Bonds have a reputation as safe, stable investments. But writing off bonds as boring investments best for the risk-averse could be a mistake.
While it’s true that investing in bonds tends to lack the dramatic highs (and the lows) that come with investing in stocks, that doesn’t mean that you should ignore the opportunities bonds present. Here are four reasons why you might want to have a portion of your portfolio in bonds.
1. Bonds are a way to diversify your portfolio. Many financial experts recommend diversifying your portfolio to include a variety of asset classes, including bonds. This is a concept known as asset class diversification. Because different asset classes tend to perform differently at different times, you may be able to create a portfolio that generates more stable returns by investing across asset classes. For example, stocks and bonds tend to historically move in opposite directions, which means that owning some of both can help smooth out the ups and downs in your portfolio.
2. Bonds are (usually) less risky than equities. If you are looking to dial-down risk in your investment portfolio (such as when you near retirement), increasing your allocation to bonds may be one way to do that. However, keep in mind that less risky doesn’t mean risk free. Bond issuers can default. You also face inflation risk. Because bond payments are set in advance (that’s why they’re known as fixed-income investments), you lose purchasing power due to inflation.
3. Bonds can provide a steady, predictable source of income. Stocks and other investments are unpredictable — you don’t know with any certainty how well a given stock might perform in a certain year or even how well certain types of stocks (like small-cap stocks or international stocks) will do. Bonds are a bit different. They are debt investments, which means you are essentially agreeing to loan an entity, like the government or a corporation, money for a certain period of time. The entity you are lending money to agrees to pay you a certain amount of interest (known as the coupon) over the time they have your money, plus repay your initial investment when the bond reaches maturity. That means that unlike some other investments, you have a pretty good idea of how much money you’re going to see from your bond investments over the years.
Of course, bonds aren’t risk free. Bond issuers can default, and you could lose your money. That’s why riskier bond issuers tend to offer investors higher coupon rates — their greater risk is compensated by greater total return. But in general, bonds are more predictable in how much money they generate for investors than stocks, which is one reason why they’re so appealing to retirees.
4. Bonds can provide valuable tax savings. Depending on the types of bonds you own, you may be able to save on taxes. While you’ll pay normal taxes on corporate bonds, income from Treasury bonds (which are issued by the U.S. federal government) is free of state and local tax. Then there are municipal bonds, or bonds issued by state and local governments. You won’t pay federal tax on money you earn on these investments, and you may also be exempt from state and local tax. For anyone who is looking to minimize their tax burden, especially retirees, this can be an appealing proposition.
The principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investments seeking to achieve higher yields also involve a higher degree of risk. As interest rates rise, bond prices typically fall, which can adversely affect a bond’s performance. Fixed-Income investments are subject to interest rate risk and values may decline in an increasing interest rate environment.
Using diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss in declining markets.
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This newsletter was prepared by Integrated Concepts Group, Inc. The opinions expressed in this newsletter are for general information only and are not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. The views expressed are those of the author and may not necessarily reflect those held by PlanMember Securities Corporation. Material presented is believed to be from a reliable sources and PSEC makes no representation as to it accuracy or completeness.