While bonds are an important part of a well-developed investment portfolio, they are sometimes considered boring or less advantageous than “real” stocks. However, there are several important reasons to include bonds in your investment portfolio, especially if you are retired or approaching your intended retirement date.
Here at Guiding Wealth, we want to help you choose the best investments for your unique financial circumstances. Here are some important reasons to consider investing in bonds.
How Do Bonds Work?
Also known as a debt security, a bond is a loan to a large organization, such as a big corporation or the government. By purchasing a bond, you essentially become a creditor to the organization.
Most investors make money from bonds through regular interest payments. If you hold your bond to maturity, you can get back the principal amount — or the face value when you bought it.
Stocks vs. Bonds
When most people think about the difference between stocks and bonds, they usually focus on the return. Generally, stocks have the potential to provide greater returns than bonds. However, there is another fundamental difference that’s key to understanding these two types of investments.
A stock is a representation of equity whereas a bond is a representation of debt. When you buy a stock, you are gaining ownership of a small fraction of the company, so your investment is tied to its success or failure. Buying a bond, however, is akin to providing a small loan to the organization. As such, bonds tend to be a safer investment because creditors are prioritized over shareholders for reimbursement, especially if the company goes bankrupt.
Additionally, there are some bonds that are considered risk-free, but there aren’t any risk-free stocks. The most well-known type of risk-free bond is a U.S.Treasury bond. This type of investment doesn’t offer a very high interest rate, but it does provide a reliable form of capital preservation.
The Benefits of Bonds
Despite getting a “bad rap” for not offering high returns, bonds provide many advantages. This is especially true when they are part of a diversified portfolio that also includes higher-risk/higher-reward investments.
Reliable returns
One of the best things about bonds is that they offer dependable returns. Even if you don’t treat a bond like a stock by selling it at a profit, you can still earn money on the interest, which is paid biannually. For many types of bonds, interest income is tax-free.
While most bonds, especially municipal bonds from local and federal governments, tend to have fairly low interest rates, you can also invest in high-yield bonds. Like any higher-reward investment, however, these bonds tend to be risky; they’re often known as “junk bonds.”
Stability
Another benefit of bonds is their stability. Unlike stocks, bond returns aren’t tied to a company’s success or profit margin. Rather, payments are based on interest rates, which tend to remain relatively stable for long periods of time.
Capital preservation
Finally, bonds allow investors to preserve their capital. If you hold onto a high-quality bond (municipal, treasury, investment-grade, or corporate bond) until maturity, you will get back the principal balance. The value of the principal isn’t guaranteed to keep up with inflation, but you can still count on recovering your initial investment, which stocks can’t promise.
Bonds generally won’t return as much as stocks that perform well. However, they do offer reliable income payments and bring stability to your portfolio.
How Are Bonds Performing in Your Portfolio?
Some investors are hesitant to purchase bonds because of the low potential returns and/or long maturity periods. Bonds may seem inferior to stocks, but a truly diversified portfolio has various types of investments, including those that sometimes look like “losers.”
When you are thinking about adding bonds to your portfolio or looking at the ones that you already have, it’s helpful to redefine what “good performance” means. Stocks and bonds have different functions in your portfolio, so it doesn’t make sense to compare them based on the same benchmarks.
You want your stocks to provide high dividends and to increase in value enough that you can sell them at a profit. When you look at your bonds, you want to focus more on the stability, capital preservation, and diversification they are providing.
Bonds Are Vital Elements of a Diversified Portfolio
Bonds may not elicit the excitement of popular stocks, but that doesn’t mean they aren’t good investments. In fact, bonds can provide several unique benefits that directly counteract some of the risks of stocks, so they are essential pieces of a well-rounded portfolio. With their predictable income and stability, bonds are especially advantageous for retirees who want secure investments to balance out the highs and lows of the stock market.
At Guiding Wealth, our goal is to help each of our clients build an effective investment portfolio that balances risk and reward wisely. Our financial planners can help you prepare for retirement and provide expert guidance through all phases of the transition. To learn more about how we can help you build a diversified investment portfolio, contact our team.