How American olim should invest in bonds

Last Updated on February 29, 2024

The information contained in this article is for general educational purposes and should never be viewed as specific investment, tax, or legal advice.

Since starting this blog I have received many interesting questions regarding the financial issues Olim deal with. One of the questions I have received from multiple different readers centers around what to do about bonds in your investment portfolio. Should an Israeli be buying shekel bonds or USD bonds? What should Americans do about Israeli bonds while trying to avoid PFIC tax implications associated with buying a shekel bond fund?

In this article we will explain briefly what bonds are and what purpose they serve, and then break down different strategies for Americans living in Israel.

What is the point of bonds anyway?

Before we jump into the issues and solutions around bonds let’s understand the core purpose of why we have bonds in our portfolio. A bond is essentially just an IOU from a company or government. Ask any financial professional if they expect bonds to outperform stocks over the long-run and their answer will most likely be no. Owning a share of a successful company’s growth and earnings is generally a far more profitable venture then owning a share of its debt. Historically, stocks have way outperformed bonds over the long-term.

Nevertheless, bonds fill an important role in an investment portfolio. Two main ways bonds bring value are:

1. Stable income – Owners of bonds are entitled to periodic interest payments. A diversified bond portfolio will generally enjoy a fairly predictable cash flow that can be relied upon with far more consistency than the returns of other asset classes.
2. Reduced volatility & risk in our portfolio – quite simply, bonds can dramatically reduce the bumps along the road in your investment journey, making for a smoother ride and helping you stay committed to your long-term investment goals through thick and thin.

With interest rates still so low relative to inflation, reason number two has and continues to be far more important than reason number one. Very often the biggest risk to a well diversified investment portfolio is the investor and emotional decisions that investor might make. Having too high of a stock allocation can cost you dearly in the long run if you panic sell during bear market. It can also be far more costly for a retiree who must take withdrawals from his/her portfolio and won’t necessarily have the luxury to ride out a long market drawdown.

Bonds offer some level of protection against these drawdowns and our own emotions. This has proven true, even in a year like 2022 where bonds have seen some of their worst losses ever and still helped reduce the drawdown of a stock portfolio.

The problem with bonds for Americans in Israel

Getting exposure to bonds in an investment portfolio is usually pretty easy – similarly to stocks, all you have to do is buy a low-cost broad bond market index fund. The problem – Americans looking specifically to keep a portion of their portfolio in shekel bonds in order to reduce their exchange rate risk are in for a bigger challenge for several reasons:

• Israeli bond funds are generally PFICs. This means that purchasing an Israeli bond fund can result in punitive US taxation and costly reporting requirements dramatically reducing the attractiveness of such an investment.
• Researching and buying individual bonds in order to avoid the PFIC issue can be extremely tedious and is not a practical option for many individual investors. Finding quality bonds selling at a price that would generate a positive return if held to maturity can be difficult.
• Many bonds, especially the more stable Israeli government bonds, currently still have low interest rates. Once you factor in the commissions and monthly costs of an Israeli brokerage or bank investment account needed to access these bonds, your expected return for purchasing these bonds can easily be negative or very low.
• If you haven’t made Aliyah yet, shekel bonds are even more difficult to access.

For these reasons, shekel bonds can be a difficult asset to easily incorporate into you investment portfolio and alternatives should be considered.

First things first – check your pension

For those looking to incorporate bonds into your portfolio, the first thing you need to do is check how many bonds you already own. Anyone who works in Israel has a pension and that pension likely has a very significant bond allocation. For example a Keren Pensia Makifa, has a minimum of 30% of the portfolio in Israeli government shekel bonds, even in the “all-stock” tracks. Many of the other tracks and components of both an Israeli Pension and Keren Hishtalmut have significant bond allocations.

For someone who has been contributing to their pension for many years, this can often represent all or a very large portion of the desired bond allocation target of your portfolio and additional bonds may not be necessary at all. Practically, as one nears retirement, changing your pension track to one that has a higher bond allocation is often the simplest way for an American in Israel to increase their overall exposure to shekel bonds.

Skipping bonds and holding shekels instead

If there is a high likelihood that holding cash (shekels) will produce a better result net of fees then buying bonds, don’t buy bonds. Your investment decisions shouldn’t be about making money for your bank, broker or advisor. If the commissions and fees you will pay are going to eliminate most or all of the returns you will earn on bonds, consider just holding shekels instead. Having a higher allocation to cash will likely provide even more stability to your portfolio then bonds will.

You can segregate the funds in your Israeli bank account (פיקדון ריבית יומי (פר”י or look for a longer term deposit in order to potentially earn a higher interest rate. A long-term investor with decades until retirement and a well thought out investment plan they are committed to sticking with can also consider forgoing a bond allocation completely until much closer to retirement.

Including USD bond funds in an Israeli’s portfolio

Once you have evaluated how many shekel bonds you already own, if an additional allocation to bonds is warranted, the next step is to consider USD bonds in your portfolio. As mentioned previously, accessing the largest bond market in the world – the US bond market – is simple. Using any US or Israeli brokerage account, you can easily buy a low-cost broadly diversified bond ETF such as the ones offered by Vanguard and Ishares. The main question remains – does someone whose cost of living is in shekels benefit from owning bonds in another currency – especially given that the USD and many of the world’s currencies have depreciated massively against the shekel since 2002?

While it is clearly true that owning USD bonds exposes an Israeli investor to exchange rate risk, I think those that entirely dismiss them as a pointless asset for Israelis to own are oversimplifying the situation. USD bonds can play an a role in your portfolio in their ability to reduce the severity of a major market drawdown. Let’s break this down further:

The dollar as a safe haven

As the reserve currency of the world, the US dollar has a unique status amongst the world’s currencies and tends to behave accordingly. During times of uncertainty, market meltdowns, and global panic, the world tends to pile in to the US dollar as a “safe haven” to store capital until the dust settles. This causes the USD to strengthen against most or all the world’s currencies including the shekel.

This means that during a crisis, when you hold US dollar denominated assets while measuring their performance in a currency such as the shekel, you are likely to see significantly less volatility then if you were looking at your portfolio from a dollar perspective alone. In other words, the strengthening of the dollar commonly seen during a market crisis can counteract some of the portfolio declines when measuring your portfolio in shekels. Extensive research has shown that that the US dollar as a safe heaven is both persistent and pervasive feature over many decades.

The theory in action

To examine this concept in reality, I took a simple portfolio invested 60% in VT (Total world stock ETF) and 40% in BND (Total USD Bond Market Index ETF) and measured the monthly performance of this portfolio in both dollars and shekels from January 2020 until July 2022. This isn’t to say an Israeli would want 40% of their portfolio in USD bonds – this is an example for illustrative purposes only. Given the pandemic crash and the major market drawdown of this year, this time period has seen significant stock, bond, and currency market volatility.

“The dollar as a safe haven” theory stood up well. The dollar saw significant spikes, strengthening rapidly against the shekel, especially in months that saw the worst market losses, including March 2020, April 2022, and June 2022. In other words, because the dollar was increasing in value, this 60/40 portfolio measured in shekels had significantly less volatility and losses than the exact same portfolio measured in dollars. For an Israeli investor that relates to his/her investments in shekels, these dollar bonds very much served their main purpose as described above.

This is obviously a short time period but it does illustrate how the stability of bonds combined with the common rush to the “safety of the dollar” can provide significant downside protection during a crisis – often the exact time investors need that emotional protection the most.

In summary, despite the fact that USD bond returns for someone living in Israel can be significantly impacted by the exchange rate, their protective qualities during a crash can make them an attractive piece to include as part of a well diversified portfolio. This doesn’t mean they should fill up your entire “fixed-income” or “safe” bucket – but they can be considered as one of the pieces. This is especially true for a DIY investor that is having trouble accessing the Israeli bond market in a timely and cost-effective manner. An allocation to USD bonds can also be combined with other approaches such as the other strategies mentioned in this article as well as some of the different options for reducing exchange rate risk – outlined here.

Series I Savings Bonds

In additions to traditional USD bond funds, Ibonds can be an attractive alternative to consider for some or all of your bond allocation. Series I Savings Bonds are 30-year bonds issued by the United States Federal Government with an interest rate that goes up or down based on inflation. Because they are issued by the federal government and essentially built to compensate you for inflation of the dollar, they are considered by most to be almost risk-free and are very attractive alternatives when compared to traditional USD bonds.

Take note that these bonds cannot be traded, must be held for at least 1 year, and have a slight penalty if redeemed within 5 years. The minimum purchase amount for Electronic I Bonds is $25. Each individual investor can purchase up to $10,000 in electronic bonds per calendar year.

To purchase these bonds you must have a social security number (or EIN) but do not need to be living in the US. Bonds being issued between May 2022 and October 2022 have an initial annual yield of 9.62% (!!) To buy these bonds you must open an account on Treasury Direct and connect to your US bank account. While the site is pretty old-school (last updated in 2002!!), the process for purchasing these bonds is pretty straightforward once (if) you get your account set up.

Unfortunately, some people that are trying to sign up will be automatically blocked from opening an account and required to take extra verifications steps not easily accomplished from Israel. It is unclear how many people this is happening to or why it is happening, but getting unblocked or having your identity verified can be challenging.

Other strategies

Now that we have discussed the challenges around accessing shekel bonds, the bonds already in your pension, and the advantages and disadvantages of USD bonds – let’s take a look at some of the other alternatives:

Defined outcome ETFs

Defined outcome ETFs such as those offered by Innovator are ETFs that are designed to help investors maintain some exposure to equity market returns while providing a buffer against some of losses during a market downturn. Some view the downside protection offered by these funds as a potential alternative to bonds. These products are extremely complex and should not be used unless you understand how they fit into your portfolio. They also do not produce income such as interest or dividends.

Alternative assets

With interest rates steadily dropping since the 1990s, there has been a growing trend to replace portions of a typical bond allocation in a portfolio with other “non-correlated” assets. The idea is that by investing portions of your capital away from traditional assets like stocks, bonds, and publicly traded RIETs, you can achieve a level of diversification that both improves returns and smooths out volatility.

Although the definition of what exactly qualifies as an “alternative investment” is debatable, trillions of dollars have reportedly poured in to “alts’ in the last decade. Robust alternative investment markets have been created that are accessible to institutions and advisors such as iCapital and CAIS as well as platforms specifically geared at retail investors where you can purchase shares in alternative assets like art, real estate, and farmland with small amounts of money.

There are many different risks when investing in alts which are not similar to investing in bonds. One of the most common risks is known as liquidity risk. Essentially, it can be very difficult to get your money out of these investments in a hurry and long lock-up periods are not uncommon. In addition, many alternative assets have not lived up to their promise of uncorrelated returns. In general, alts are not that similar to bonds and you shouldn’t expect them to behave or perform like bonds.

Many alternative asset platforms can be accessed in Israel but they do require a US address in order to open an account. Stay tuned for a more detailed article on this subject in the future.

Bonds you should avoid

I would be remiss to write a whole article about bonds without discussing the type of bonds almost all Olim should avoid – US municipal bonds. Municipal bonds (“munis”) are issued by state and local governments in the United States. For a US taxpayer, one of the major advantages of munis is that the interest they payout is typically exempt from federal income tax and in some cases, state tax as well. In exchange for this tax benefit, munis typically offer a lower interest rate than other similar bonds.

Israel obviously does not recognize this tax benefit as they don’t derive any benefit from US municipal projects. If your Aliyah “10 years tax holiday” has passed and you own municipal bonds or muni bond funds you could find yourself with lower-yielding bonds without any of the tax advantages of those bonds.

Summary

Bonds may not be the most interesting investment out there but they do play a very important role in an investment portfolio, especially for those nearing retirement. Americans living in Israel looking to invest in bonds beyond their Israeli pension, while avoiding PFICs, have some good alternatives to consider – even if they can’t invest in Israeli shekel bonds easily.