Investing. The word alone connotes stocks and bonds. Diversification is the sister term associated with investing. Subtract your age from 100 to figure out how much of an allocation in bonds you should own. Why do we need to have bonds? And what makes bonds a necessary portfolio companion? While trying to understand portfolio allocation a little bit better, I came up with the following five points.
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First, Some Basics
Bonds are fairly simple to understand, they’re loans with a specific duration. They pay interest at stated dates. There’s an issue date and a maturity date. The issue date is the beginning of the loan and the maturity date is when the principal is paid back to the investor. Therefore, unlike stocks that you own forever, bonds are a temporary loan to the issuer.
Types of bond instruments
- Money markets are mutual funds that invest in short-term debt instruments. They are not insured by the federal government.
- CDs are bonds issued by banks or credit unions, insured by the FDIC.
- Bonds are debt instruments issued by a governmental institution or a corporation.
Bonds are necessary for wealth protection
Investment allocation is the panacea to protecting invested assets. According to Rick Van Ness, author of Why Bother With Bonds, managing investment allocation is equally as significant as your ability to save money.
Investing in stocks is a way to gain from the growth of the economy. However, stocks are risky, every year, every day of the year. If you are investing, boring as they may be, you need bonds.
Bonds dilute risk. They soften the blow when the stock market tanks. For example, a loss of 50% in a portfolio of only stocks would only suffer only a 25% loss if 40% of the portfolio was invested in bonds. While no one wants to lose money, the latter situation is better than the former situation.
This occurs because high-quality bonds have almost no correlation to the stock market. Correlation refers to the relationship of the behavior between two investments and the impact on value. In other words, if the stock market goes up, a highly correlated investment will also go up. Bonds turn left when stocks turn right. Therefore, an investment with no correlation to stocks will not move in the same direction as the stock volatility, offering stability when the stock market is charging up or dropping like a stone. Ideally, choosing bonds, such as US Treasury bonds, with little or no correlation to stocks gives an investor a win-win situation.
If you’ve ever heard of the phrase ‘Modern Portfolio Theory’, this is what they’re talking about. Modern Portfolio Theory dictates that an asset can be added to the mix of a portfolio and if it’s value sensitivity moves in an opposite direction of the existing assets, volatility is reduced and the portfolio is optimized for maximum return.
Bonds Lack Suspense
Bonds are not completely risk-free, but have much less risk than stocks. What you won’t get are surprises. When you invest in a bond, you’re lending money at a stated rate for a stated period of time. No less, no more.
The longer you own a bond, the safer it becomes. In other words, the closer you get to the maturity date, the higher the probability that the amount invested will be returned to you.
The biggest bond risk is on high-yield bonds from companies with a low credit rating. Otherwise known as ‘junk’ bonds, they are highly correlated with stocks, meaning that they lose value when stocks tank.
CDs are a form of bonds and are sometimes more valuable than bonds.
This is true for several reasons. CDs are guaranteed by the FDIC, a bond holder’s investment is guaranteed only by the issuer. Second, if the stated interest rate were to become undesirable, the CD withdrawal fee may be lower than the loss on a bond sale if the bondholder chose to sell their bond and reinvest at a higher interest rate. In addition, the interest rate on a CD may be higher than an equivalent Treasury bond. Also, there are no purchase fees or annual fees with CDs.
As of today, bankrate.com is indicating a 5-year CD offering 2.5% interest by Goldman Sachs, where treasurydirect.com is offering 5-year notes paying interest at 2.066% through 2.434%. The minimum deposit on the Goldman Sachs CD is $500. Amounts up to $250,000 are insured by the FDIC, eliminating credit risk. If I were investing today, I would go with the Goldman Sachs CD.
All bonds are subject to interest rate risk, including government-backed bonds.
Interest rates are the only unpredictable factor related to bond investing. Bond prices move inversely to the interest rate. If the interest rate goes up, a bond’s value decreases. Why?
If an investor entered into a 5-year bond with a stated 5% interest rate, and shortly after, the interest rate moves up to 6%, this investor is missing out on the additional 1% because of being locked into the 5% investment for 5 years. That makes the 5% bond’s market value less desirable. The cost of missing out is reflected in the price of the bond which fluctuates in the 5-year period that the bond is held.
All US Treasury debt is low-cost, doesn’t require diversification, and is the highest credit quality. However, treasury bond prices can fluctuate contingent upon prevailing interest rates and investor confidence.
To create your own bond fund, you can buy CDs or bonds with staggered maturity dates.
This is the same as laddering, where you create a rolling schedule of consecutive maturity dates.
Bond laddering is simply buying bonds with different maturity dates. When one bond matures and the principal is returned, the investor would re-invest the money into a new bond. This creates a rolling schedule of bond maturities and reinvestments. To avoid fund costs, you could create your own basket of bonds. However, you’d have to devote the time and attention to the investments.
The availability of low-cost bond funds and ETFs eliminates the need to do it yourself. US Government bonds can be purchased on www.treasurydirect.gov.
I need to work on diversifying and I like to take my own advice, but my stocks have been on a tear lately and I don’t want to liquidate anything. Bad, I know. I’m not a good at rebalancer.
My real reason is that once I have an investment in place, I don’t like to touch it. Therefore, to diversify my portfolio, I plan on adding new money. Over the next year or so, my goal will be to steer money into CDs and bonds. Based on my research, I like the CD route to reduce costs. Along with CDs, I will focus on the following Vanguard choices, with a 25% emphasis in the Treasury Inflation-Protected Securities (TIPS) fund.
I am constantly asked about when I think the next stock market crash will be. It seems like 2008 was just yesterday and it’s hard for people to erase it from memory, especially those wanting to retire early. Stocks are expensive and feel overblown. Are they? We don’t know for sure. What we do know is that stock market swings are based on investor emotion. Owning bonds is the antidote to stock investments that take us to artificial highs only to disappoint by slamming back down to earth. I would rather take control where I can. If bonds are the way to portfolio protection, I’m signing up.
Short term high-quality bond fund
VFSTX Vanguard Short-Term Investment Grade
BSV Vanguard Short-Term Bond ETF
Municipal Bond Fund
VWITX Vanguard Intermediate-Term Tax Exempt
International Bond Fund
BNDX Vanguard Total International Bond Index
Treasury Inflation-Protected Securities (TIPS) – recommended 25% of bond investment.
VIPSX Vanguard Inflation-Protected Securities Fund Investor Shares
All-in-one bond fund
BND Vanguard Total Bond Market ETF