Most investment professionals consider bonds a safe component of portfolios. They’re supposed to provide the stability and certainty that stocks can’t. Others say that bonds aren’t as safe as they seem. Who do you believe?
Both sides actually make some good points. How much you decide to allocate to bonds vs. stocks will depend not only on factors like your age and risk tolerance, but also the amount and stability of your income. Your investment success will also largely depend on your ability to curb spending and set aside money for the future. Before we look at the pros and cons of investing in bonds over stocks, we need to make an important distinction between investing in bonds through funds or ETF securities vs. buying individual bonds.
Bond Funds vs. Individual Bonds
One way to invest in bonds is by purchasing individual corporate or government bonds through your investment professional or brokerage. If you invest this way, you are guaranteed to receive the interest rate payments based on the bond’s coupon unless the issuer goes bankrupt. If you’re buying a corporate bond, make sure the issuing company’s financial statements are in good shape. If you’re buying government debt, there is usually less risk of default, but it can and does happen occasionally.
You can also invest in bonds via mutual funds or Exchange Traded Funds (ETFs), which are basically collections of bonds of different maturities. They trade similarly to stocks in that there is an actual price that is constantly changing, and these securities trade hands on exchanges, over-the-counter markets, or other secondary markets. They may focus on corporate or government debt, short or long term bonds, or a mixture of any of these. The prices of these funds fluctuate not only based on the prices of the bonds they contain, but also the supply and demand of the overall bond market, which is very much out of your control. This means that, like stocks, you could lose some of your initial investment if you are forced to sell your position at a time when the fund is trading at a lower price than when you bought it.
There are a number of good reasons many consider bonds to be safer than stocks:
1. Less Volatility: Historically, bond prices fluctuate less than stock prices. Depending on how you invest in them, they can offer returns that are guaranteed, or close to it, so they can be a stabilizing factor for your portfolio.
2. Better Planning: Because of the greater stability in bond returns, they can make it a little easier to plan for your future. Knowing that your bonds will pay you a certain amount each year allows you to set savings targets and better estimate your return on investment. For example, you can more easily predict how much money will be in your Roth 401k plan upon retirement based on the bond allocation in the fund.
3. Inverse Correlation to Stocks: Historically, stock and bond prices have moved in opposite directions. That can provide a margin of safety in case the stock market takes a dip. However, as we’ll see in the next section, stocks and bonds have become more positively correlated over the past couple of decades. So this hedging element is not always relevant.
4. Two Ways to Profit: There are two ways you can make money from bonds: interest income and capital gains. You will collect interest on your bonds, but you can also profit by selling your bonds at a higher price than where you purchased them before they mature.
1. Lower Returns: Although bond returns tend to be smoother than those of stocks, they are usually lower. This is especially true in today’s record low interest rate environment.
2. Inflation: Higher inflation rates hurt the purchasing power of your money. If you earn 2% on an investment, but inflation is running at 3%, you will actually have a real return of -1%. In effect, you will lose money in terms of purchasing power.
3. Losses are Possible: While defaults are extremely rare for high quality issuers, they do happen and you can lose your principal if the issuer can’t meet its obligations. As mentioned above, you can also lose money if you sell a bond or bond fund when the price is lower than where you purchased it.
4. Aging Bond Bull Market: Bond prices have been rising and yields have been falling for 30 years. Many believe that we’re closer to the end than the beginning of the bond bull market. Historically, however, it can take a lot longer for the bond market to exit its peak than it does to bottom out. So we may have a little longer to go, especially if the central bank keep intervening to maintain lower rates.
5. Increasingly Positive Correlation with Stocks: Stocks and bonds have actually been moving in similar directions for the past couple of decades, with a few notable exceptions. During the financial crisis of 2008, investors sold stocks heavily and moved money to the perceived safety of bonds. Thus, if both asset classes continue to move in tandem, there is no added benefit of diversification when it comes to investing in bonds.
You can see that while bonds have some advantages over stocks, they do carry their own unique set of risks, especially in today’s marketplace. As with any investment, it’s always best to do your homework before you commit any of your hard-earned money. Weighing the risks against the rewards ahead of time can save you a lot of regret down the road.