Most investment experts talk about the benefits of diversification — essentially, mixing some stocks, bonds and cash in your portfolio. Having too many eggs in one basket, so the reasoning goes, means that you could wind up with broken eggs if the basket falls.
Bonds and bond funds are common in retirement portfolios because they typically perform differently than stocks. When you own a stock, you own a share of ownership in a company. But when you buy a bond, you are simply making a loan to a government body or to a corporation. The borrower promises to pay back the bond holder the amount of the loan, plus interest. Bonds issued by government agencies (the U.S. Treasury, for example) are generally considered among the safest investments you can buy, since they are backed by the “full faith and credit” of the United States, one of the world’s largest and most stable economies.
So, what do bonds do for you?
There are a number of potential benefits to owning bonds:
- Current income: Most bonds pay a fixed rate of interest for a certain period of time, say, 3% a year for 10 years. At the end of that period, you get your principal investment back.
- Diversification: Bond prices often move in opposite direction to stock prices, meaning that when bonds are rising in price, stocks can be moving down. This can provide a stabilizing effect on your portfolio. (In another twist, when bond prices move up, their yields go down.)
- Priority payment: Another benefit to bonds is that if the company issuing them goes bankrupt, bond holders get paid before stock holders. Bonds generally have low default rates, meaning that companies tend to make it a priority to pay the interest due on any loans outstanding.
To be fair, bonds have certain drawbacks. For one, they do not offer growth potential. You know what to expect with a bond — your money back plus interest.
Second, some bonds are callable, meaning that the issuer can redeem (take back) the bond prior to maturity. Companies tend to do this when interest rates are low, and they can reduce their borrowing costs. You get your money back, but no interest for the remaining term of the bond.
Third, the value of your bond will fluctuate depending on current interest rates. When rates rise, the value of the bond falls. In a rising interest rate environment, choosing a bond or bond fund with shorter than average duration (that is, its sensitivity to current interest rates) will make it less likely that its value will fluctuate.
There are some key differences between owning individual bonds and bond funds. Return of principal is not guaranteed in bond funds and the interest can fluctuate with changes to the underlying bond portfolio. Interest rate payment frequency varies between individual bonds and bond funds and there are additional fees and expenses associated with bond funds that do not apply to individual bond ownership.
Diversification, asset allocation, and rebalancing do not assure profits or protect against losses.
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