Before answering these questions, let’s touch on a few investing basics. Whenever you consider any investment, it’s crucial to investigate how the holding fits in with your risk tolerance and goals. Bonds are considered less risky or volatile — meaning their price movements vary less than those of stocks. Conventional investing wisdom recommends that by adding bonds, you can reduce your portfolio volatility substantially.
Bonds can reduce your investment risk, but should you invest in them now? Before answering that question, you need to have an asset allocation in line with your personal risk tolerance. If you’re going for a higher return, you must take on more risk for the opportunity to achieve that greater payoff. Bonds are an important part of an overall portfolio strategy. After you determine your preferred asset allocation, then it’s time to fund the bond or fixed portion of your portfolio.
At a high level, you can help determine your bond allocation by using a basic and simple formula. This formula can provide an approximate reading of what your non-stock allocation should be — that is, it may give you a hint or some idea of how much of your investments should go cash or bonds vs equities. Here’s the formula:
100 – [your age] = your stock allocation
For instance, if you’re 40 years old, you can start off with a 60% allocation for stocks (100 – 40), thereby making your cash and bonds allocation around 40%. This approach is not set in stone, but is rather a guide that you can use to figure out what allocations to make.
Individual Bonds vs Bond Mutual Funds
All bonds are not alike. Bond investments range from the most secure one year government Treasury bill yielding less than 0.17% as of early 2012, to longer term junk (or low rated) bonds averaging above 7% at this time (e.g. check out the JNK ETF). The investor can purchase individual bonds and hold them until maturity, at which time the face value will be returned to the investor. For example, buy an A rated 5 year investment grade bond at par for $1,000.00 and receive yearly coupon or interest payments of 2.5%. Go longer term on your investment horizon and the 20 year A rated bond will pay 4.35% on average. If you sell the bond in the secondary market before maturity, you may or may not receive your original $1,000.00 principal payment back. Furthermore, unless you have at least $30,000.00 or more to invest in bonds, it is difficult to get enough diversification in your portfolio when investing in individual bonds. So, individual bonds in and of themselves, have some draw backs.
What about a bond fund? The advantage to investing in a bond fund is that you get great diversification for a reasonable amount of money. Additionally, there are multiple varieties of bond funds, suitable for any investor’s preference. But unlike investing in individual bonds, funds do not have a maturity date. Put your cash in a bond fund today, and when interest rates rise, your principal investment value is certain to fall. Long story short, when interest rates go up, you’ll lose money when you sell.
Bonds vs Stocks: Long Term Investment Performance
Anyone over the age of 30 is familiar with historical bond interest rates. In fact, over the last 83 years, the annualized average stock returns were 9.23% and Treasury bond returns were 5.14%. So how do you reconcile that history with the more recent inverted returns of stocks and bonds? During the first decade of this century, bond returns far surpassed those of stocks.
Historical Annualized Returns
As you can see, for the past ten years, stocks returned a measly 2.88% while lowly government bonds returned an unusually stout 6.49%. The recent returns are inconsistent with the long term asset class returns.
How is an investor to predict future returns and organize his or her portfolio with such conflicting data? Let’s understand why bond returns have soared.
When interest rates fall, bond prices rise, and vice versa.
Treasury bill interest rates, the barometer for the interest rate market, have fallen substantially over the last few years. In 2006, the one year Treasury bill rate was at 4.68% while in 2011 the rate fell to 0.03%. There’s no magic here. The infallible bond return and interest rate relationship held true. Interest rates fell and bond returns rose.
It’s highly unlikely that bond interest rates will drop any further; in fact it’s practically impossible. How much lower can they drop from 0.03%? Given bonds’ inverse relationship with interest rates, if you invest in a bond or bond fund now, then when interest rates increase, the value of your bond holding will decline.
The Yield Curve and Bonds
The yield curve is a graphical representation between bond yields and time. At any point in time, a yield curve can be created for any type of bond; it plots short and long term interest rates along the X axis, while yield (or interest rates) is found along the Y axis. The yield curve informs the investor about professional bond traders’ views of the future of the economy. Research has shown that the yield curve is helpful in making economic forecasts.
A steepening and upward yield curve suggests that the economy is expanding as monetary policy invigorates the economy. As the economy expands, corporations’ profits increase, stock prices rise, and investors usually flock to equities in order to participate in their growth. If the economy begins expanding too quickly, the government may raise interest rates to temper the economic growth. Further into an economic expansion, as interest rates rise and bond prices fall, investors tend to increase their bond holding to capture the higher yields.
A flat curve foretells a slowing economy. The inverted or downward sloping yield curve forecasts at best, an economic slowdown and at worst, a recession. In fact, every recession since World War II has been preceded by a downward sloping yield curve.
This chart, depicting 200 years of US government bond yields (through 2006) shows that we are at unprecedented low levels of return for bonds. Remarkably, world events caused small declines in bond yields in most cases, although not all. As previously stated, the most important driver of bond yields are interest rates. When interest rates rise, so do bond yields. Conversely, when interest rates are low, as in the current environment, bond yields are low. Watch out when rates begin to rise; although you will be able to snare higher interest rates on new issues, the existing bonds in your portfolio will certainly decline in value, with the longest maturities, falling the most.
How to Invest in Bonds Today
Now that you understand basic bond investing, here are some recommendations for the bond portion of your portfolio.
1. Buy individual bonds and hold until maturity. If you have a larger portfolio and can afford to diversify among several individual bonds, this strategy can protect your principal investment. For example, if you have $30,000.00 of investable assets for your bond portfolio, then you can invest in individual bonds. Consider a few corporate bonds with varying maturities from 3-7 years. Throw in some Treasury I (inflation protected) Savings Bonds and you have a reasonably diversified bond portfolio. Plan on holding the bonds until maturity and protect your principal. If interest rates rise, you will not have to sell at a loss. By varying the term of the bonds, if interest rates are higher when the 3 year bonds mature, then take the principal and reinvest in a higher yielding bond. If you purchase a lower rated bond, you can boost your yield a bit. Just realize that when the credit rating declines, the risk of issuer default goes up.
2. Don’t have much to invest? Put your entire investment portfolio in Treasury I Bonds with varying maturities. You are certain to protect your principal investment and the return will rise if inflation kicks up. You may also consider investing in TIPS or Treasury Inflation-Protected Securities.
3. The only bond funds to consider now are those with exceptionally short term maturities. You won’t get much of a yield, but you shouldn’t lose too much principal value when interest rates rise.
Making Bond Buying Decisions: Is Now a Good Time to Get Into Bonds?
Given that interest rates are at historical lows and the principal value of your existing bonds will decline when interest rates rise, the answer is… it depends. If you plan on holding the bonds until maturity, now is a fine time to invest in bonds. If you expect to sell the bonds before they mature, this is a bad time to invest in bonds. If you are considering investing in a bond fund, with the exception of extremely short term bond funds, be prepared for the value of your bond fund to decline when interest rates rise. Why not hedge your bets and invest incrementally in bond investments over the next few years?
Barbara Friedberg, MBA, MS is editor-in-chief of Barbara Friedberg Personal Finance.com where she writes to show you how to build wealth. Learn about personal finance from a real life Portfolio Manager & university professor! Stop by the website, subscribe to the FREE Wealth Tips Newsletter and get a free bonus eBook, 20 Minute Guide to Investing.
Created June 7, 2007. Updated February 27, 2012. Copyright © 2012 The Digerati Life. All Rights Reserved.