Where Do Bonds Fit in Your Investment Plan?

And, for a given company, think about it: If the company is doing well, shouldn’t its stocks and its bonds reflect this? I worked for years as a corporate controller and chief financial officer, and I learned that if a company is doing great, you want to own its stock to get returns that reflect this growth. If you just own the company’s bonds, there’s a cap on what you will get even if the company is growing like gangbusters. If the company goes belly-up, bondholders might get paid before stockholders, but they may get pennies on the dollar. And regardless, you can minimize your chances of being in this position by carefully assessing credit quality.

Though I’m generally not a big fan of corporate bonds, they can play a role in portfolio diversification if they’re chosen carefully: the right companies (different companies than the stocks you own) with the right maturities.

By contrast, the price movements of U.S. Treasuries and other government bonds don’t tend to correlate with those of stocks. So, despite their lower rates compared with corporate bonds, they can play a defensive role in a portfolio and provide protection against down stock markets to preserve capital for the long term — assuming you keep maturities low to protect against rising interest rates.

Even as they approach retirement, some investors reasonably choose not to keep much of their portfolios in bonds. This may not be a bad decision, depending on their individual situations. The person who may not need bonds, even as they get on in years, has good income, maintains a substantial emergency fund to pay living expenses, is in good health, plans to work indefinitely (perhaps they own a business) and tends to be an aggressive investor with a high risk tolerance. When such individuals choose to own few bonds or even none, they may be making the right decision.

So on one hand you have the risk of a stock market decline damaging your portfolio, and on the other, the risk that bonds may not deliver the level of returns necessary to reach your retirement goals. Though no investors should exceed their individual risk tolerance, weak returns — such as those from Treasuries because of their low rates — pose the potential for losing buying power over time if they represent too great a percentage of a total portfolio. Loss of buying power is related to the documented generalized fear of many women that they may end up destitute in their later years.

One way to balance returns and risk in bond investments is to consider the broad spectrum of bond types available to individual investors. For example, municipal bonds — issued by municipalities, water and power authorities and other local entities — can give investors good returns with manageable risk, plus the advantage of keeping returns free of federal taxes and state taxes, provided you live in the state where the issuing entity is located. Traditionally only accessible to wealthy investors because high investment minimums precluded diversification for the average investor, these investments are now accessible to the typical individual investor through exchange-traded funds (ETFs).

Some ETFs also offer solutions for investment in domestic bonds as preferable alternatives to bond funds where managers create problems for investors by buying and selling holdings.

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