I’m a huge proponent of investing in stocks for many reasons. I believe we all should become owners, not loaners.
However, there comes a time when considering alternatives, such as bonds, makes complete sense.
Understanding Bonds:
When you invest in bonds, you’re essentially loaning money to a company or government. In return, they agree to pay you interest over the term of the bond and return your principal investment at maturity.
Why Do Companies and Governments Issue Bonds?
Companies and governments issue bonds to help them raise funds for new projects, cover ongoing expenses, or to preserve their own capital and borrow from others.
Which Bonds Should You Buy?
Just like stocks, you have the option to buy individual bonds. Whether it’s from Apple, the US Government, or your local country club, you have the option to purchase a very specific bond.
But similar to stocks, I prefer to own many bonds within one fund.
Bond mutual funds or ETFs offer investors exposure to a diversified portfolio of hundreds, if not thousands of individual bonds.
These funds generate income, known as a yield, based on the interest payments from the underlying bonds.
How is that yield determined?
Yield of a bond fund measures the income received from the underlying bonds held by the fund. The 30-day annualized yield is a standard formula for all bond funds based on the yields of the bonds in the bond fund, averaged over the past 30 days. It does not indicate the fund's future yield.
There are even ‘tax-free’ and ‘tax-exempt’ bond funds (typically issued by government agencies or local municipalities). If you invest in these securities, the interest you earn may be excluded from your gross income and exempt from state income taxes.
For those in the higher tax brackets, highly recommend you consider these.
Should You Invest in Bonds?
Bonds are often considered less risky than stocks, providing stability and downside protection. You’ve heard the saying, “We buy stocks so we can eat well, but we buy bonds so we can sleep well”.
A few main reasons why investors purchase bonds is capital preservation and to generate income.
While bonds historically offer lower returns compared to stocks (2 - 4% annually on average vs 8 - 10%), they can provide the diversification needed within your portfolio.
This is a helpful chart to look at the performance of a 10-year Treasury Bond by year:
The Risks of Bond Investing:
Despite their perceived safety, bonds certainly come with risks and 2022 was a friendly reminder that stocks and bonds can produce negative returns within the same year.
Not to mention the losses you may experience in a bond fund can be substantial.
Look at the bond fund ‘TLT’. This portfolio is comprised of US Treasury Bonds with maturities greater than 20-years.
During 2022, as interest rates began to skyrocket, this fund fell 31% in 12-months. That will certainly make you feel something.
Other inherent risks with bond funds:
Inflation Risk: When inflation increases, the interest coupon on most bonds remains fixed, so you are immediately losing purchasing power.
Default Risk: When loaning money to a company, there is a chance they go bankrupt. The likelihood of default varies between companies. Higher-risk bonds typically offer higher interest rates to compensate investors for taking on additional risk. For example, Apple has a much lower default risk than say AMC. So, the interest rate you earn from an Apple bond will be much lower than AMC.
Interest Rate Risk: This is a significant concern for bond investors, especially during periods of rising interest rates:
Duration Risk: Bond duration measures the sensitivity of bond prices to changes in interest rates. For funds with longer durations (such as TLT), you will see larger swings when interest rates change.
For example, TLT has a current modified duration of 17 years. So for every 1% change in interest rates, this fund would move inversely by ~17% (Fed brings interest rates down by 1% during 2024, TLT should go up in price by about 17%).
Why Own Bonds?
There will be investing periods where stocks outperform bonds and vice versa.
This chart highlights the mindset you may have during particular years:
Liquidity: Create a position in bond funds if you foresee yourself dipping into your accounts within the next 12-24 months. That way, when you are not touching the money you are earning a solid interest and not seeing the balance fluctuate very much. Then when you go to pull the money out, you can let you stock funds continue to ride.
Income Stream: Bonds can help you create an income stream that you tap into in retirement.
I used to never even entertain the idea of investing in bonds. For those that are younger, I do recommend the majority of your investments are in low-cost stock index funds.
But bonds can play a vital role in building a well-rounded portfolio. It’s crucial to understand the inherent risks and rewards prior to investing.
Please reach out with any questions or if you are curious if bonds make sense in your portfolio.
Disclosure: This material is for general information only and is not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.
All indices are unmanaged and may not be invested into directly.
All investing includes risks, including fluctuating prices and loss of principal.