Even people who understand the stock market sometimes slip when it comes to bonds.
It makes sense because to most people fixed-income investing equates to math, which can be scary. Still, it doesn’t have to be hard, and such securities are usually a vital part of a portfolio.
Fixed-income securities provide investors with stability. Typically, price movements in bonds and stocks aren’t correlated. When stocks drop, as they sometimes do, then bond prices won’t necessarily fall. They may rise, fall or not move.
The result is lower volatility for the entire pot of investments. Wall Street pros see volatility as risk, so reduced volatility is less risky. That’s not the whole story. Bonds pay regular coupons, income that can be used to invest in other assets.
[See: 11 of the Best Fixed-Income Funds to Buy.]
Recession protection. The U.S. economy has been steadily expanding since the financial crisis, but it won’t forever.
“The expansion will end, and when it does it will suppress interest rates below 1 percent,” says Lance Roberts, chief investment strategist at Clarity Financial in Houston.
There is a tendency for professional investors to buy U.S. Treasurys when the economy enters a recession. Their buying bids up bond prices so pushing down yields. The price and yield of bonds move in opposite directions.
Currently, 10-year U.S. Treasurys yield around 2.3 percent. Roberts expects that would fall to less than 1 percent in the next recession and send the price of such bonds much higher.
During times of war investors also buy U.S. Treasurys as a safe-haven asset.
Understand what you are buying. It’s also true that not all bonds are as safe as Treasurys. “If people are trying to get more return from bonds they need to understand what they are buying,” says Bob Stammers, director of investor engagement at the CFA Institute in New York.
If you don’t comprehend the whole picture, then you could unwittingly add unnecessary risks to your portfolio.
So-called junk bonds are an example. These securities come from companies with less-than-pristine credit and have much higher yields than do investment-grade, or high-quality, fixed-income securities. Yields for junk debt are about 3.6 percentage points more than the equivalent government bond yields, according to data from the Federal Reserve Bank of St. Louis.
That sounds great. But it isn’t.
“If investors are chasing yield, do they understand the real risks?” Stammers says.
Frequently not, is the answer.
“What I am more worried about is when people go into junk bonds, are they taking more risks than they are in the equity portion of their investments,” Stammers says.
[See: 7 ETFs for a Solid Portfolio Defense.]
Junk bonds are often referred to as “stocks in drag” since they tend to behave in similar ways to equities. They don’t have the price stability of high-quality bonds and don’t add the same stability to your portfolio.
Municipal bonds likewise need care. These are securities sold by states and other municipalities. They can be popular with some investors because they are frequently exempt from federal, city, and state taxes.
But not all such bonds are high quality. Some distinctly aren’t. Bonds sold by Puerto Rico provide an example of extra-low quality securities that hurt many investors.
Avoid complication. If you are in any doubt about how to invest, then keep things simple.
A good start for most investors is to consider an allocation of 30 percent of a portfolio to bonds with the remainder in stocks.
In the bond portion of the fund you ideally want a mix of high-quality corporate and government bonds. You can purchase U.S. government bonds at the Treasury Direct website. Corporate bonds usually don’t trade in small values so maybe out of reach for some small investors.
It’s probably easiest for to purchase a broad bond fund (either a mutual fund or an exchange-traded fund) rather than trying to construct one yourself.
“I’m a big fan of bond ETFs for small investors who want fixed income exposure,” says Adam Johnson, founder and author of the Bullseye Brief newsletter. “ETFs trade in large blocks and get way better prices than individuals.”
The simplest approach might be to buy the Vanguard Total Bond Market ETF (ticker: BND), which holds a basket of government, government agency and high-quality corporate bonds. The bonds have an average effective maturity of more than eight years and the fund has annual expenses of 0.05 percent, or $5 per $10,000 invested.
For those willing to take on a little more risk, try the Vanguard Intermediate-Term Corporate Bond Index Fund ETF ( VCIT), which holds a basket of high-quality corporate bonds. The bonds have an average effective maturity of around 7.5 years. The fund has annual expenses of 0.07 percent.
[See: 10 Skills the Best Investors Have.]
Neither Vanguard fund owns any junk bonds.
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Bonds Are Ideal For Balancing a Portfolio originally appeared on usnews.com
