Bonds are seen as a safe haven for investors.
While government bonds such as U.S. Treasury and municipal bonds provide income to investors such as retirees, these assets face interest rate risk when the Federal Reserve lowers rates for an extended period. Bonds are often perceived by investors as a safe asset when stock returns are volatile but yields in bonds are sensitive to declining interest rates. U.S. Treasury bonds are issued by the federal government while municipal bonds are issued by a state, city or government agency such as a toll road authority or school district. The government entity who issues the bond agrees to pay the face value of the bond when it is due or matures and interest on the bond for its duration. “Investors like bonds for both the security and income,” says Mike Molitoris, CEO of Flagship Wealth Management Group. “They are viewed as a safe haven.” Here are six things to learn about investing in government bonds.
They have shorter maturities.
Bonds have varying maturity dates. The maturity dates can range from shorter ones such as one year, to longer such as 30 years. This is when the bond matures and the issuer will pay the principal or face value of the bond. A shorter maturity means that an investor receives a lower yield because there is less risk of interest rates rising and the bond defaulting. “The further out a bond’s maturity, the more sensitive it is to interest rate movements,” says Ron McCoy, CEO of Freedom Capital Advisors. “Bonds that are shorter term, seven years or less in maturity, are less volatile than a 30-year bond,” he says. A shorter maturity depends on when you plan to retire, how much income you need and the diversification of your portfolio.
There is credit risk.
Credit risk or the risk of default is a factor that investors should prioritize before adding a bond. Government bonds can default if a municipality is unable to maintain its services or pay employees if the tax revenue falls short or dries up. All bonds are rated for various risk factors. Knowing a bond’s rating can assess the risk level before investing, McCoy says. Often investors assume there is little to no default risk with U.S. government debt. The Congressional Budget Office, known as the CBO, projects that U.S. debt as a percent of gross domestic product, or GDP, will go over the 120% threshold for the first time in the next 15 years. “This means for the first time investors will have to factor in a real probability of default in U.S. debt, especially in long maturity debt,” says Derek Horstmeyer, an assistant finance professor at George Mason University.
Know the risk from interest rates.
As interest rates fluctuate, investors face more risk, especially in long dated bonds that mature in 30 years. If the Fed does not drop rates again in 2019, long maturity bonds will plummet in value, Horstmeyer says. “These bonds are most susceptible to any changes in Fed policies with respect to interest rates,” he says. “People who are close to retirement and want to avoid this interest rate risk should overweight the short maturity debt that they hold.” While long term bond funds reported eye-popping returns in 2019, these funds face vulnerability, says Sean McKeon, portfolio manager and principal of FundX Investment Group. The Vanguard LongTerm Treasury Fund (ticker: VUSVX), with an effective maturity of 24 years, soared over 10% in August and gained 22% year to date, mirroring the decline in rates over that time, he says. The fund lost almost 8% in November 2016 when the 30-year Treasury yield jumped from 2.58% to 3.02%.
There are bond funds and ETFs.
Investors often allocate money into a bond fund instead of a single bond because it has better pricing and is less risky, similar to a mutual fund that owns many stocks. The portfolio managers have years of experience to determine if a bond is suitable based on interest rate risk, default rate risk and can identify opportunities an ordinary investor may not be able to determine, Molitoris says. There are also bond ETFs. In this current declining interest rate environment, bond funds in the intermediate maturity range provide a better risk and reward trade-off for most investors, such as the iShares 7-10 Year Treasury Bond ETF (IEF), McKeon says.
Treasury bonds are considered safe.
Treasury notes and bonds are backed by the full faith and credit of the U.S. Treasury, so there is virtually no risk of default. This narrows the risk factors but it also means that government bonds and bond funds are acutely sensitive to interest rates, McKeon says. “An analogy often used is a teeter-totter,” he says. “When you are far out at the end of the teeter-totter, farthest from the fulcrum, even the smallest shifts up or down at the center are magnified.” In the past, Treasurys generated higher yields. On Sept. 9, 1999, the yield for a 30-year Treasury bond was 6.1%. Currently, the yield for a 30-year Treasury bond is at 2.11%.
Municipal bonds are for local projects.
Municipal bonds are debt issued by various states and cities and to raise revenue for education, roads and economic development. Revenue bonds are backed by funding sources such as tolls and general obligation bonds are backed by property taxes. The passage of municipal bonds can be a lengthy process. Discussions are held by state and local government officials such as school board members and city council members before a bond measure is placed on a ballot. If a bond is passed by voters, then the municipality can start issuing and selling bonds so it can fund the construction of a new school, park or sports stadium. Municipal bonds are also rated by credit rating agencies to determine the amount of risk such as the possibility of defaulting.
Facts to know about government bond investments:
— They have shorter maturities.
— There is credit risk.
— Know the risk from interest rates.
— There are bond funds and ETFs.
— Treasury bonds are considered safe.
— Municipal bonds are for local projects.
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