The financial press trumpets bonds as the asset of choice for retirees relying on a fixed income. Although this may be true, bonds also play an important part in younger investors’ portfolios.
Bonds have many benefits.
Bonds bring balance to a portfolio and add protection against market volatility. They also provide predicable solid returns for investors. Here are a few of the reasons that young investors should add bonds to their investment portfolios.
Bonds Provide Diversification
As a young investor, your portfolio should primarily consist of stocks but should have some exposure to bonds. This ensures you’re not too heavily invested in any one asset class.
Some background: Stocks and bonds have an inverse relationship. When stocks thrive, bond prices usually regress. When bond prices soar, stocks tend to drop.
So if you’re totally invested in stocks, you will miss out on the increase in bond prices. Bonds can help you survive severe market downturns like the tech bubble crash of 2000 and the market crash of 2008. As a rule, younger investors should have between 20 to 30% of their investments in the form of bonds.
Bonds Provide Income
The only “real” return on any investment is income that it produces.
Let’s say you owned 100 shares of Nike and it rose from $50 to $100. Your portfolio might be up 100%, but you don’t have a realized gain until you sell your shares. Dividends and interest income, however, provide a realized gain to investors in the form of cash. These regular interest payments are a nice income stream for the young investor.
Bond income can be used to buy shares of a company or funneled into another investment. The best bonds for young investors seeking capital preservation and solid interest income are investment-grade corporate bonds. You can count on high-grade corporate bonds for regular interest payments.
Bonds Can Provide Risk
It’s true: bonds can add some risk to your portfolio.
You already know about safe low-yielding investments such as saving bonds and treasuries. But younger investors can be more aggressive with riskier (and higher-yielding) junk bonds. Junk bonds are rated below investment grade and pay a higher interest rate due to the additional risk. Obviously, junk bonds have a higher risk of default.
The best junk bonds to buy are held by companies whose financial statements are improving and their credit quality is getting better. You could purchase BB rated bonds which are considered high risk and receive a healthy interest payout. But avoid D rated bonds. These are the lowest rated bonds and have the greatest risk of default.
Bonds Have Tax Advantages
High income investors may find municipal bonds a great investment.
These tax-exempt securities fund government projects such as bridges and highways, so the interest income is often exempt from state and local taxes. Municipal bonds pay lower yields than regular bonds, but the tax savings make them attractive to high income earners.
Let’s say you make $210,000 a year and are in a 33% tax bracket. If you bought a regular corporate bond paying 4% interest, your after-tax total return would be 2.68% (4.00 – 1.32). That’s just at the federal level! If you had to pay state taxes as well, your return would be even lower. Your return would be higher by simply purchasing a municipal bond yielding 3%.
What about you? Do bonds have a place in your portfolio? Why or why not?