A bond is essentially a loan – you hand money to a company or government to help fund their operations, and they hand you the bond. You hold it for a specified period of time, during which the bond issuer pays you interest, which can either be distributed to you as income or automatically reinvested for conservative growth potential. At the end of the time period, they give you back your original investment.
The longer the time period, and the lower-rated the company or government (meaning a bigger risk that they’ll default on their debt to you), the higher the interest rate they’ll pay in general.
For example, a high-yield or “junk” bond often pays relatively high interest rates to investors due to the higher likelihood that the issuer may default, in the opinion of bond rating agencies. On the other hand, U.S. government bonds are rated very highly, because the ratings agencies believe there’s a very low risk of default, and therefore you’ll typically be paid a relatively lower interest rate.
A municipal bond issued by a city or state pays you interest that is exempt from federal tax, a nice feature for taxable accounts that are not individual retirement accounts. They also may be state-tax free if issued within your state of residence. You still need to keep an eye on the quality, or rating, of those local and state government bonds, as default risk varies.
You can buy a series of bonds with staggered end dates; as each one ends, you buy another, so the result may be a fairly steady flow of income over time. This is called a “bond ladder.”
If you buy a bond fund – a large basket of bonds instead of individual bonds – the fund manager does the laddering for you, buying dozens, hundreds or even thousands of bonds. With bond index funds, the process is essentially automated, typically with lower annual expenses than traditional mutual funds. Bond funds also are generally more liquid (easier to sell for cash if needed) than individual bonds.
Bond funds are generally more stable than stock funds, so in addition to producing income, they also are commonly used in investment portfolios to provide some cushion against stock market volatility. For example, bond funds may be used for the conservative half of a moderate portfolio.
Bond funds also may be a suitable place to park money you expect to use relatively soon – a large purchase, for example – when you want to seek a little more growth potential than the bank without exposing yourself to potential stock market losses.
However, bonds are not always a slow, steady march forward. Some recent years saw bond fund values drop 3% or more, until 2020 when they shot back up 3%-4%. But this is unusual; volatility is still generally much less than stock markets, and bond market downturns are generally short-lived compared with recessionary stock markets.
One important factor to consider when purchasing bonds or bond funds is that bond values are related to interest rates in the general economy in an inverse way: When interest rates rise, prices for existing bonds tend to fall, and when interest rates drop, prices for existing bonds tend to rise.
Why? Imagine you purchase a bond for $1,000 that pays 3% interest. The following year, a new $1,000 bond of the same quality is available that pays 4% interest. How much will someone pay for your 3% bond now if you want to sell it? Obviously, it will be less than the $1,000 you paid for it. On the other hand, if interest rates for similar new bonds drop to 2% from 3%, you may receive more for your 3% bond than the $1,000 you paid for it.
The longer-term the bond, the bigger this effect becomes, whichever way interest rates go. So, in a very low interest rate market environment like right now, it may make sense to stick with short- to mid-term bonds in anticipation of interest rates eventually rising. In a high interest rate environment, it may make sense to consider longer-term bonds.
Some say bond yields are so low right now that you may do just as well with dividends from stock funds. But the stock market roller coaster may not be your cup of tea, and that volatility can make dividend payments inconsistent.
Because bonds generally pay better interest than banks, and are generally much less volatile than stock markets, they may have a useful role to play in your portfolio unless you are a very aggressive investor. These opinions are for general knowledge only, so before investing, consult a financial professional to determine what’s best for you. And remember, even though you’ve heard this this a hundred times, it’s really true: Past investment performance never predicts the future.
Certified financial planner Kenny Gott is president at Piatchek & Associates and author of the book “Bottom Line Financial Planning.” He can be reached at email@example.com.
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