How Can Bonds be Used as Part of Your Investment and Retirement Planning Strategy

Using Bonds to Build an Investment Strategy for the Future

Inflation-adjusted yields are at some of their most attractive levels in decades. While higher yields may put a dent in price appreciation, they also mean a bigger coupon payout for investors when a bond matures. Investors can thank high interest rates for that. Yields, in general, are the best predictor of returns going forward. If you can lock in yields for the next five to seven years at 5.5% or 6.0%, it makes a lot of sense.

We think it’s a good idea to look to fixed income in the near term rather than sit in cash, even though rates may not necessarily fall any time soon. You can start doing this now because you are getting attractively compensated in a reasonably high-quality portfolio. Bond yields are now higher than earnings yields in the S&P 500. This sends a message that bonds are once again providing a lot of value in an overall portfolio.

Bonds can include: government, corporate, municipal, high-yield, asset-backed, and mortgage bonds. There are generally no one-size-fits-all answers in financial planning and there can be many shades of grey. An individual’s circumstances will dictate what the correct course of action will be and what percentage of your portfolio bonds should comprise.

To simplify things a little, the relationship between bonds and stocks is generally inverse. They move in the opposite direction. This means that when bond prices increase, stock prices decrease; and vice versa. So one role of bonds in your portfolio in addition to providing income is to smooth out and reduce the volatility of your portfolio.  Bonds can provide an additional stream of income in a portfolio, with less risk than individual stocks or stock mutual funds.

Are bonds for everyone? Why or why not?

It’s important to find the right balance between safety and growth when assessing the role bonds, stocks, and other investments should play in your portfolio. There are many strategies available, from aggressive to conservative.  Safety (such as investing in bonds and fixed income) often comes at the price of reduced return potential and erosion of value due to inflation. On the other hand, if you invest too heavily in growth investments (certain equity categories and strategies), you may be taking unnecessary risk.  Safety at the expense of growth can be a critical mistake for those trying to build an adequate retirement funding strategy. Choosing the wrong investment strategy is a common mistake that people fail to monitor correctly. 

Generally, those who are younger are advised to invest more aggressively, tapering to more secure investments, such as bonds, as they grow older. As you near retirement and once you retire, you’ll have to rely on your accumulated assets for income. To ensure a consistent and reliable flow of income for the rest of your lifetime, you must provide some safety for your principal. It’s common for individuals approaching retirement to shift a portion of their investment portfolio to more secure income-producing investments, like bonds. There’s no one size or style of investing that will fit all. For some people, it can be better to accept lower returns so that they don’t lose sleep over the impact shorter term market moves can have on their savings. 

What are the factors an investor should look at to decide if a bond is right for their portfolio?

There are many elements that investors should consider in assessing a bond issuer’s creditworthiness and whether a bond is right for their portfolio, including: credit rating (from credit agencies such as Moody’s/ Standard & Poor’s/ Fitch), maturity, call structure (ie. when can the bond be called and subject buyer to reinvestment risk), interest yield (including yield to maturity and yield to call), issuer sector (industry), credit metrics such as leverage ratio (Debt/ EBITDA) and interest coverage (EBITDA/ Interest Expense), liquidity (or current cash holdings of the issuer), the issuer’s management team (reputation and experience), and general industry and economic conditions. It may also be helpful to assess if the bond is trading at a premium or discount to par value.

Factors that should be considered in deciding if bonds are a good choice for one’s portfolio, include the investors personal circumstances, as well as his or her risk tolerance and risk capacity. Because everyone has a different situation you should determine what’s best for you based on your age, goals, life expectancy, liquidity, income, and other retirement/ investment accounts and holdings. In general, over long periods of time, investors will make higher returns in diversified equity strategies versus bonds but this will come at the cost of increased volatility and ‘mark to market’ risk.

Bonds (and investment grade rated bonds) are generally considered a conservative investment that can be suitable for individuals that have a low risk tolerance.  Many things can influence your risk tolerance: your age and stage of life, your personality, your overall financial goals, as well as your previous investing experiences.

How can buying a bond fund, as opposed to an individual bond, simplify or improve bond buying?

Just as you can invest in individual stocks or ETFs when investing in the stock market, you have a choice between individual bonds and bond funds when investing in bonds. When you buy and sell individual bonds, you will have to pay a spread, similar to a markup or mark-down. When you buy a bond fund, you will have to pay an annual management fee, known as an expense ratio. When you purchase a bond fund, you may also have to pay a transaction fee and there may also be a redemption fee when you sell your investment in the fund.

There are many advantages to investing in bond mutual funds or ETFs, including simplified diversification, lower minimum investment requirements, professional fund management, improved tax efficiency, and low expense ratios.

One large disadvantage of investing in bond mutual funds is the predictability of returns. If a bond fund declines in value you could lose money if you sell it for less than what you paid for it. Investment turnover in actively managed mutual funds can lead to short-term and long-term capital gains. Mutual funds may have significant embedded gains and in some instances you can pay taxes for economic gains you never realized based on the timing of your purchase and the structure of mutual funds.

Investing in individual bonds also carries some advantages including: reduced market risk (when bonds are held to maturity), lower risk of default (for higher rated bonds), consistent income from interest, and the ability to decide which bonds to invest in (including terms such as maturity, credit rating, issuer industry, etc.) If interest rates are rising, then individual bonds and bond ladders could be a good strategy, since bond prices are dropping while yields are on the rise.  A bond ladder strategy, or buying a portfolio of bonds with different maturities that are spread out, will often allow you to take better advantage of a rising interest rate environment. As shorter dates bonds mature you can reinvest the proceeds in higher yielding bonds, and capture higher interest rates.

Investing in individual bonds does, however, have some additional risks as well. For example, it’s important to understand the correlation between interest rates and bond prices and yields so you’re not buying or selling at the wrong time.

Your credit exposure is generally higher when you invest in individual bonds since a greater portion of your portfolio is invested in just one or a few different bonds. When you invest in bonds, one of the biggest risks is that the issuing company or government will default. When you invest in a bond fund, your portfolio is often spread across dozens or hundreds of different bonds. If one issuer defaults, it will have less of a significant impact on your overall portfolio.

When you diversify with individual bonds, the burden of choosing bonds lies with the investor, rather than a fund manager. You may need to spend time researching different bond options to decide which ones are the best fit for your portfolio. In addition, you may need to invest larger amounts than you would with a bond fund to achieve the same level of diversification when choosing individual bonds.

Conclusion

When it comes to investing and retirement planning, it is important to have a carefully planned mix of bonds as well as stocks, and to diversify your portfolio within those different types of investments. Setting and maintaining your strategic asset allocation are among the most important elements for long-term success. Choosing the right mix of investments and then periodically rebalancing and monitoring your choices can make a big difference in your outcome and usually proves itself over time.