Negative Bonds

Jonathan Clements

MANY PARTS of our financial life look like bonds, with their steady stream of income. For instance, you can think of receiving a regular paycheck as similar to collecting interest from a bond portfolio. Ditto for the income you might collect from Social Security, a traditional pension plan or an immediate fixed annuity. If you receive a lot of income from these bond lookalikes, that can free you up to invest more heavily in stocks.

Our financial life, however, may include not just bond lookalikes, but also “negative bonds”—in the form of mortgages, auto loans and other debts. When we own a bond, somebody else pays us interest. But when we’re in debt, we pay interest to others. Because we are considered less creditworthy than, say, the federal government and major corporations, we typically pay a higher interest rate on our debts than we can earn by buying bonds.

This has two key implications. First, suppose we want to put more money in interest-generating investments, like bonds, savings accounts and certificates of deposit. Often, it makes more sense to pay down debt, because the after-tax interest cost we avoid is greater than the after-tax interest we could earn by investing.

Second, when we look at our finances, we should subtract the amount we owe on various loans from the amount we have in bonds and similar investments. Suppose we have $100,000 in stocks and $100,000 in bonds. It might seem like we have a conservative portfolio.

But if we also have a $100,000 mortgage, our effective bond position is zero—and our finances are far riskier than they appear. My advice: As you head toward retirement, lower the riskiness of your financial life—by paying off all debt. That will increase your net bond position, while also lowering your cost of living, by freeing you from a major monthly financial obligation.

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