Bonds are taking a verbal beating in the financial news right now. Financial pundits question the wisdom of owning bonds when interest rates are poised to rise, as they appear to be today. Mike Larson, for example, gave his recent tirade in Money and Markets the headline, “Don’t Get Fooled Again – It’s Time to Dump Your Bonds Now.” We believe Larson, and media figures like him, are wrong about bonds. In our opinion, following their rash advice to sell and avoid bonds may seriously harm your investment portfolio.
It’s true that there are risks associated with investing in bonds, including interest rate risk. Still, bonds are an important part of an investment portfolio. It’s how you own bonds that matters most, and can actually help reduce your risk.
Own Bonds Directly and Have Them Mature at Different Times
As I work with clients, my goal with bonds is to create a well-diversified portfolio of bonds that mature at staggered times over the next five years. This bond portfolio provides what we expect to be “safe” money.
Our definition of “safe” is that we know the interest rate we expect to earn on the bonds in the portfolio and their value at maturity. That’s why we buy individual bonds and plan on holding them to maturity.
As an investor, if you hold a particular bond to maturity (assuming the credit rating of the bond’s issuer remains consistent with the rating at time of purchase) you should expect to get the interest and the face value of your bond back when it matures. Note, however, that if you need to sell the bond prior to maturity, you may experience a loss if the bond had declined in value.
If you buy bonds that mature at intervals over the next few years, you will hopefully have predictable access to cash. In this way, bonds are useful because they are predictable, consistent with their inherent risk. When an investment is predictable, you can safely make plans around it, noting (of course), that all investments carry risk, including loss of principal.
Beware of Bond Funds
A word of warning: investing in bond funds is different than purchasing bonds directly. Bond funds have no maturity, so they can be down in value when you need the money. When we compare holding bonds directly versus investing in bond funds, we believe individual bonds offer more certainty than bond mutual funds. That’s why we believe directly owned bonds should be a part of almost every investor’s portfolio.
An added benefit to the strategy of owning bonds in this way is that the bonds mature, and when a bond matures, you receive cash, absent a default. When your bond becomes cash, you can reinvest at higher rates, if interest rates have risen, or rebalance your portfolio away from stocks and buy bonds at good prices, if stock prices have increased.
Tips for Buying Bonds
Of course, no strategy is foolproof, so here are a few considerations:
- Individual bonds carry individual issue (default) risk. Purchasing high-quality bonds is a good start, but then each should be monitored regularly for rating and price changes.
- There is no fund manager’s expense ratio to pay if you buy and hold bonds to maturity, but you will probably pay a small, one-time trading fee to obtain each bond. In addition, bond dealers charge a markup or markdown on bonds they purchase from or sell to you.
- Short-term bonds that mature in a few years – both bond funds and individual bonds – are generally less volatile than long-term bonds from the same issuer.
- You should have enough assets allocated to bonds to enable you to stagger their maturity dates over the next few years. We call this building a well-diversified bond ladder.
Learn more about bond ladders and much more in our new ebook, How to Use Bonds to Enhance Your Portfolio, Whatever the Market. In this free resource, we also discuss the pros and cons of owning bonds. No one strategy is correct for everybody, but when it comes to bonds, don’t succumb to the panicky headlines. Click here to download.