8 Things You Need to Know About Bonds

These investments have had a bad run of late, but they still play an important role in retirement accounts

Penelope Wang,

AARP

Comments

En español

Published July 21, 2023

backlit board showing bond yields and coupons

Getty Images

For decades, Americans viewed bonds as safe, stable investments that could help offset the wild rides their other dollars often took in the stock market. Nowadays, not so much. This year’s political battle over the debt ceiling raised the possibility that U.S. government bonds — until recently, arguably the least risky bonds on Earth — might fail to make scheduled payments. And this episode came after 2022’s dismal year for bonds. Last year, the typical “core” bond index fund — the go-to option found in many 401(k) plans — lost 13 percent, according to investment research firm Morningstar. That’s the biggest loss since 1999, when Morningstar started tracking that fund category. The 10-year Treasury bond lost 17.8 percent, its worst return in more than 90 years.

Granted, stocks fell even further last year, with the broad market’s total return down 18 percent. But as the markets continue to struggle in 2023, you may wonder what role bonds should play in your finances. Here are answers to eight key questions.

1. What is a bond, anyway?

Quite simply, a bond is a loan an investor makes to a borrower — typically a company or a government agency. If you’re the investor, you receive regular interest payments on the loan; that’s why bonds are called fixed-income investments. A bond has a maturity, or term, which is the amount of time over which it is scheduled to make payments. When the bond reaches maturity, the loan amount, or principal, is returned to you, the investor.

Bonds from U.S. issuers fall into three main categories, based on the borrower: Corporate bonds are issued by companies; municipal bonds, by city and state governments; and government bonds, by the U.S. Treasury or entities affiliated with the federal government. Bonds have different maturities, ranging from weeks to decades. They have different credit quality, or likelihood that the borrower will make the promised payments and return the principal. At the safer end of the spectrum are Treasuries; at the riskier end are high-yield bonds, commonly known as junk bonds, often issued by high-risk private companies. Generally, the greater the risk, the higher the interest paid by a bond.

Bonds: Slower and Steadier

growth of ten thousand dollars invested from january two thousand to april twenty twenty three Ending amounts are over twenty five thousand for bonds and over forty four thousand for stocks.

Returns on bonds are usually lower than those of stocks, but the bond market tends to hold its value better, with declines less steep than those suffered by stocks.

NICOLAS RAPP

2. Why did bonds drop in value last year?

After years of low interest rates, the Federal Reserve last year began hiking interest rates to fight inflation. That meant investors could buy newly issued bonds with higher yields. That also meant anyone trying to sell lower-interest-rate bonds before their redemption date had to drop their price to compete with the new, higher yields — hence the 13 percent drop in average value. (At other times, when interest rates fall, older bonds increase in value, since newer issues can’t match their higher rates.)

Despite declines such as the one in 2022, bonds do provide more safety than stocks, which tend to fluctuate more in value. Bonds don’t always zig when stocks zag, but over the long term, holding fixed-income securities does reduce risk and bolster your portfolio. “Even if the market values drop, you continue to earn income on your bonds, which over time makes up for the loss in value. Plus, with high-quality bonds, you can expect to get all your principal back at maturity,” says Julie Virta, a senior financial adviser at Vanguard.

3. What should I expect from bonds?

For starters, you aren’t likely to get a smooth ride anytime soon. No one can accurately predict when inflation will ease and rates will come down again.

Still, assuming you hold on to your bonds for the long term, you can get a reasonable estimate of your future returns by looking at the current yields. “Most of the return on a bond is the income it pays out,” not any change in the market value of the bond itself, says Christine Benz, director of personal finance and retirement planning at Morningstar.

In that case, there’s good news: Bonds are paying a lot more income now. The 10-year Treasury note recently yielded 3.69 percent, up from 1.63 percent in early 2022; six-month Treasury bills were paying 5.5 percent. “Even if the Fed continues hiking rates, these are still near their highest levels in over a decade, and you might as well take advantage of them,” says Collin Martin, fixed income strategist at the Schwab Center for Financial Research. (You can buy U.S. Treasury debt through the government website TreasuryDirect.gov.)

4. What makes more sense: owning individual bonds or bond funds?

For most investors, the simplicity and convenience of bond funds make them a better option than holding individual bonds, says investment consultant Rick Ferri, author of All About Asset Allocation. With a bond mutual fund or exchange-traded fund (ETF), you get professional management, as well as broad diversification. For example, Vanguard Total Bond Market (VBMFX), a bond index fund, holds more than 10,000 individual issues. Be sure to opt for funds with low operating costs; a good target for index funds and ETFs would be 0.15 percent or less of your holdings per year. Investing in a fund minimizes the chance that a single bond’s default — the failure to pay interest or to return your principal — will devastate your investments. Owning a fund lowers the transaction costs of trading corporate and municipal bonds, which could be high for individual investors, Ferri says.

If you prefer to own a portfolio of individual bonds, you may want to work with a financial adviser who could help manage the portfolio. Or you might opt for a so-called laddered portfolio of Treasury bonds, Martin says. That means buying bonds that mature at staggered future dates — every year for the next five or 10 years, for example. As each bond matures, you can roll over the proceeds into a new issue, a strategy that allows you to hedge against interest rate changes.

5. Can I live off the yield in bonds?

That depends on how much money you have invested in bonds, of course. Usually, however, bond yields aren’t a good source for covering your costs as time goes on, because inflation eats away at your money’s purchasing power. Even if your interest income pays the bills this year, the same amount from that same portfolio might not meet your needs a few years later. So it’s crucial to keep a portion of your assets in stocks, which through their greater ability to grow in value offer the best shot at keeping up with inflation over the long term. It’s also why you need to be willing to sell a portion of your stocks or bonds at times to pay the bills, and not just depend on interest payments and dividends. “What matters is not whether you touch your principal but how much your portfolio grows over time,” Benz says. “This total-return approach is a more reliable way to cover your living expenses.”

6. How much of my retirement accounts should I hold in bonds?

The overall mix of stocks and bonds in your portfolio should be geared to your individual circumstances and risk tolerance. As a starting point, you may want to consider a 60-40 stock-and-bond mix, an allocation used by many target retirement income funds. Research by Morningstar has found that retirement portfolios holding 30 percent to 60 percent in bonds, with the rest in stocks, had a 90 percent probability of not running out of money over 30 years, assuming a roughly 4 percent withdrawal rate.

7. What types of bonds should I own?

Most people will do best with a mix of high-quality short- and intermediate-term bonds. (Short-term bonds mature within two or three years; intermediate-term bonds, in 10 years or less.) Before you invest in any type of bond or bond fund, consider whether you will hold it in a taxable brokerage account or a tax-sheltered account, such as an IRA or 401(k). Bonds that throw off a lot of taxable income generally belong in tax-sheltered accounts, while those that offer tax breaks can be kept in taxable accounts, Ferri says.

Your tax-sheltered account, for instance, is a suitable location for a core bond fund, which tends to generate taxable income. If you’re in a high tax bracket, it may make sense to buy a municipal bond fund to keep in a taxable account, Ferri says. Issued by state and local governments, muni bonds are federally tax-free and often free of state and local taxes, so you may get a higher after-tax yield from munis than you would from taxable bonds, even if the munis have lower pretax yields. (To do the math on a particular muni bond, search online for “taxable equivalent yield calculator.”)

8. Does it make sense to hold some riskier bonds that might pay more?

Some types of bonds, such as junk bonds, offer above-average yields, recently around 5 percentage points higher than Treasuries. But those high-yield bonds typically offer less safety: Nearly 12 percent of them defaulted around the time of the Great Recession, compared with less than 1 percent of investment-grade bonds. For people with a very long view, 30-year Treasury bonds traditionally offer higher yields than 10-year issues, but in recent years, that difference has averaged just half a percentage point.

Reaching for an extra bit of yield usually doesn’t offer adequate compensation for the greater risk of loss, says William Bernstein, author of The Four Pillars of Investing. “If you’re going to take risks, do it in stocks, which offer better potential returns,” Bernstein says. For most retirees, “the highest-returning asset is the one that lets you sleep at night.”

%{postComment}%