Do bonds have a place in my financial portfolio?

What is a bond?

A bond is a loan or an IOU between an entity and a person/institution who buys the bond in return for a fixed interest rate. Compare that to a stock which is actually an ownership in a company. As a stock holder and a part owner of a company, you bear the risk of the company performing well and get a share in the profits or losses. A bond holder on the other hand gets a guaranteed (well, guaranteed as long as the entity issuing the bond stays solvent – more on that later) return in the form of interest or a coupon rate. When something is guaranteed (kind of), the returns tend to be lower. One final comment – bonds tend to be for fixed periods. Fixed periods of 30 days, 60 days, 90 days, 6 months, 1 year, 10 years, 30 years and so on. That means you typically earn the interest rates on the bonds during the period of the bond but get your principal back only at the end of the term. But you have options to sell these bonds in between that time period if you want to.

Why on earth does one invest in bonds?

This was my first question when I started investing. What is so exciting about 1% – 2% and 3% interest rates when I can get those juicy 10% – 20% returns (btw on an average the US Stock market returns in the long run have been around 10%).

• Bonds provide a predictable fixed income stream – depending on what stage of your investing life you are in or the dependance on your portfolio for income, you may or may not care for the fixed income.
• Bonds help diversify and reduce risk in the portfolio – without getting too geeky, understand this – if you have a portfolio of $1M and you put a 100% of it in stocks, your portfolio is going to go up and down with the stock market. In a down market year that’s not going to very palatable for most people. If you decide to allocate a portion of your portfolio to bonds, you essentially significantly reduce the risk of that portion of the portfolio. But the overall portfolio can also get optimized for what is called a risk-adjusted return.
• Bonds preserve the principal – related to the above points, unlike stocks where you can potentially lose your entire principal, with bonds you can preserve that principal because they will be returned by the end of a period. If you are a retiree with a nice nest egg, you may not be interested in riding the stock market ups and downs and want to preserve your portfolio. Bonds will help do that.

Bonds tend to get the most press when stock markets are down. At the time of writing this article, in Oct 2022, the markets have been taking a beating in 2022. So everyone is looking to bonds as a safe haven. But there is another factor that is also driving people to bonds in 2022 – rising bond yields due to rising interest rates. My next article will cover the relationship between interest rates and bonds.

What type of bonds exist?

This is what initially drove me crazy. When you invest in stocks, in general there is not a ton of complexity. But my head started swimming when I was trying to understand the types of bonds. So, I am going to summarize the high level categories of bonds for you as I have come to understand it. There are many types and classifications but the below are the most prominent ones in the US:

• Company issued bonds – companies raise money to fund their investments by borrowing money from the public. They issue bonds. Now, as we all know not all companies are equal. A large, stable company bond is less risky than a small or failing company that issues bonds. Large, stable companies don’t have to pay as much interest rates compared to a failing or a smaller company. Sometimes the risky bonds are also called high yield or more colloquially called junk bonds. People actually invest and trade in junk bonds as part of their strategy.
• Federal Government issued bonds – In the US, the US treasury issues bonds. This is how the government raises money to fund its obligations it cannot cover through its tax revenues. I covered this briefly in the article on ‘How the government economic policies impact my finances’. Government bonds (depending on the strength of the government’s finances) are generally considered very low risk. US treasury bonds are considered risk-free (though there is no such thing as risk free truly). The US government issues many different types of bonds which I wont overwhelm you with. The interest rates are typically subject to US federal taxes but exempt from local or state taxes.
• Local government/municipal bonds (a.k.a muni bonds) – these are basically bonds issued by local state, city or counties to fund some of their obligations. There are different types of muni bonds. But one reason why muni bonds tend to get attention is because the interest from muni bonds tend to be tax free from federal tax and most often from state taxes too (there are exceptions). There can be default risk here depending on the fiscal condition of the issuing government entity.
• Agency bonds – this is the final one I will cover. These are typically issued by the quasi US government entities like Fannie Mae and Freddie Mac. Most agency bonds are mortgage backed securities. These got a lot of attention during the 2008/2009 financial crisis.

So, are all bonds created equal?

The answer is No. But how do I know which bond is better? First off, what I mean by ‘better’ when you talk about bonds is how risky they are. Ratings agencies exist to classify bonds based on risk ratings. The US SEC (Securities and Exchange Council) has designated 10 agencies as Nationally recognized statistical rating organizations that review financial information about bond issuers and issue a risk rating to the bond issuer. You may have heard ratings range from AAA (the best rating) to D (the worst rating)

The lower the rating, the higher the interest rate the bond issuer has to provide, so as to attract investors. So, when you decide to invest in bonds, understand the risk rating.  You can read this article from Fidelity to get a basic primer on how bond ratings work.

So, do bonds have a place in my portfolio?

It depends. I would argue bonds have a place in most people’s portfolio. How much should be invested in bonds is going to depend a lot on your life situation and appetite for risk.

Classic asset allocation will say that depending on your age, your mix between stocks and bonds should shift for the reasons I explained earlier in the article. Typically, the closer you are to retirement age, the higher the mix of recommended % of bonds in your portfolio. Folks who are much younger or feel they have a much longer horizon for retirement may choose to invest exclusively in stocks to get better returns because they are in what is called the wealth-creation stage. While, on the other hand someone who has already built up a sizeable portfolio might be in what is called wealth preservation stage and invest a large portion in bonds. So, it completely depends on your situation and goals. Remember, what I always say – personal finance is personal.

Thank you for reading and hopefully this article gave you a bit more perspective on bonds. I wish you success in your personal finance journey!