Bonds: They're Better Than You Think
After a scary time, bonds are a good way to rebuild your investing confidence.
Sept. 29, 2009 — -- The pain of last year's steep stock market declines remains fresh in the minds of investors.
That's why many continue to steer clear of stocks and keep their savings parked in cash, despite the pitiful interest rates currently paid on CDs, money market funds and other cash accounts.
Some investors prefer an FDIC guarantee even if it means earning just 1.5 percent on a one-year certificate of deposit. They just can't stomach the thought of exposing themselves to the types of stock market losses they experienced last year. And that I can understand.
But let me remind these folks that there is a middle ground that offers the potential for higher returns without taking on the risk of stocks. That middle ground is bond investing.
Bonds are a prudent way to rebuild your investing confidence after the scariest episode in our lifetimes. Start with bonds and then move up the investment ladder slowly.
What you want ultimately is a portfolio that includes a mix of both of stocks and bonds along with a dash of cash. The size of each portion will differ by investor.
Historically, bonds have outperformed cash holdings and underperformed stocks. In recent years, however, bonds as a whole have outdone stocks.
Over the past five years, the Barclays Capital U.S. Aggregate Bond Index -- a measure of the overall U.S. bond market -- offered an average total return of 5.5 percent per year compared to .85 percent per year for the Standard & Poor's 500 stock market index.
This shows bonds can be a pretty good investment. Just remember, past performance does not guarantee similar results in the future.
Also, be aware bonds are by no means risk free, though the risk level usually is lower than what you get with stocks.
Investing in Bonds: What You Should Know
Here are 10 things to know about bond investing before making a big move into bonds.
1. A bond is a loan. An individual bond represents money that has been loaned to a corporation or government entity. In some cases, a series of small loans such as home mortgages are bundled into a single bond that is sold to investors.
2. The issuer of the bond is the borrower, who makes a series of interest payments to the bond holders over a certain term. Then at the end of that term the bond issuer pays off the amount borrowed.
3. Interest rates goes up, bonds go down. The values of existing bonds fluctuate in value, with much of that fluctuation tied to interest rates. As interest rates rise, bond values fall. The reason is that if there are newer bonds coming out that pay higher rates of interest, then existing bonds that pay lower interest rates are of less value to investors.
4. Conversely, if interest rates fall, then existing bonds rise in value.
If you're investing in bonds today, you need to be aware of this inverse relationship. Current interest rates right now are at extreme lows thanks to Federal Reserve efforts to stimulate the economy. This means at some point interest rates are likely to rise, causing bond values to fall.
The longer a bond's term, the more susceptible it is to this form of risk. Given current interest rates, it's best to invest new money in short- or intermediate-term bonds rather than long-term bonds, which typically carry terms of 10 years or more.
Investors who intend to hold a bond until maturity do not need to worry about this fluctuation in value. Assuming the issuer remains solvent, the investor will receive the bond's face value at maturity.
5. Bond funds can and do lose value. Mutual funds and exchange-trade funds that invest in bonds offer several advantages including diversification and the ability to sell them quickly at a low cost. For these reasons, I prefer bond funds over individual bonds.
6. But a bond fund investor must be aware that his or her investment can decline in value, particularly over the short term. The fluctuation occurs as the individual bonds in the portfolio respond to market conditions.
For a long-term investor, this shouldn't be much of a concern. But it is a reason funds set aside for short-term needs such as buying a home or paying next year's tuition bill should remain in cash and not be invested in bonds.
7. Bonds come in a variety of categories, each with their own pros and cons. The main categories are treasury, agency, municipal and corporate. Treasuries are issued by the U.S. Treasury and are considered to be the safest type of bond. They are exempt from state and local taxes but are subject to federal income tax. Agency bonds are issued by U.S. government-sponsored entities and also are exempt from state and local taxes.
8. Municipal bonds are issued by state and local governments. Their main advantage is that they are exempt from federal taxes and usually free from state taxes in the state in which they are issued. This advantage makes them attractive to high income taxpayers.
Corporate bonds are considered riskier than U.S. government or municipal bonds and as a result pay higher rates of interest. Some corporate bonds, of course, are considered safer than others.
9. High yield means high risk. If you're investing in bonds for the first time, stay away from any bond fund that describes itself as a high-yield bond fund. High yield means higher risk as the issuers of these bonds are considered to be less financially stable than others and therefore are forced to pay higher interest rates. Another name for high yield bond is junk bond.
10. A high-yield bond fund can be an appropriate holding for many investors, but if you're new to bond investing, steer clear.
For those just starting to construct a bond portfolio, I'd recommend starting with a low-cost mutual fund or exchange-traded fund that tracks the overall bond market, such as the Vanguard Total Bond Market Index Fund (VBMFX) or the iShares Barclays Aggregate Bond ETF (AGG). To that you might want to add a short-term bond fund that includes a mix of treasuries, municipals and corporate.
This combination will diversify you across bond categories while putting some emphasis on the short-term segment in recognition that interest rates are likely to rise sooner or later.
The hope is that decent returns and limited volatility from such a bond portfolio will help erase last year's memories and instill some confidence in investors.
This work is the opinion of the columnist and in no way reflects the opinion of ABC News.
David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.