Bonds: Should they be included in my portfolio?
By Bill Gallagher, CFP®, MPAS®
What is a bond?
A bond is a financial instrument that represents a loan from the investor to a government entity or a corporation. The majority of bonds today are issued by the U.S federal government, its agencies, municipalities, and U.S. corporations. There are two key features of bonds that differentiate them from other financial instruments:
- Regular coupon payments
When an investor purchases a bond, they are, in essence, lending their capital to the issuing entity. In return, the entity will pay the bondholder interest (either quarterly, semi-annually, or annually) for a stated period of time. At the end of that period the bond will mature, and the entity will return the bondholder’s original investment. The maturity of a bond can range anywhere between five to thirty years. While bonds have historically carried lower volatility than stocks, there are risks involved. Bondholders will find that they are exposed to default risk, interest rate risk, inflation risk, and reinvestment rate risk.
How can I purchase bonds?
There are two main ways in which an investor can purchase bonds:
- Purchase individual bonds
- Purchase a bond mutual fund or exchange-traded fund
Investors can purchase an individual bond through a broker or directly from the U.S. Government (in the case of a U.S. government bond). An investor may decide to purchase an individual bond if they were targeting a certain maturity date or stated level of interest. While an investor has the ability to purchase a variety of bonds it typically requires a large sum of money to build a well-diversified portfolio of individual bonds. Therefore, many investors choose to invest in a bond mutual fund or exchange-traded fund. A bond fund provides the investor with access to a diversified portfolio of bonds, with a lower initial investment. Before investing in a bond fund, it is important to be aware of the fees associated with the fund. In addition, it’s important to understand what type of bonds the fund is investing in. There’s a difference, in terms of risk, between investing in a short-term government bond fund (low risk) and a high-yield corporate bond fund (high risk).
Why should I include bonds in my portfolio?
Most people purchase bonds for interest payments. A retiree may want to invest a portion of her money in bonds so that she can use the interest payments to supplement her retirement income. However, bonds can also act as a ballast to the portfolio when you hit stormy seas. During periods of uncertainty and weak economic fundamentals, stock prices tend to decline. However, during these difficult periods bond prices tend to rise. The opposite is also true – when stock prices rise, bond prices tend to decline. Therefore, bonds can be used in combination with stocks, not only to create a diversified portfolio but to help reduce overall volatility (risk) and maximize the portfolio’s risk-adjusted return. This approach may also provide the investor with a more comfortable ride and not cause her to panic during periods of stock market declines.