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Negative Bonds

WHEN WE BUY BONDS, we lend money to the government or corporations and, in return, we receive regular interest payments. When we borrow money, the roles are reversed: Instead of receiving interest, we’re paying it to others. On the family balance sheet, any money we borrow is effectively a negative bond.

This is a useful concept for two reasons. First, by viewing our mortgage, student loans, car loans and credit card balances as negative bonds, we’re able to think holistically about our financial situation. Suppose we own $100,000 of bonds—but have a mortgage and student loans that total $300,000. In effect, our net bond position is a negative $200,000 and perhaps our financial situation is riskier than we intended. We could lower that risk level either by purchasing more bonds or by paying down debt.

That brings us to the second reason to view our debts as negative bonds: Often, paying down debt is the most attractive bond investment we can make. We’re considered less creditworthy than the federal government or a major corporation, so we typically have to pay a higher interest rate when we borrow. The upshot: By paying extra on our loans, we can usually avoid more interest than we can earn by buying bonds.

In the past, such advice would have required a caveat about the tax-deductibility of mortgage interest. But thanks to today’s much higher standard deduction, many homeowners get little or no tax benefit from the mortgage interest they pay. That means paying extra on a mortgage will usually deliver a higher after-tax return than buying good-quality bonds.

Even so, folks might choose to own bonds and other conservative investments, rather than paying off debt. Why? First, if we find ourselves out of work or faced with some other financial emergency, it’s a lot easier to cash in investments than borrow money. Indeed, if we don’t have a paycheck, borrowing may not even be an option. Second, if our finances are shaky and we think we might lose our home to foreclosure, we’re better off hanging onto our cash than paying extra on our mortgage.

Next: Compounding

Previous: Opportunity Cost

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BenefitJack
BenefitJack
2 months ago

Great insight.

Aren’t bond fund investments in retirement savings plans (401k, 403b, IRA, etc.) somewhat risky today – with interest rates about as low as they can go? So, if (when?) interest rates increase, won’t bond fund investment returns be depressed?

I encourage folks who are in debt (especially high cost debt like credit card debt, payday loans, etc.) to pay themselves first by saving in the 401k plan then leverage those assets (including any deferred federal and state income taxes and vested employer contribution) to retire debt – always with a strategy in case employment should end.

Today, as has been the situation for the past 12 or so years, the interest rate on a loan from a 401k plan is often less than the interest rate on a loan from a commercial source and, at the same time, the plan loan interest rate is often greater than the investment return (and certainly much less risky) when compared to the bond funds offered by the 401k plan.

So, by borrowing from the 401k plan, a participant may improve both their household wealth AND their retirement preparation.

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