When you invest with a traditional financial advisor or a robo advisor, your money will generally be allocated to a combination of stocks and bonds to form a balanced portfolio.
The division of stocks versus bonds depends on all sorts of factors including your time horizon to retirement, how much you spend, your risk profile and so on. The younger you are and the more money you have, the higher your allocation to bonds generally.
The idea behind putting more of your nest egg into bonds than stocks as you close in on retirement is that bonds are regarded as a safer investment than stocks.
But bond investing is not without risks and you should know what you are buying before investing your hard earned savings.
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How Bond Investing Works
For most of your life, you have probably been on the side of the fence where you borrow money to pay for a car, a home, or perhaps your tuition expenses. With each loan you may have taken out, you committed to a repayment period at a certain interest rate, whether variable or fixed.
When you buy bonds, you are on the other side of the fence. Instead of paying back interest to a lender, you now become the lender and earn interest. It is the responsibility of the borrower to fulfill their obligations to you over a specific time period and pay your principal back at an agreed upon interest rate.
When you step into the shoes of the lender, your mindset flips from wanting the interest rate to be as low as possible to wanting it to be as high as possible while keeping the risk low. So, you want your borrower to be creditworthy and the risk of default to be minimal.
If you were to think about the safest borrower to whom you could lend, the U.S. government would probably come top of your list. U.S. government debt is considered to be as safe as it gets.
The ranking of the safest bonds in order are generally regarded to be as follows:
- Government bonds
- Municipal bonds
- Corporate bonds
Government bonds fall into three categories:
|Short-term Treasury Bills||Up to 1 Year|
|Intermediate-term Treasury Notes||2-10 Years|
|Long-term Treasury Bonds||10+ Years|
When your goal is to save for the short-term, Treasury bills may be appropriate but the interest earned on them is generally low. For example, if you needed to park money that you had slated for the down payment of a home into an interest-earning account for a short time period before completing escrow, Treasury bills may be a good option.
If you have a longer term time horizon, Treasury notes and bonds with longer maturities may be a better fit for your portfolio, and will pay a higher yield.
Municipal bonds are issued by city and state governments. If you live in a state that issues bonds, interest payments earned are often exempt from state taxes.
These bonds are used to finance city and state project spending, such as the construction of schools, roads, dams, and bridges.
Corporate bonds generally pay the highest yields but also have higher risk than government bonds and munis.
There are exceptions to the rule from time to time. Very large companies, such as Apple, with large amounts of cash reserves and highly successful business models can often issue debt at very low interest rates because the likelihood that they will default is low.
In rare cases, corporate bond yields can be so low that the interest payments owed by sovereign nations are higher!
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PRIMARY RISKS OF BOND INVESTING
Default Risk: The primary risk when investing in bonds is default risk. When the borrower fails to meet or honor its obligations to pay back the principal it received when the bond was issued plus interest payments, the lender risks not receiving their loaned money and interest due.
Interest Rate Risk: When interest rates rise, bond prices fall. The reason for the decline is that new bonds issued on the market pay higher interest rates so the old bonds are less attractive to bond investors.
Rising interest rates are bad when you own bonds because their prices fall, but falling interest rates have their own drawbacks. If you own a bond paying a high interest rate and the Federal Reserve lowers interest rates then when the bond comes to maturity, you will be unable to earn the same high interest rate you had been enjoying because market yields for equivalent bonds are lower.
For this reason, when interest rates are very high as they were in the 1980s, locking in a high long-term government bond interest payment is a smart investment strategy. Imagine locking in a 15% yield for 30 years – guaranteed by the full faith and credit of the U.S. government!
Be Wary Of High Yield Bonds
The risks of bond investing are not confined to default risk and interest rate risk. Sometimes, the most attractive bond on the surface is the one to shy away from. Novice bond investors often swoon when they come across a high yield bond that pays a high interest rate.
But these bonds often have high yields for a reason – and it’s not usually a good one! Remember higher interest payments reflect higher risk. So, when yields are high, it means that risks to investors are commensurately high.
Bonds rated by Standard and Poor’s above BBB or those rated by Moody’s above Baa are generally regarded as appropriate for consideration by casual investors.
There are no guarantees however that ratings agencies will hit the nail on the head when it comes to evaluating bonds properly. During the 2007-09 stock market crash, securitized loans were notoriously difficult to analyze and even major ratings agencies found it difficult to properly ascertain creditworthiness and default risk of bond issuers.
So, the takeaway is: if in doubt, steer clear. Better to stick with a lower yield bond than a high yield bond that keeps you awake at night.
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How To Buy Bonds In
A Retirement Portfolio
When you buy stocks and bonds, you don’t need to pour over research reports to pick the very best ones. Exchange-traded funds and index funds offer a way for stock and bond investors to diversify risk across stock and bond holdings.
If you work for an employer who has a 401(k) plan set up, you will be restricted in the choices of funds available. The bond funds made available to you will generally include a diverse group of bonds of varying maturities.
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HIGH INTEREST RATE ENVIRONMENTS
If you are selecting bond investments by yourself in a brokerage or IRA account when interest rates are high, purchasing longer maturity bonds is a smart move. You get to lock in a high yield for a long duration even if interest rates decline.
LOW INTEREST RATE ENVIRONMENTS
Conversely, when interest rates are low, it is better to choose short-term and intermediate-term bonds because rising interest rates will cause bond prices to fall, which could hurt your portfolio value.
Regardless of the maturity of the bond you purchase, you don’t need to hold it all the way through to maturity. So, if interest rates are low but you expect them to rise, you can exit your bond position on the secondary market and find another bond paying a higher yield when rates rise.
If you are buying individual bonds but new to the market, err on the side of caution. You may wish to consider government Treasury bills and notes before buying municipal bonds unless you are confident your city and state are not in financial distress as Illinois has been with its pension crisis.
What Taxes Do Bond Investors Pay?
When it comes to investing, what matters most is not your gross portfolio return but your after-tax return – the amount you actually get to keep after paying Uncle Sam.
Smart bond investing allocates tax-efficient bonds to taxable accounts and tax-inefficient bonds to tax-deferred accounts.
The golden rule for new bond investors is: do not buy municipal bonds in a tax-deferred account, such as IRA or 401(k). Tax-deferred accounts are by definition not taxed, so there is no reason to buy munis, which are generally exempt from state tax if you live in the state.
Conversely, tax-inefficient bonds are bonds that require you to pay taxes on interest earned. Corporate bonds fall into this category and so, to maximize your after-tax returns, it is best to buy these bonds in a tax-deferred account, such as an IRA.
|Bond Type||Tax Status||Best Account|
High net worth individuals may also favor municipal bonds because of their tax-exempt status.
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Your Bond Investing Takeaway
When you buy bonds, examine the key factors that can affect your returns:
- Interest rates
As you get closer to retirement, a higher portion of your portfolio should generally be allocated to bonds over stocks.
The combination of equities and bonds forms a balanced portfolio that reduces the volatility of holding equities alone so you can sleep more peacefully at night without worrying so much about the effects of a stock market crash on your portfolio.
What bonds have you found to be good investments? Share your investment experiences in the comments below, we love hearing from you.
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