How Bonds Work and How They Might Work in Your Investing Strategy
Although they’re an extremely important way to prepare for retirement, most people don’t know how bonds work.
In this article, we’re going to address some important traits of bonds that lend them to being such a smart, safe vehicle for building a nest egg.
Bonds and Interest Move in Opposite Directions
When interest rates climb, new bonds are going to pay higher rates than older ones. As a result, old bonds generally drop in price when this happens. Falling interest rates, on the other hand, mean that older bonds are going to pay higher interest rates than newer ones. Consequently, older bonds usually attract premiums.
That Doesn’t Mean You Should Sell Them When Interest Rates Go Up Though
Despite what we just covered, don’t take that as advice that you should sell your bonds when you see interest rates start going up. Instead, maintain a reasonable portfolio of bonds. This is a great way to hedge against any upcoming market volatility.
Low Coupon Bonds Get Hit Hardest by Rising Interest Rates
Another point about interest rates: their effects on bonds will also depend on the bond’s coupon rate. This term refers to the yield returned by a fixed-income security. Put another way, it’s the amount paid out on the date the bond was issued.
Of course, there are plenty of other variables that could influence the health of a bond. However, if all else is equal, a low-coupon bond will take the biggest hit from interest rates going up.
Rising Interest Rates Can Be a Good Thing
One final word on interest rates: although they’ll hurt bonds initially when they rise, they also have the potential to improve an investor’s returns over the long term. Now, this is different for ETF bond funds. When interest rates go up, there’s no assurance that you’ll get your invested principal back.
This only applies to individual bonds. They’ll always pay you your principal back at maturity. In fact, a portfolio of individual bonds is immune to the damage done by rising interest rates. This is why I do not recommend bond funds.
How Bonds Work Regarding the Yield Curve
It’s important to understand what the yield curve is if you plan on investing in bonds. That’s because it plots the yields of Treasury securities. This applies as much to those with 90-day maturities (which are the shortest) as to those which have the longest – 30 years.
Keep in mind that there are several types of bond yields too. In simplest terms, the yield is how much the bond is expected to return on your investment, but you should understand the different dimensions to this concept before investing. It’s an important element in how bonds work.
There Is Still No Such Thing as a Sure Thing
A lot of people pitch bonds as the safest investment you can possibly make. To be fair, there might be some truth to that. They definitely don’t experience the kind of volatility we see with stocks, for example.
However, that doesn’t mean bonds don’t carry any risk. If you buy corporate bonds, you run the risk of the company going out of business and leaving you with a worthless investment. Even countries can’t be considered 100% reliable. Sure, it seems unlikely anything will ever happen to the United States, but should its government dissolve, its Treasury bonds will no longer be worth a dime.
Every single type of investment carries risk. Bonds are no different, so be smart about assessing these risks before you make any sort of investment.
Investment-Grade Bonds Don’t Always Provide High Returns
This goes hand-in-hand with the point we just covered, but we’re giving its own section here because investment-grade bonds often seem like a guarantee where yields are concerned. They receive this designation because of how high they’re rated by Moody’s or Standard & Poor’s.
Still, even though they’re most likely going to meet their obligations, that doesn’t mean they can’t show lower-than-expected yields. When this happens, think long and hard before moving your money elsewhere.
It’s Important to Consider a Bond’s Duration
There are a lot of things to consider when deciding on which bonds to buy. However, the duration of a bond is going to be paramount. This refers to how sensitive its price will be to changes in interest rates. Although it’s an approximate measure, it’s still very important to consider.
Let’s look at an example to show you why. Say a bond has a duration of five years. If its yield falls by a percentage point, its price will go up roughly 5%. Likewise, if its yield grows by 5%, the bond’s price will fall by just as much.
The Right Percentage of Bonds for Your Portfolio
With all this being said, you may think that it would be best to load up your portfolio with as many bonds as possible. Again, though, recall that we pointed out that bonds are not without their risks.
Again, I always recommend against ETF bonds funds, but that doesn’t mean other options are completely safe by default. Like with any other investment vehicle, you need to think about your goals and assess your tolerance for risk before making any decisions.
A Diverse Portfolio Is Still Important
Thanks to the power of compounding, bonds can be an extremely effective way to prepare for your future and ensure a comfortable retirement. Nonetheless, depending on where you are in your investment journey, you may still want to keep somewhere between 30% and 40% of your money in stocks. The rest will do well in bonds, especially if you use compounding.
Think You Now Know How Bonds Work?
If you want more help understanding bonds – or even if you think you’re caught up – try this quiz created by Walter Updegrave. As Updegrave points out in the introduction to this piece:
“Bonds have been in the news a lot lately, as yields on 10-year Treasury bonds have been rising amid concerns that tax cuts and infrastructure spending in a Trump administration could spur inflation.” At the same time, Federal Reserve made a decision to raise rates by 0.25 at their meeting on December 14. The FED’s chair, Janet Yellen, has confirmed during a press conference that they are expecting moderate inflation in 2017 and they are going to hike rates three times next year. This means higher bond yield and attractiveness for investors.
All of which makes this a good time to see whether you really understand how bonds work and what role they might play in your investing strategy.”
Review the information above and then test your understanding with this quiz to make sure you now have a better understanding of how bonds work.