The Smartest Moves for Bond Investors Today, and What to Do When You Have Too Many Investments

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. We have a special episode for you this week. The author behind the popular Ask the Analyst column on Morningstar.com is coming to the table. Morningstar portfolio strategist Amy Arnott is going into the mailbag to answer readers’ questions about bonds, including TIPS and other portfolio matters.

It’s good to see you, Amy.

Amy Arnott: Good to see you, too.

Hampton: You’re here to tell us about your Ask the Analyst column. What do you have to tell us?

Arnott: This is a column I started in April, so it’s been about six months now. And the idea is to ask people directly what they would like me to write about. It’s meant to be educational, and I try to write about topics that would be of interest to not just that specific reader, but a lot of our readers.

Hampton: Thank you in advance because I’m so excited to have the column in the podcast. So, we’ll let everyone know. Everyone listening, watching, we are going to tackle the topics in a sort of lightning round fashion, and we’re going to start with bonds. Amy, a reader asked, “My wife and I are a little bit confused about how bond ETFs work. Can you explain what happens when market yields go up?”

Arnott: You have the basic relationship with bonds is yields and price go in the opposite direction. So, whenever market yields go up, the bond price goes down. You can kind of think about it like a teeter-totter where yields go up, price goes down, and vice versa. And the reason behind that is, let’s say you have a bond that’s paying 3.5%. If market yields go up to 4.0%, then why would you want a bond paying 3.5%, so it’s worth less? And if you are holding an ETF, most likely the portfolio has a lot of different bonds, maybe a hundred bonds or more.

So, how it reacts to changes in market interest rates really depends on the overall duration, or interest rate sensitivity of the portfolio. The bad thing is if interest rates go up, you might have a negative total return on your ETF holding. On the positive side, since the portfolio manager is always going to be having bonds mature, buying new bonds as money comes into the fund, he or she would be able to buy bonds with higher yields. So, that could help you over time, but you might still have losses in the short term if interest rates go up.

Hampton: Here’s another question about bonds. For a five-year time frame, what might be the smartest choice for fixed-income money? Five-year TIPS, I bonds, or five-year Treasuries? What are the benefits and weaknesses of each choice?

Arnott: With TIPS and I bonds, you’re obviously getting built-in inflation protection, which is one of the major benefits. With I bonds, the major drawback is that you can only buy a limited amount. You can buy $10,000 per year plus another $5,000, but only if you use money from a tax refund. So, $15,000 total if you have a bigger portfolio that might not be quite enough to make a big dent in things. That’s the big advantage of TIPS is that you don’t have that limitation on how much you can buy. And with Treasury bonds, I think the main advantage is they’re very simple, straightforward; you can easily buy and sell, but you’re not getting that built-in inflation protection.

One drawback of all three, actually, is that interest income that you’re getting is taxable. And with TIPS in particular, there’s something called phantom income that you’re getting because of the adjustment that they make to keep up with inflation. So, you still have to pay tax on that phantom income even though you’re not actually getting the money until later. That could be a negative. And one of the main reasons, with TIPS especially, you probably want to hold it in a tax-deferred account.

Hampton: Good to know. Now the Federal Reserve raised interest rates in September, and an 85-year-old reader wrote in saying they bought their tax-free New York municipal-bond funds days before a rate hike and have substantial losses with more rate hikes coming in the near future. They’re being told that these are paper losses and should stay the course and take the tax-free income. What do you think, Amy?

Arnott: Well, first of all, it’s kind of upsetting that this person was sold a fund that might not be quite right for their needs if they’re 85 years old and relatively conservative and not comfortable with losses. That’s one thing I would point out to start. And nobody really knows what’s going to happen with interest rates. There are a lot of people out there trying to predict. A lot of institutional investors are now saying that maybe the Fed will make one more small interest rate hike toward the end of this year and then stop. But we don’t know if inflation doesn’t start moderating, they might have to make more interest rate hikes. So, I would say the losses this person has experienced are probably temporary, but we don’t know how long it will take to get back to break even.

What I would suggest is if you’re not comfortable with those types of losses, go back to the person who sold you that fund and tell them that and ask if you can transfer into another New York muni fund that’s less interest rate sensitive. So, you would be looking for something with a short-term or intermediate-term duration.

Hampton: The next question focuses on where to hold bonds. A reader wants to know: Is it better to hold them in a Roth or a traditional IRA?

Arnott: I would vote traditional in this case. And the main reason is because with the Roth IRA, you’re never going to pay taxes on any of those gains. Normally, you want to reserve that space for assets that have the highest growth potential, like stocks. For that reason, I would try to favor a traditional IRA for bonds.

Hampton: This reader asked you, Amy, “What are your thoughts on using a TIPS ladder for a specific number of years inside a tax-deferred account to fund Roth conversions?”

Arnott: I think it’s a very good idea and actually kind of a great use case for a TIPS ladder. So, let’s say if you are 65 and you want to make a series of Roth conversions before you have to start taking RMDs at age 73, for example, you could set up a TIPS ladder with staggered maturity dates from age 65 to 73, so eight years. And then as each of those bonds matures, you can use the proceeds to fund a Roth conversion. One thing I would point out with the strategy is ideally, when you make the Roth conversion, you’re going to owe taxes on the amount that you convert. Ideally, you would want to be able to pay those taxes from a taxable account so that you can maximize the amount that you’re putting into the Roth. But overall, I think it’s a great strategy.

Hampton: Let’s pivot to questions that center more on portfolio matters like number of holdings, asset allocation, and withdrawals. A parent wants to know where to pool money to pay for their daughter’s law school tuition. They have cash in our brokerage money market fund, one brokerage balanced fund, Vanguard Tax-Managed Balanced Fund VTMFX, and an IRA. What do you tell them, Amy?

Arnott: I think the order that the question listed is probably the order that you would want to look at for what would be best versus what would be worst. So, if you have enough assets in a money market fund, I think that would be ideal for paying your daughter’s tuition. The tax-managed balanced fund, even though it is tax-managed, you could still have unrealized capital gains that you would have to pay taxes on when you sell. So, it may not be ideal. And then with the IRA, there might not be any tax consequences if you’re using the proceeds for a qualified educational expense. But on the other hand, that money is really meant for your own retirement. So, I would favor the other types of vehicles instead of pulling money from your own retirement account.

Hampton: This investor says they have 231 mutual funds, stocks, and ETFs spread across 14 former workplace and personal brokerage accounts. They’re asking, “If fees are flat, is it better to stay the course or sell in this market and consolidate to six to 10 ETFs in one or two accounts?” They’re 59 and plan to work two more years, then retire and start drawing down on these funds.

Arnott: First of all, I would say that’s a huge number of funds and a very large number of accounts. I think I would definitely be in favor of trying to simplify things, and it probably is going to be a multiyear project. I would start with trying to simplify the number of accounts. So, ideally, you would want to get down to maybe your current 401(k) and take all of those old workplace 401(k) accounts and put them in a rollover IRA. And then also on the taxable brokerage side, I would try to consolidate those so that you’re getting everything into one account, and you should be able to do that without any tax consequences if you make what they call an ACATS [automated customer account transfer service] transfer. And over time, I think you probably want to cut down the number of holdings as well. But again, that might be a multiyear process.

If the person is still working, they plan to retire in a couple of years, what you could do is after they retire at age 61, their income is most likely going to be a lot lower. So, you could take advantage of those low-income years to sell some of those funds that might have embedded capital gains, and you might have to do that over multiple years. But I think if you can get down to six to 10 funds, that would be a much better situation and will also make things a lot easier for you as you get older and also make things easier for your family if you eventually pass away or aren’t able to manage your own money.

Hampton: And what I pulled out of your answer is that this could take multiple years.

Arnott: Right. But it’s still worth doing.

Hampton: All right.

Arnott: Yeah.

Hampton: Here’s a question about limiting capital gains. The reader says that they have, “Been investing for decades and have several mutual funds in their taxable brokerage account that have high expense ratios and high tax-cost ratios. They’re not bad funds, just expensive, especially when compared to ETFs. They’re retired and would like to sell these funds and invest in some less expensive options. Is there a way to do this without generating a lot of capital gains?”

Arnott: I think my answer is similar to the last question, where you might want to look at a strategy for doing this over a multiple-year period. And the good news is that you actually have a lot of room to realize capital gains without owing any taxes. If you’re married filing jointly, for example, the 0% bracket for capital gains goes up to about $98,000 for taxable income. So you have quite a decent amount of room to realize those gains without paying taxes. And depending on how big the portfolio is, you might need to do that over several years. But again, I think it’s definitely worth doing.

Hampton: Now, we’re going to tell people how they can submit their own question to ask the analyst. But first, what should they know before they even start typing, Amy?

Arnott: I’m not able to give you specific tax advice or investment advice for your individual situation because I don’t know enough about your finances, your overall tax picture, things like that. But if you have a question that you think other people would also be interested in, that’s definitely fair game.

Hampton: Everyone listening, watching, you just heard it straight from Amy on what to ask and what not to ask. A link is in the show notes. Amy’s column publishes on Morningstar.com. You can also read her previous columns. I recommend that you do. Amy, thank you for coming to the table and bringing Ask the Analyst here.

Arnott: Thanks so much, Ivanna.

Hampton: Before we go, let me tell you about what’s coming up on the next episode of The Long View podcast. Co-hosts Christine Benz and Amy Arnott, who you just saw, will welcome two researchers from the Morningstar Center for Retirement & Policy Studies. Jack VanDerhei and Spencer Look will share insights into their research on Social Security reform and retirement outcomes, like saving enough to retire and feeling confident about the decision. The episode is set to drop on Tuesday, Oct. 13.

I appreciate you for checking out Investing Insights this week. Thanks to senior video producer Jake VanKersen, associate multimedia editor Jess Bebel, and content development senior editor Valentina Djeljosevic. I’m Ivanna Hampton, editorial multimedia manager at Morningstar. Take care.