Well, not really.<\/p>\n
007 is sexy, dangerous, volatile. Espionage is like a high-wire act without a net. The risk? Life and death.<\/p>\n
Financial bonds can be the opposite. Most people probably would say they\u2019re not sexy, not exciting. \u201cMature\u201d is part of their vocabulary.<\/p>\n
But bonds are an important part of any portfolio. They offer diversification that can help offset the risks of stock volatility. I try to make sure clients have a portion of their assets in some lower-volatility holdings, such as investment-grade bonds. That lowers the overall risk in their portfolios.<\/p>\n
At their heart, bonds are pretty simple. A government or company wants to raise money for some purpose. So it sells bonds for the amount it needs, with a promise to pay back the principal, plus interest, after a specified term. It\u2019s sort of like a loan for which the recipient sets the terms.<\/p>\n
Of course, it\u2019s more complicated than that. Bonds vary widely in amount, length, packaging and risk. Governments and industries aren\u2019t in the finance business; they just need money for things. Often, they\u2019ll sell bonds in bulk to a large financial-services firm, such as BlackRock, or one of the major banks, which will turn around and market them to investors.<\/p>\n
Agencies such as Moody\u2019s, Standard & Poor\u2019s and Fitch determine credit ratings for bonds. There are a whole bunch of levels, with enough letters, numbers and plus\/minuses to make it seem like algebra. Lower-rated bonds typically pay higher interest rates because they carry more risk.<\/p>\n
Somewhere in the middle there is a line that separates \u201cinvestment-grade\u201d bonds (BBB- rating or better) from \u201chigh-yield,\u201d or \u201cjunk,\u201d bonds (BB+ or lower). That\u2019s one of the main distinctions for individual investors, who tend to access the bond markets by investing in individual bonds, bond mutual funds or bond exchange-traded funds.<\/p>\n
U.S. government bonds tend to get the highest rating, AAA, essentially because Washington could print the money to pay them off if necessary.<\/p>\n
Bonds issued by subordinate governments \u2013 state, county, city\u00a0\u2013 are collectively referred to as \u201cmunicipal\u201d bonds. What makes them desirable is that interest from most municipal bonds is exempt from federal income tax. Also, most states \u2013 Arizona included \u2013 exempt interest from bonds issued by their own governmental units from state and local income taxes, if the purchaser resides in that state. So, depending upon an investor\u2019s tax bracket, a municipal bond that pays less interest could end up netting more than a taxable bond.<\/p>\n
That brings us back to diversification. Your retirement plan should have an evolving stock-to-bond ratio based upon what you have saved, how long you have before retirement and how much you want to spend annually during retirement. You should reevaluate and rebalance periodically based upon your specific income needs. Some people will need to increase their bond exposure each year while others may only do that once every 10 years. Everyone is different, and you must remember that your time horizon is your entire life, not just the day you retire.<\/p>\n
Back in the 1980s, one could buy certificates of deposit (CDs) that paid around 8 percent interest, which aren\u2019t available nowadays. With interest rates lower, you have to develop a plan, based upon your income needs, to balance your portfolio so that you achieve the type of returns you need to maintain your desired lifestyle.<\/p>\n
Think of your portfolio as divided among buckets:<\/p>\n
What you don\u2019t want to do when choosing between stocks or bonds is to try to time the market. I advise clients to own less-risky, investment-grade bonds from the beginning in a strategy that relies on stocks for capital appreciation; that\u2019s the place to take risks. One goal for the bonds is to get a higher rate of return than a CD or savings account while still providing some stability in your portfolio.<\/p>\n
This can be beneficial for people who are a long way from retirement. They can afford to wait out volatility, knowing that, in the long run, the market always has gone up. When the market is down, they can sell some bonds and use the proceeds to buy stocks while prices are lower.<\/p>\n
Let me explain that from a client\u2019s perspective: Say you\u2019ve structured a portfolio to be about 60 percent stock and 40 percent bonds, but the stock market drops. As the stocks lose value, they make up a smaller percentage of your portfolio. In that scenario, you can rebalance by selling some of your bond holdings and purchasing stocks while prices are low. You kill two birds with one stone \u2013 buying low and rebalancing.<\/p>\n
Think of bonds as your safety net. Don\u2019t take on too much risk, such as buying junk bonds. Yes, they may offer higher interest rates, but that\u2019s because companies that issue them have a higher probability of defaulting on those bonds. They\u2019re called junk bonds for a reason: They carry a lot more risk.<\/p>\n
For example, in 2008, when the S&P 500 was having its second worst year of all time, the high-yield bond index (below investment grade) was also down 26.2 percent. During that same time, the investment-grade bond index (BBB- or better) went up 5.2 percent. You don\u2019t want your bonds taking a huge hit at the same time your stocks are.*<\/p>\n
Bonds are a very important part of your portfolio. Something that appears boring can hide important details. Know what you own. Understand the purpose of your bonds before you buy. Pay attention to the goals of bond funds. A competent financial adviser has access to details about specific investments and should be happy to explain the distinctions.<\/p>\n
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