Wondering if bond investments should be an integral part of your portfolio? Below are some common questions regarding investing in bonds.
What are bonds?
- Bonds are simply IOUs. By buying a bond, you are in effect, making a loan. In return, the borrower (or issuer) agrees to make interest payments to you at a fixed rate of interest until maturity (the date on which the bonds will be paid off). That’s why bonds are commonly referred to as “fixed-income” investments.
Typical issuers of bonds are corporations, local, state, and federal governments.
Why own bond investments?
- Income: Provides a steady stream of income via fixed interest payments.
- Low Risk: Offers greater security than most stocks since an issuer of a bond will do everything possible to meet its obligations. The interest owed on a corporate bond must be paid to bondholders before any dividends can be paid to the stockholders of the company. And it’s payable before federal, state, and city taxes. So companies place a high priority on making timely bond payments.
- Low Volatility: Because the terms of a specific bond are known in advance, the value of that bond will usually fluctuate in a relatively narrow range as compared with stocks.
Why do interest rate changes move bond prices?
- Bond markets tend not to see big swings in value like stock markets do. But they do fluctuate, mostly due to changes in interest rates.
- As interest rates change, the values of bonds will fluctuate. When interest rates fall, the prices of existing bonds go up. And when interest rates rise, the opposite happens. Investors seek equilibrium between the interest incomes of old bonds relative to newly issued bonds.
How much risk am I comfortable with?
Knowing the general traits used to identify the different bonds within a bond fund can help you determine the bond fund’s impact on your overall risk profile.
- Average maturity. Bond funds come with short-, intermediate-, or long-term maturities. The longer the maturity, the more sensitive the fund is to changes in interest rates. We are presently invested in bond funds with short-intermediate maturities.
- Credit quality. Bonds that are backed by the government or one of its agencies have the best “creditworthiness” and a lower chance of default than most corporate bonds. Corporate bonds with high credit quality are considered investment grade bonds, and those below investment grade are considered high-yield (“junk”) bonds. Our corporate bond exposure is in investment grade bonds.
What is the best way to invest in bonds?
- According to Vanguard, “Because of the lack of transparency with bonds as compared with stocks, many or most investors could be better off if they invest in bonds through mutual fundsor ETFs (exchange-traded funds) rather than by buying individual bonds.”
Do I want domestic or international bond investments?
- Investing in both U.S. and international bond funds can add another level of diversification to an already well-balanced portfolio.
Is the placement and type of bond fund important?
- If you’re in one of the highest tax brackets and investing outside of your retirement account, we can reduce your tax exposure using a tax-exempt bond fund. We use both short-term and intermediate-term municipal bond funds. Similarly, locating a bond fund inside a tax-deferred account (IRA, 401k, or annuity) may be prudent tax planning.
At present, we do not know the direction of interest rates or what the Federal Reserve will do next and when. To best protect your portfolio from the inevitable shocks to the financial markets, we are hedging our risk exposure by being broadly diversified (corporate investment grade bonds and government bonds; U.S. and international) with short-intermediate-term maturities to lessen the sensitivity to changes in interest rates relative to long-term maturities.
In summary, unless you are an exception and have a very high tolerance for risk and a long time horizon, having bond investments in your portfolio provides a buffer (or ballast) to the inevitable shocks stocks we experience while collecting “rent” in the form of interest income. Thus, how much your portfolio is allocated to bonds is dependent on your risk tolerance, time horizon, and liquidity needs.