Pay Down All Your Debt First Before Investing a Cent in Bonds

pay down all your debt
This is what happens when you invest in bonds while still having debt. Source

One of my best friends at work performed investment research for the company where we worked. I got to know him really well, to the point that we would exercise together, play basketball, and go to church. At some point, he became comfortable enough around me to share his financial picture. He had student loans with 6% interest, but he also owned the PIMCO bond ETF, which paid about 2% a year in interest before taxes. He had set up a negative arbitrage situation of -4% a year guaranteed! If a highly certified investment expert made this mistake, you will probably make it too because portfolio models never include the negative bonds you already hold in the form of loans. Pay down all your debt before making a single bond market investment.

The Math is Overwhelming

Even if you receive preferential tax treatment on your mortgage interest, what you pay is far above what the US government pays on equivalent maturities. The 15 year mortgage average is currently at 2.89%, and the 30 year average mortgage rate is at 3.61%. Mortgage rates are at new lows, but countries now issue bonds at all time lows too. In fact, much of the world now sells bonds at negative interest rates.

The 10 year US bond yield is 1.37%. If you think that is low, the 10 year German bund yield is -0.18%. If you invested in an all US bond portfolio outside of retirement accounts, you would owe tax on the interest. At the top rate of 43.4%, you would only keep about $0.77 of interest for each $100 you put into the US bond markets.

Would you rather pay down your mortgage and earn a guaranteed 2.89%, or buy US bonds and take home 77 cents for each hundred dollars you invested? Most investors choose the 77 cents over the $2.89 every time because of risk aversion.

View your debt as a negative bond investment

When you owe a lender interest payments, you must pay interest until you finish off the loan balance. What if you have a 20 year student loan with a 6.8% interest payment? How should you think about that liability in your financial portfolio? In fact, that student loan is exactly like owning a bond, but in reverse. You must pay 6.8% interest, but you receive no tax deduction as with mortgage interest. We already saw that the tax deduction didn’t matter that much in that case, but given that you can’t deduct the interest on the student loans from taxes makes them even worse.

You own a 20 year bond with 6.8% coupon payments, but in reverse. If the economy is bad, great, slow, or inflationary, you must make these payments. Why then would you listen to conventional investment advice and put 10%-40% of your portfolio in bond investments?

Bonds are a part of a sound asset allocation strategy because they reduce volatility. The fear is that average mom and pop investors would pull their funds from the stock market forever if they ever lost 50% or more in the stock market, and many of them did. For that reason, we rationalize holding 40% bond allocations at 2% interest why owning a home and paying 3.5% interest.

the radical approach that will make you wealthier when you pay down all your debt

I suggest a more radical approach. Consider your debt to be a negative bond allocation. So if you have $100,000 in student loans and a $100,000 401k all in stocks, then under this rule you would be 50% stocks and 50% bonds. You would put all your retirement money in the stock market and ignore the bond market until you repaid every last cent of that student debt.

In other words, most people should have a 100% stock allocation in their investment and retirement accounts, because most people have a lot of debt. It’s so foolish to bail out the federal government with your hard earned money. After all, the feds are manipulating interest rates to afford interest payments on ballooning federal debt.

Most default investment options at work include at least 10% in bonds as part of their portfolio. If you have debt and have the option to just use stock index funds instead, do that and take the money that would have gone into bond investments and pay down your debt.

prepare for a wild ride for your investment account, and more financial security

Debt is one of the scariest things in the world to me. When you have payments to make no matter what, good luck quitting your job and traveling the world. Good luck getting out of a dead-end corporate job. My friend invested in bonds instead of paying down his debt because he was scared he would need that money in the case of an emergency.

You always need to have an emergency fund with at least three months expenses in the bank. Anything more than that, and you are being overly cautious at the expense of higher investment returns. My friend from earlier had one of the safest jobs in the private sector, yet he paid 6% interest while receiving less than 2% interest on his bond investments.

Since you still have debt payments to make in the case of a market crash that would affect your stock holdings, paying down all your debt and owning bonds to reduce volatility perform similar tasks. If you are one of the millions of Americans that have debt, do not set yourself up for a negative interest rate arbitrage situation. Pay down all your debt first before investing a cent in bonds, especially at these pathetically low interest rates.

Readers, what do you think of this strategy? Can anybody make an argument for the other side where you would invest in bonds even with debt? Comment below!

15 thoughts on “Pay Down All Your Debt First Before Investing a Cent in Bonds”

    1. I absolutely would. Most retirement accounts with good target date fund options also include low cost index funds as well. Some people such as those going for tax free PSLF loan forgiveness might want to just make the minimum student loan payments and keep the target date funds, but everyone else with that kind of debt should just be 100% stocks and use the rest of the money that would’ve gone into bonds to pay down that student debt. Since student debt isn’t tax deductible, that means it’s actually like owning a 9%-10% taxable bond, but in reverse! That really smarts in a world where the 10 year US bond yield is at 1.37%.

  1. I love the new redesign! It looks great and the sidebars are very useful. I agree that paying off debt should take priority over investing. I think feel that they’re missing out if they’re not investing at all but the guaranteed return on debt payoff should be their motivation.

    1. Thanks Mr. Enchumbao! Glad to see your comments aren’t hitting the spam folder anymore as well. What a difference a year’s worth of knowledge gained by playing around with WordPress themes makes. I’m using the default 2016 theme right now but who knows what I’ll use long term. Yeah if anything you make out like a bandit paying down 7% interest debt.

      1. Yes, I really appreciate that you took the time to care of that. My comments were going into the spam folder for other bloggers as well. Some of them are too busy to check their inboxes and fix it so I stopped commenting.
        I love the clean look of this theme. Good luck on your new business venture.

  2. I agree, pay all debts first before investing in anything for that matter. As far as emergency fund, I should really work on that. Sometimes when you focus too much on debt, you forget to put away some for emergency 🙂

    1. And the only alternative is using credit cards if you don’t have the emergency fund, so its important even above paying down debt in my humble opinion

  3. It’s shocking to me that so many people need this advice. But it’s true… SO MANY PEOPLE NEED THIS ADVICE haha. But then again, sometimes what is common sense for one person, may be the most enlightening piece of information for another. Great post Travis.

    I’m Brian btw. I came over from MoneyBoss. Looking forward to reading more of your stuff!

    1. Great to put a name with a site Brian. Yeah what’s obvious to us might be totally unknown to most people so gotta get the word out there

  4. It doesn’t make sense to put a whole lot of money into investments when there’s high-interest debt in the mix. 7% is still fairly high. It’s hard to get that kind of return in traditional vehicles.

    1. Almost impossible really, especially on an after tax basis. Considering the risk free interest rate on a 10 year treasury bond is about 1.5% and about 0.8% after taxes, earning a guaranteed 7.9% return is pretty much out of this world good. Thanks for stopping by John!

  5. But John, if the low interest bond fund is in a taxable IRA and tax bracket is ~15%, does it still make sense to sell the IRA to pay off the 6% debt? Also, many bond funds have had nice appreciation in the last 3 quarters. How do we factor that in this strategy?

  6. It’s worth pointing out that you CAN DEDUCT STUDENT LOAN INTEREST FROM YOUR TAXES. You are allowed to deduct up to $2,500 in student loan interest per year, although it begins to be phased out once your modified adjusted gross income reaches $65,000 and is completely phased out once your MAGI hits $80,000. It’s right on line 33 of IRS form 1040 (https://www.irs.gov/pub/irs-pdf/f1040.pdf). That being said, I would still agree with the general premise of the article, even after taking the tax deduction into account the return you’re guaranteeing yourself by paying down the debt is attractive when compared to traditional bond investments.

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