation or general prognostications about where the economy is going.

Rebecca Hotsko (11:27):

And so another piece that I want to cover with you on this is having you talk about the difference between bonds with different maturities. So, we know that the normal curve, the term structure of bonds is upward sloping. Can you just walk us through why and the risks behind investing in shorter term bonds versus longer term bonds?

Brian Martucci (11:53):

Yeah, so when we talk about an upward sloping curve, we’re talking about if you plot the interest rate like a smooth curve, you think of a graph with an X and Y axis and you’re looking at the yield as it relates to maturities, the yield is going to be lower in a normal environment, the yield’s going to be lower for shorter maturities like six months, one year, two years, than it is for longer maturities, like 10 years, 20 years, 30 years.

(12:20):

And that’s because there’s more inherent risk in holding bonds for longer periods of time, because the future gets harder to predict the farther you go out. And so there’s more risk that the bond issuer will run into financial trouble. There’s more risk of periods of higher inflation that will affect the bond’s returns. There are other risks that can arise. When you’re starting to look beyond one year or two years, it just gets a lot less certain.

(12:49):

Now the yield curve currently isn’t behaving as normal for some weird reasons. So, the old curve is flat to inverted depending on when you look at it. And that can be a sign of shorter term economic problems or expectations that there are going to be economic problems in the future. We’ve heard a lot of talk about in the near future, we’ve heard a lot of talk about recession coming next year, and the yield curve is telling us that we should take those concerns seriously. I mean we can talk more about that if you’d like.

Rebecca Hotsko (13:25):

Yeah, it is interesting, because I saw this morning that the 10 year yield has now hit its highest level since the global financial crisis. And the two year yield is also at its highest level since 2007. So, it’s just interesting the bond prices in the bond market, it just has lots of information about other markets and market’s expectations. And so I think that’s a really interesting thing about looking at bonds, just that information in the prices.

Brian Martucci (13:53):

Yeah, exactly. And I don’t know how much stock you’d want to put in this, but if you ask a lot of people, they’ll say that the bond market is the smartest money around. So, what the bond market does should be taken really seriously, more so than what individual stocks are doing or even the broader stock market. People who trade bonds for a living are really attuned to risk and probabilities and just general economic conditions.

(14:20):

So, when the yield curve inverts or when yields spike, shorter term yield spike especially, then it’s something to take seriously. And one specific, when we’re talking about yield curve inversions, we look at pairs of bonds often. So, one common pair that people look at for clues about what’s happening in the economy is the 10 year and the two year US Treasuries. As we talked about the two year, in a normal environment, should have a lower yield than the 10 year, because the 10 year is a much longer maturity.

(14:51):

But recently and currently the two year yield is higher than the 10 year, although the 10 year is really spiking as well. So, that’s a potential recession indicator. It’s not the only one. There’s also the 10 year and the three month that people look at and that curve should basically never be inverted. So, when it is, it’s almost always a sign of a recession historically. And then there are other ones that they’re kind of more esoteric ones like Jerome Powell, the chair of the Federal Reserve said that he prefers looking at the relationship between the three month and a derivative of the expectations for the three months, 18 months from now, which is kind of confusing, but that’s high finance.

(15:36):

You’re just looking at synthetic products that most retail investors don’t deal with, but they still tell us important things about where the economy could be going.

Rebecca Hotsko (15:45):

So, when the yield curve is inverted, can you talk about what’s going on to create that? Is it a scenario where there’s more demand for those long-term Treasuries and so more investors are buying them and bidding down so the price is going up and then the yields are going down compared to the two year?

Brian Martucci (16:06):

Yeah, that’s a good way to describe it. It’s relative. So, the demand for both might be lower than in different periods. But the relative demand for the longer term security, the longer term bond is higher. And so they’re bidding the price down relative to the shorter term, which people don’t want to own as much because of the uncertainty.

Rebecca Hotsko (16:27):

And then I guess the next thing I want to talk with you about is the two broad different types of bonds we can invest in. So, starting on the highest level, government versus corporate bonds. Can you talk a bit about those and maybe the key differences investors should know about?

Brian Martucci (16:46):

Sure. So, government bonds, we’ve been talking about US Treasuries a lot, and sovereign governments all issue bonds or generally, I don’t know for sure that every country in the world is issue bonds, but I would assume that they do. There are really common bonds like US Treasuries, German bonds, Swiss bonds, and the UK bonds have been in the news a lot because of the political instability over there. Those are called gilts. So, national governments, they’re always issuing bonds to fund their activities.

(17:18):

There are also municipal bonds, at least in the US where more local units of government are issuing them. So cities, counties, school districts, even some other units have bond issuing ability and there are tons and tons of municipal bonds, which we can talk more about. And then on the corporate bond side, a lot of companies that need to raise capital, a common way for companies to raise money is to go public. But companies that are already public and don’t want to issue more shares, they often issue corporate bonds that have debt financing, it’s just borrowing, and that can help fund their activities.

(17:57):

And every bond government or corporate has a credit rating that depends on the financial strength of the issuer, but especially on the corporate bond side, there is a lot of difference between a blue chip company that’s issuing corporate bond that’s very likely to be repaid, and maybe more of a high flying company that could come back down to earth or just companies that aren’t as mature in their markets. Those are a lot riskier to invest in.

Rebecca Hotsko (18:25):

So, then for investors maybe thinking about wanting to add some bonds to their portfolio, either corporate or government bonds, it’s a bit different than buying stocks. Can you talk about how investors can buy bonds?

Brian Martucci (18:42):

Yeah. It depends on what bond you’re buying. A lot of professional, or I shouldn’t say a lot of, but the brokerages that cater to more professional or experienced investors like interactive brokers, for example, those brokerages, you tend to be able to buy a lot of different types of bonds right through the brokerage, either on the secondary market and sometimes as initial issues. And so that’s helpful if you want to hold a bond directly, you can buy Treasuries or corporate bonds or municipal bonds. You can also buy bonds directly from the US government or US Treasury bonds, at least the website TreasuryDirect is the place to do that.

(19:25):

They don’t have every type of bond that they issue, but you can buy longer term bonds there, I think 20 and 30 year bonds. And also I bonds, which are inflation protected bonds. A lot of people, practically speaking, don’t buy bonds directly. They invest in bond funds, which are more liquid. They’re mutual funds or ETFs, but ETFs are generally more appropriate for your average millennial retail investor, because they tend to have lower expenses and they’re a little bit less complicated tax wise. And you’re not investing in specific bonds when you’re buying an ETF, but you’re investing in a diversified basket of bonds that fit a particular style or type.

(20:08):

So, you can invest in emerging market bonds or municipal bonds or short term US government bonds, kind of whatever you want to do. A diversified securities portfolio that you would build for yourself, probably have a few different bond funds in it.

Rebecca Hotsko (20:24):

And so I guess just on the ETFs, so that’s kind of a good way to get a diversified basket of bonds, like you mentioned. But I’m wondering if you have any tips of what millennials should look for when comparing different bond ETFs? Because like stocks, there’s a lot of different ETFs out there, so what should they be looking for when comparing these?

Brian Martucci (20:48):

Kind of just like stock ETFs, you definitely want to pay attention to the expense ratio. So, the fee that the ETF takes to manage itself, those can vary a lot based on how the ETF is managed. So, passive ETFs that are managed with a really light touch, they tend to have super low expense ratios, like below 0.1%. So, you’re paying very, very little and that’s annualized. So, you’re paying very, very little to keep that bond in your portfolio. More actively managed bond portfolios or bond ETFs, they might perform a little bit better because they’re being actively managed and the managers are looking for opportunities.

(21:28):

But that expense ratio can really eat into your returns, especially when we’re talking about bonds where the volatility is lower. So, the gap between the worst case scenario and the best case scenario for your returns is a lot smaller than it is for a stock ETF. So, that’s an important one. And you want to look also at the type of bonds that are being held in the ETF. So, if you want to invest in municipal bonds, you want to buy a municipal bond ETF. If you want to invest in US government bonds, you buy a Treasury ETF, but you also want to look at the risk of the underlying investment.

(22:02):

So, municipal bonds, even though they’re government bonds, can be a lot riskier than US government bonds, because not every city or state or county is financially in a strong position and they can’t just print money for themselves. Same deal with merging market bond funds. Those tend to have higher yields which make them more attractive. But that’s partly because sovereign governments can run into serious financial trouble. And we saw that with, for example, the Greek debt crisis last decade. That’s just one example. There are a lot of lower profile examples of countries that run into serious financial trouble that their bondholders often end up taking.

(22:41):

They might get some of their investment back, but they’re not going to be made whole necessarily. And that’s a significant risk. So, it’s important for you to just think about the worst case scenario and invest accordingly.

Rebecca Hotsko (22:55):

And I guess the other thing I kind of want to point out about bond ETFs versus investing in just a corporation or a government bond is the par value. So, for ETFs it’s just all based on market price. You don’t get that par value, but if you’re investing in an individual bond, then even if the price goes down as interest rates go up, if you hold it to maturity, you’ll still get your money back. But that’s not the case with ETFs. But I’m just wondering if you have any thoughts on if, I guess, ETFs are more sensitive to price swings or not in the interest rates, or how you think about that?

Brian Martucci (23:35):

Yeah. I can’t tell you offhand specific ETFs how they compare to the underlying bonds in terms of their sensitivity to price changes. But generally speaking, I mean you make a really good point, that if you have a long time horizon and so you can afford to hold a five year bond or a 10 year bond to maturity, that is always preferable to investing in an ETF and hoping that you’re going to have an equivalent value at the end of that timeframe. Because ETFs, they own the underlying bonds that they’re invested in, but they don’t have maturities, they just keep going, because they’re always buying and selling bonds with new maturities.

(24:15):

So, you can invest in a short term US government bond ETF that holds bonds with maturities no longer than five years for 15 years or 20 years or 30 years if you want. It’s just going to keep rolling over into new bonds and those bonds are going to have new coupon rates based on what the bond market has done in the meantime. So, holding individual bonds is preferable from that perspective if you’re really focused on making sure you get all of your investment back. But the flip side to that is that holding bonds directly can be cumbersome, because you have to buy them individually.

(24:55):

That’s sometimes easier said than done, depending on the bond. And a lot of bonds have minimum, the coupon, smallest unit of the bond, is often fairly high in dollar terms, like a thousand dollars maybe or even more. Or there’s a minimum investment that you have to make. So, from a practical perspective, if you don’t have thousands and thousands of dollars to invest, it’s more within reach to invest in a bond ETF that you just have very small slices of those coupons, but you’re still getting that exposure. So, there are pros and cons.

Rebecca Hotsko (25:31):

So, I also want to talk to you about I savings bonds, because you mentioned those before. And with rising inflation, investors are looking for products to help them hedge against this inflation. So, I’m just wondering if you can talk about this product and how that compares to the ones we’ve already talked about.

Brian Martucci (25:49):

Yeah, the I savings bonds are kind of an interesting case. They’re not really like other bonds or not too many other bonds, at least. They are for US persons, people who live in the US. I believe you need a social security number to buy I savings bonds. And their key differentiator is that they are inflation protected. So, their coupon rate, their interest rate changes every six months based in part on what the actual inflation rate is doing, the consumer price index in the United States.

(26:22):

So, they’re inherently protected against the inflation risk that we talked about. And it doesn’t mean they’re always a great investment relative to stocks, but if you hold an I bond, at least in theory, your investment won’t lose value. It’ll always keep up with inflation. Whereas if you hold a not inflation protected US treasury bond and inflation goes up, but your interest rate won’t follow, so you be losing money. So, as far as I bonds go, they’re a great investment for longer term savings if you’re looking to not just have your money in a bank account.

(26:58):

That said, there are some important restrictions that make them less ideal. They’re not the perfect investment. So, one important investment restriction is that you can only buy $10,000 worth of I bonds a year per person. It’s per social security number. So, even if you file taxes jointly with your spouse, you can both buy $10,000 worth of bonds. That limit will be a big deal for some people who are maybe higher earners and more conservative in terms of how they invest. Probably a lot of people won’t be able to hit it and that’s fine. There is some talk in Congress of increasing the investment limit per year to $30,000 I think, which would be great for people who can meet that.

(27:40):

The other restriction is that you can’t cash out of an I bond right away. And again, these are long term investments, so you wouldn’t want to, but you literally can’t sell in the first year, so you have to hold it for 12 months. And then between the one year mark and the five year mark, there’s a penalty if you cash out. So, it’s equivalent to three months of interest, which the longer it goes on, the less of a big deal that is, but it’s still something to keep in mind. Then after five years you can cash out with no penalty and your bond, if you do nothing, will mature in 30 years. So, pretty long time horizon. But I mean it’s a good investment if you are concerned about inflation and you’re watching the money you have in your savings account kind of dwindle away, I bonds are good.

Rebecca Hotsko (28:22):

So, I am wondering, since it has that added protection of inflation, is it offset then by a lower yield compared to other government or corporate bonds?

Brian Martucci (28:34):

Well, the yield has two parts to it. There’s kind of like a base yield, which does change based on the bond market, but isn’t directly tied to inflation. And then there’s the inflation part, which at least in theory it gets it back up to the inflation rate. It resets every six months. So, inflation can vary within that time. It’s not going to be a perfect match. But generally in periods of high inflation, your I bonds will keep up. The rates reset for all bonds. So, let’s say I buy an I bond this month, the rates are going to reset in November, so coming up, and that’s going to affect the rate on my bond, not just on bonds that are bought in November. And then that’ll keep happening every six months. So, right now the I bond rate is 9.63%, I believe. That’ll change next month.

(29:28):

It’ll be similar, I would think. Might go down slightly. And then over time though, as hopefully inflation cools off, the rate on the I bonds that I bought this month will decline quite a bit. So, back in the early 2010s when inflation was basically nothing, I bonds were not seen as a good investment because you might as well have your money in a savings account. It was going to be about the same return. They have performed much better in recent years. But it’s still something to keep in mind that it’s not always going to be that sky high interest rate that you’re getting right now.

(30:02):

And it’s, at least in theory, you’re not really going to gain anything in real terms, you’re just going to keep pace with inflation. So, historically over longer periods of time, you’re still probably better off investing in the stock market, although it kind of depends what your longer term expectations of inflation are.

Rebecca Hotsko (30:21):

Yeah, and I think that’s a good point to point out. It’s that the stock market has outperformed bonds over the long term, but it kind of depends when you need that money. If you need that money for a large investment, maybe in the near term next few years, then you might be more focused on just capital preservation and making sure that you’re not getting eroded by inflation, versus trying to, I guess, accumulate as much wealth and really on that growth aspect. So, it just depends on your current investment strategy and needs. And I also want to talk to you about, I guess on the I savings bonds, are there any tax benefits that investors should know about?

Brian Martucci (31:04):

Yeah, there are tax benefits. So, you do have to pay federal income tax on your I bond interest, but if your state has a state income tax, you don’t have to pay state income tax on your interest. And if you live in a city or county with a local income tax, you don’t have to pay local income tax either. So, it’s an even better deal for people who live in higher tax areas than folks who live in states without income taxes. There are advantages, it’s not quite a tax benefit, but there are advantages to, you can use the interest for education expenses as well. So, they’re kind of like a back door college savings fund in that way. I wouldn’t say that’s a reason to go out and buy I bonds. The state and local tax benefits are probably a bigger deal for most people.

Rebecca Hotsko (31:53):

And then how can investors get exposure to these? Where can they buy them?

Brian Martucci (31:58):

The best place and actually maybe the only place to buy them, at least now is the TreasuryDirect website. So, I believe it’s treasurydirect.gov, the website’s kind of wonky, people make fun of it, but it works and you can create an account. I did it earlier this year, it took probably less than an hour, I don’t remember exactly. It was pretty painless, sort of like opening a bank account and you just buy the bonds directly there. They’re new issues.

(32:22):

There’s no secondary market for I bonds, at least that I’m aware of. If you want cash out, you just basically sell it back to the government through TreasuryDirect. So, it’s pretty straightforward. I’m trying to figure out a reason if you have extra cash, why you wouldn’t want to buy I bonds, but I really can’t. It’s a good supplement to your savings.

Rebecca Hotsko (32:46):

And then the other thing I wanted to talk to you about, because I know you have an article written on this, is exchange traded notes. And I guess how those are different from bond ETFs.

Brian Martucci (32:58):

Exchange trade notes aren’t as common as bond ETFs and the biggest difference is that they don’t own the underlying bond. So, when you buy a bond ETF, you’re indirectly buying the bonds themselves, because the ETF’s manager or issuer owns them. An ETN, Exchange Traded Note is, and I couldn’t explain how this is done, but they are indirectly gaining exposure to mirror the price of that basket. So, you might have an exchange traded note that holds short term US government bonds, but they don’t actually hold those bonds, they just kind of mimic the price of what an ETF that holds those bonds would do.

(33:38):

That matters because there is tracking risk involved, which means that if the ETN isn’t actively managed, over time the price could diverge from the underlying basket of securities, whereas the ETF is more likely to mirror the price. It’s still not perfect for ETF, but there’s less tracking risk in that way. And exchange traded notes also have more liquidity risk, because they tend to be traded more thinly than bond ETFs. So you can really get into a situation where you just can’t find a buyer at the price you want to sell for or vice versa. And that can affect your returns quite a bit.

(34:19):

The not holding underlying bonds is also important because should the issuer go belly up, you have less recourse. From a practical perspective, you’re probably not going to get all your money back if a bond ETF goes belly up, but you still have more protection. And just generally if you hold bonds directly than you do with an instrument that doesn’t really hold any assets directly, if that makes sense.

Rebecca Hotsko (34:46):

Definitely.

Brian Martucci (34:47):

It’s more like investing in a stock where it can go to zero and that’s it, you’re out of luck.

Rebecca Hotsko (34:53):

For sure. And then I guess the last investment product I want to talk to you about is preferred shares, because we’re looking for investments that do well in high inflation and rising interest rate environments right now. And preferred shares are interesting, because they fall into the category of performing well during rising interest rate environments, especially the ones that are rate reset preferred shares. So, I was wondering if you can just talk a bit about what preferred shares are and then maybe we could go over some examples of some.

Brian Martucci (35:28):

Preferred shares, they’re a type of stock, they’re sort of like a hybrid between stocks and bonds, but they’re treated more like stocks. And I guess the best way to think about them is there are stocks that trade on an exchange or over the counter, but they trade on the secondary market. They pay dividends that are generally higher than the corporations common stock dividends. So, just making this up, but if you had a company that paid a 3% dividend on their common stock, the preferred stock dividend might be 6% and the dividend is fixed.

(36:04):

But because the price can vary, the actual rate will change a little bit over time. Unlike bonds, they don’t have maturity dates, they just trade indefinitely, kind of like bond ETFs. There is liquidity risk with preferred shares that often isn’t present with common stock. Common stock, the float, the number of shares tends to be a lot greater. So, the market’s much more liquid, the pricing is much more efficient. Preferred shares, oftentimes some companies, their preferred shares don’t trade every day. So, that can be, again, it’s better to look at it as a longer term investment and there’s still a potential for price risk there.

(36:42):

As far as the one benefit that’s often cited of preferred shares is you are ahead in the queue, you’re ahead of common stockholders if the company goes bankrupt. Generally preferred shareholders, they don’t get much if any of their money back, but they’re still a little bit more of a likelihood that you’re going to get repaid something. Bond holders are much more likely to get repaid though, so that’s definitely not a reason to invest in preferred shares or over common shares. And preferred share prices also have more correlation with the underlying fundamentals of the company, whereas bond pricing for corporate bonds, they tend to be more sensitive to interest rate risk and more economic factors. So, if you’re looking to mirror the performance of the company, then that can be helpful.

Rebecca Hotsko (37:28):

Thanks for explaining that. I really like preferred shares personally. I’ve been adding its ZPR to my portfolio. For my Canadian listeners, it holds preferred shares in primarily energy stocks and Canadian banks. And the nice thing about preferred shares, as you mentioned, is that it gives you exposure to these companies in a different way. So, you get preference of dividend payment. And another thing I like about rate reset preferred shares is that the dividend payment increases in benefits as interest rates rise. So, in this ETF I mentioned in particular, it benefits when the five year government of Canada bond yield rises. So, it just helps serve as a portfolio hedge against rising rates, which is nice in this environment.

Brian Martucci (38:16):

Oh yeah, absolutely. If you can find rate reset preferred shares that meet your investment goals, I would definitely say yeah, because inflation will come and go, but it’s nice to have that downside protection when we’re in a hot inflation environment like we are right now.

Rebecca Hotsko (38:31):

Yeah. But then the other thing to remember is the coin will flip, so it’s when the Fed pivots and they start going down, then in the next few years the preferred shares won’t perform as well. But it’s just the point of, I guess, diversifying your portfolio to meet your investment needs. So, if you need some more diversification, then not everything in your portfolio will be going up at the same time.

Brian Martucci (38:56):

Yeah, totally agree. That’s a great point.

Rebecca Hotsko (38:59):

And then I guess just lastly, I’m wondering if you have any bond funds you would like to share with our listeners that maybe you’ve done some research on and think might be of interest to them and that they can investigate further?

Brian Martucci (39:12):

Sure, yeah. And I would always encourage everyone to do their own research, I’m not really recommending these per se. So, definitely make sure that you do your own due diligence. But some pretty, I guess, popular and straightforward bond funds that I think a lot would be suitable for a lot of millennials is one is the ticker is VTEB, it’s the Vanguard Tax Exempt Bond ETF. It has a super low expense ratio, I think 0.06%, give or take, and it holds mostly municipal bonds and some bonds issued by states in the United States. And the tax benefits are a little less clear cut than they would be if you were buying municipal bonds directly. But there may still be some tax benefits to holding tax exempt bonds in general.

(40:02):

And again, that’s not necessarily a reason to invest in this particular fund, but it’s something to keep in mind because your returns can be a little bit higher than they would be otherwise. Another one along those lines is PCA is the ticker, it’s the Invesco Municipal Bond ETF, same kind of deal. You’re investing in mostly local governments and their bond issues. We were talking about short term US Treasury bonds, and a good one for that is the iShares Core one to five year US bond ETF. Is ISTB is the ticker. That also has a really low expense ratio.

(40:38):

It’s just kind of a way to get exposure to shorter term US Treasury bonds. And right now those are, because of the yield current version that we were talking about, those are performing, in terms of their yield, performing really well by historical standards. So, if you’re looking for income in the short term, that could be a good bond ETF to buy into.

Rebecca Hotsko (41:01):

Thank you for sharing those, Brian. I think that is all I had for today. Before we close out the episode, can you remind our listeners where they can go to read all your articles and connect with you?

Brian Martucci (41:15):

Sure, yeah. I am at moneycrashers.com. I’m the finance editor there. We have tons of articles about a lot of what we talked about and you can find me on LinkedIn as well. And thanks for having me. This has been great.

Rebecca Hotsko (41:28):

Thank you so much.

Brian Martucci (41:30):

Thanks.

Rebecca Hotsko (41:31):

All right. I hope you enjoyed today’s episode. Make sure to subscribe to the show on your favorite podcast app so that you never miss a new episode. And if you’ve been enjoying the podcast, I’d really appreciate it if you left us a rating or review. This really helps support us and it’s the best way to help new people discover the show. And if you haven’t already, be sure to check out our website, theinvestorspodcast.com. There’s a ton of useful educational resources on there, as well as our TIP finance tool, which is a great tool to help you manage your own stock portfolio. And with that, I will see you again next time.

Outro (42:09):

Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday we teach you about Bitcoin and every Saturday we study billionaires and the financial markets. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.