Volume 90 No. 7 - July 2019
Sometimes, bonds don’t get the credit they deserve. They’re often viewed as old-fashioned or boring. They also do little to assuage investors’ FOMO, or Fear Of Missing Out. That’s especially true during the bull market run we’ve seen over the last decade. However, bonds do bring balance.
Bonds can help you sleep at night. As long-term assets that offer interest income set at a fixed rate, bond issuers often continue making promised payments to investors even when the equity markets turn south. Of course, that’s assuming that the issuers themselves don’t default on their promises due to their own financial difficulties. This brings up the important point that while bonds hedge against equity risk, they are not risk-free.
But, should you invest in bonds? First, let’s look at the reasons why investors choose bonds, and then we’ll examine some of the risks:
The Case for Bonds
In a portfolio, bonds can serve a lot of uses – from diversification and encouraging savings to principal preservation and even planning cash flow for future expenses. The details of bonds’ benefits work out something like this:
Portfolio Diversification – Generally, bonds have a low correlation with the performance of other asset classes. For example, when the equity markets fall, investors sometimes flee to the relative safety that they perceive in bonds, thus pushing their values up. A portfolio consisting of both equities and bonds often provides investors with some diversification during volatile market swings.
Saving for the Future – Perhaps the best-known bonds are savings bonds. Savings bonds issued by the US government are backed by the full faith and credit of the US government and have been used for generations to teach children and young investors about investing.
Preserving Principal – When you buy a bond, you are basically loaning money that becomes the bond’s principal in exchange for payments of interest. Since bonds usually retain their value and reach maturity at par, many investors view bonds as a way to preserve the funds loaned to the issuer, or the bond’s principal. It’s important to note here, however, that even though bonds have proven to be effective in preserving principal for many, a bond issuer’s promise to repay principal and make interest payments is only as good as the faith and credit of the issuer itself.
Matching Expenses – Investors sometimes use bonds, and especially zero-coupon bonds, to plan for an expense they anticipate coming due at a certain point of time in the future. By matching the date of the bond’s maturity with the date an upcoming expense comes due, investors can take advantage of this bond-specific cash flow strategy.
Income – Beyond expense matching, investors who buy bonds often receive a stream of interest payments during the life of the bond, at predictable intervals. These payments can be viewed as an income stream, which, depending on the credit of the issuer, should be relatively certain.
But, Remember – Bonds Are Not a Risk-Free Investment
Even though bonds offer real benefits, they are not a risk-free investment. You can lose money. They still have risks, like:
Credit Risk – Bonds – even those issued by the US Government – are not risk-free assets. The promises made by issuers of bonds to repay principal and interest are only as good as the faith and credit of the issuers themselves. Bonds are certificates of debt issued by an entity that promises to pay you principal and interest over time. If circumstances change and the entity can no longer make the payments, the issuer may default and the investor may lose money.
Interest-Rate Risk – Bond prices and interest rates move in opposite directions. They have an inverse relationship. When interest rates fall, bond prices rise. Conversely, when interest rates rise, bond prices fall. This happens because bonds lock in a certain interest rate, which becomes more or less attractive depending on the interest rates that are being offered at a particular time in the open market.
Reinvestment Risk – When you buy a callable bond, the issuer retains the right to buy the bond back before its maturity date. While this bond feature often results in higher yields on callable bonds, the investor retains the risk that the bond may be called and he or she may not be able to reinvest the funds at the same rate.
Inflation Risk – When you buy a bond, you are committing to an interest rate that sounds good now, but may not be so great if inflation increases. If the rate of inflation grows to eclipse your rate of return, you could lose money in real terms – as the value of your payments erodes while your money is tied up in the bond.
Liquidity Risk – To sell your bond, you have to find a buyer. The market for corporate bonds may be thinner than for that of other types of investments, especially if doubts surface about the creditworthiness of a bond’s issuer. If you decide to sell your position before the bond matures, you may be unable to get the price you want or expect.
The Bottom Line: Are Bonds Worth It?
Bonds are boring, but that’s actually a plus – in some situations. In some portfolios, bonds work great in adding diversification and a reliable, regular source of income. In others, bonds aren’t a good choice. Although they often present less risk than stocks, when you subtract out inflation, the real return offered by bonds isn’t that exciting to a lot of investors – especially those who have become accustomed to the higher rates of return seen in our recent bull market. With interest rate at historic levels, bonds are currently less attractive than at any time since the 1960’s.
Still, bonds should not be entirely overlooked especially as you progress through retirement or anticipate a material distribution (home purchase or education expense) and as a result your risk tolerance begins dissipating. At Investment Counsel, we’re here to help you construct a portfolio that reflects your goals, objectives, and risk tolerance. If you’re interested in learning more about bonds, and how they may help your portfolio, call us and we’ll be happy to help you construct a well-balanced portfolio that can help you work toward your financial goals.
Investment Counsel Inc. is a registered investment adviser. Information presented is for educational purposes only. It should not be considered specific investment advice, does not take into consideration your specific situation, and does not intend to make an offer or solicitation for the sale or purchase of any securities or investment strategies. Investments involve risk and are not guaranteed. Be sure to consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.