Managing Bonds With Gabe Diederich

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Summary:

[120] – Even though we’ve seen tremendous volatility in the prices of bonds, they can still be a consistent source of income.

In this episode, Jeremy Keil talks to Gabe Diederich about bonds as a consistent income. Gabe has managed $40 Billion in Municipal Bonds and clearly breaks down the different types of bonds, what you should be looking for when investing your money wisely.

Gabe covers the differences between stocks and bonds, what “TINA” and “PATTY” mean and how they’re used in investing at Baird, the different types of bonds that are available, and what bond categories we can look forward to in 2023.

Gabe discusses:

  • Why someone would want to invest in bonds versus stocks, even as an aggressive investor
  • The difference between There Is No Alternative (TINA) and Pay Attention To The Yield (PATTY) and what those terms mean
  • The different types of bonds that exist and how I Bonds differ from treasury inflation protected securities (TIPS)
  • Municipal bonds and other bond categories to look forward to in 2023
  • And more

Managing Bonds

Bonds, Stocks, And Their Risks

Should we buy stocks or bonds? Why not buy stocks all the time if they do better in the long run?

These are two common questions from clients looking to learn more about investing in bonds.

Stocks certainly have a place in the portfolio. Still, when we talk about bonds, we need to remember their alternative name – fixed income – because it’s so important and tells us as investors that we’re going to have a portion of our return that’s predictable, unlike stocks.

When we have the predictable component of returns, our ability to meet a goal in life, such as a retirement or savings goal, we can forecast that goal better with a fixed income component in our return.

Another positive of bonds is that even though stocks outperform bonds when the market goes up, bonds are often a haven when the market doesn’t do well. The highs are not as high, but the lows are not as low when comparing bonds to stocks, so there is less risk involved with bonds than there is with stocks.

On the other hand, the most significant bond risk is inflation because it can lead to price declines. Investors have seen that year-to-date as bond yields have gone up, causing declines in bond prices. This impacts the bond market because if a new bond comes out with a higher yield, someone won’t want the older bond with a lower yield, resulting in the price falling.

The bond market is the backbone for all of our borrowing. It is priced very similarly to all the rates we see in our daily lives, such as savings accounts yields for the short-term and a 30-year mortgage on the longer-term side. These types of rates and their movements are also present in the bond market.

The most significant difference for bond investors is that we’re the lender. When we invest in the bond market, we’re loaning money, so we want the highest yield, but when we’re on the other side and getting a mortgage, we want the lowest yield. And although the yields aren’t as high in bonds as they are for stocks, we don’t have that fixed income return with stocks.

Why Bonds?

Why bonds? Bonds can typically be matched to the horizon of a goal.

For example, If you’re retiring in 3 years and looking for a retirement home you could buy bonds coming due in 3 years and likely get a higher interest rate than savings accounts. You wouldn’t have the risk of investing in the stock market either.

Similarly, if you have a longer horizon, you can buy longer term bonds and bond portfolios that pay a fixed income over the time frame that you need the money.

With stocks, we don’t have that defined timeline or lifespan of the investment like you would in the fixed-income market.

The biggest difference between bonds and stocks is that with bonds, there’s a promise that you’ll be paid back and with stocks, there’s hope, based on the risks involved with the investment.

Even though bonds have a lower risk, they still appeal to aggressive investors and have a place in a diversified investment portfolio. Our guest, Gabe Diederich, shares with us that treasury debt issued by the US government is what is used to ensure the government repays what it promised.

So, when the economy is volatile and uncertain, investors can find security in lending money to the government by purchasing bonds and bond portfolios.

Goodbye TINA, Hello PATTY

Over the last 13 years or so, interest rates were basically zero and it was like we had no choice if we wanted to earn money other than investing in stocks. 

This was called TINA, “there is no alternative” because there was no alternative to investing in stocks because everything else was an inferior investment.

Today is a different story, and that’s why PATTY, “pay attention to the yield,” was coined at Baird. It’s important to fixed-income investors because as the yield rises, so does their total return projection for the future.

It also provides protection against future price declines of bonds because when you own a bond fund or individual security, you’re always getting that income and when there’s price movement, your total return is the combination of both. But as you obtain more income and as yields come, when you buy the security, it takes more of a price decline to create a total loss and move you into a negative total return.

Key Differences Between Different Types Of Bonds

The key difference between different types of bonds is who the borrowers are.

The different borrowers and bond markets:

  • The US government and the US treasury for short-term needs
  • The corporate bond market (companies like Apple, Verizon, and energy companies)
  • Structured products (such as mortgages)
  • Municipal bonds (States, cities, counties, hospitals, transportation, utilities, and education)

We need to remember that there is no one stock market or bond market, but different kinds of stock markets and bond markets – there are different kinds of bonds and stocks to choose from.

I Bonds

I Bonds are savings bonds that have to do with inflation. They have a limit of $10 thousand per person. (If you want a simplified explanation of I Bonds, be sure to check out U.S. Series I Savings Bonds Simplified featuring David Enna)

Many people associate TIPS, “treasury inflation-protected securities,” as being the same as I bonds, but they are not.

With I bonds, you invest directly with the US Treasury, can only do a small amount, and your principal is set but your payment adjusts based on the rate of inflation. The good part is that the payment was pretty high recently, but the downside is if inflation falls, your payment will start to decline and you’ll get a smaller cash flow at the end of that investment.

With I bond TIPS or treasury inflation protected securities, it’s a different category of bond, and its principle is adjusted. TIPS is still a bond at the end of the day, but it may have more interest rate risk than some people expect because the principle is adjusted.

For those looking for more information, we recommend TipsWatch.com where David Enna publishes content about this almost daily.

Municipal Bonds And Interesting Bond Categories For 2023

Gabe’s team at Baird has been laser-focused over the past 12 months, finding opportunities for investors to capitalize where appropriate.

The first one is mortgage securities. They are backed by the US Federal Government and are supported and paid back with pools of mortgages. The market has cheapened and become more attractive for investors to enter and be a buyer in those securities and portfolios since the US government has decided to stop purchasing more mortgages post-pandemic and shift their focus to fighting inflation.

Another area Baird has been focused on is the financial sector within the corporate bond market – US banks for example. This has an area where there’s been a lot of issuances and sometimes when a lot of bonds get issued into the market, the prices have to dip a little bit to find enough buyers. At those cheaper prices, more yield is created because when bond prices go down, yield goes up and it has created attractive investments for investors.

Last but not least, the municipal bond market is a high-quality asset. The government is tightening the economy with higher policy rates and this high-quality asset class offers some protection there. You don’t typically see municipals in a retirement portfolio, but for investors who have maxed out their retirement investments and have other non-retirement savings, the real benefit for municipals is you don’t get taxed by the federal government on the yield, which is extremely powerful.

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To learn more about managing bonds, check out the resources below!

If you have any questions, feel free to contact us or our guest, Gabe Diederich, using the contact information provided below!

Resources:

Connect With Gabe Diederich:

Connect With Jeremy Keil:

About Our Guest:

Gabe Diederich, CFA, has nearly 18 years of experience in the financial services industry under his belt and currently manages about $10 billion worth of bonds with his team at Baird. Before joining Baird, Gabe worked at Wells Fargo Asset Management Holdings, LLC for over 15 years in roles including portfolio management, research analyst, institutional sales, regional director, and associate regional director.

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