Things you need to know about bonds.
1. Anyone in retirement or close probably needs some bonds in their portfolio. But, retirees and other investors should stop thinking about interest yield, dividends, and other income producing assets and begin thinking of a total return portfolio that can generate an income stream though a combination of growth and income.
2. In a total return portfolio, bonds serve to reduce the overall risk in the portfolio, provide a store of value to fund future income needs, and only secondarily to produce income.
3. Interest rates are low. Deal with it! Normally higher rates are available on longer term bonds or higher risk bonds. Chasing yields, attempting to find higher rates means you are taking a large risk that you may not understand. These risks are not generally rewarded by higher returns. For instance, a 20 year Treasury Bond, which most people think of as low risk, is as volatile (risky) as the S&P 500 yet has less than half the long term return. If you are going to take that much risk, take it where you are likely to get appropriate returns.
4. Bond prices are inversely related to the general interest rate in the economy. If interest rates go up, existing bond prices fall. The longer the time until the bond matures, the more you will see the price fall. To avoid this risk, stay short term, perhaps no more than 3 years until maturity on your portfolio.
5. Some investors believe that if the price of their bond declines, they have no risk if they hold a bond to maturity. But they are simply refusing to acknowledge a very real capital loss if the price of their bond has fallen. Thats because if they sold the bond they couldn’t get their original investment back. And, if they had the original investment they could invest for higher income.
6. There is almost no more insanely profitable business for a brokerage than trading bonds. They are not required to disclose what they paid for the bonds and infrequently traded bonds are marked up by obscene levels. Unless you have hundreds of millions of dollars to invest and a great deal of expert knowledge, you are far better served to buy bond index funds than individual issues.
7. Bond index funds have the advantage of broad diversification, convenience, and very low operating costs (typically less than one tenth of a percent per year). For individuals it’s the lowest cost, lowest risk to obtain access to the bond market.
8. There are many different bond index funds that allow investors to precisely target the average maturity and default level they wish for their portfolio.
9. Municipal bonds are only appropriate for people in the very highest tax brackets. Remember, it’s not tax avoidance that should be your objective, its after tax total return.
10. Municipal bonds have their own set of risks as many states and cities face real prospects of insolvency. This is not your fathers municipal bond market. And, if you trust the rating agencies after their recent performance with mortgage backed securities, there is no hope for you.