Bonds are understood to be the middle ground between stocks and cash. Bonds are more volatile than cash, but offer higher returns. Bonds are less volatile than stocks, and provide for lower returns in the long-run than stocks.
What are Bonds?
When a business or government wants to raise money, it sells bonds to investors. The most common type of bond is a bullet bond.
Bullet bonds pay a specified annual or semi-annual interest amount known as a coupon. When the bond matures, the borrower pays off the bond with a large payment equal to the bond’s face value. You can think of a bond as a way to be the banker of a large corporation, local or state government, or the federal government.
Advantages of Bonds
There are a few unique advantages of bonds:
- You’re paid first – Bond interest has to be paid before profits can be paid to stockholders and before money is spent on operating expenses. Being the first priority gives you an extra layer of safety during recessions or in the event of a bankruptcy.
- Less volatility – Whereas stocks move up and down wildly from day to day, bonds are less volatile as they are perceived to be less risky than stocks. Bonds tend to zig when the market zags, performing best when stocks are weakest, and weakest when stocks perform the strongest.
- Predictability – It is much easier to find bonds that are likely to provide a positive return than stocks that are likely to provide positive returns. A business does not have to be a top performer or a record growth company for bond investors to make money; it simply needs to be able to make good on all interest payments as they come due.
Disadvantages of Bonds
No investment is without its disadvantages. Here are a few disadvantages of investing in bonds:
- Low returns – As bonds tend to be safer than stocks, bonds also tend to provide lower returns in the long-run.
- Inflation risk – Bondholders carry more inflation and interest rate risk than stock investors. Because the total return on bonds tends to be lower than stocks in the long run, inflation eats more from bond returns than it does stock returns.
- Difficult diversification – Individual bonds sell for $1,000 of face value, meaning that a well-diversified portfolio of 50 bonds would require an investment of $50,000. Few individual investors ever buy individual bonds, and instead they have to buy into bond mutual funds or exchange-traded funds.
- Taxed as income – With the exception of municipal bonds, bonds are subject to income taxes at your normal income tax rate. Avoid higher taxes by keeping your bond exposure in a tax-deferred retirement account like a 401k or IRA.
Should You Invest in Bonds?
Broadly speaking, there are only a few groups who do not benefit from at least some bond exposure. There is only one group of people who should absolutely not invest in bonds: people with substantial high-interest debt, or people with student loan debt.
When you buy bonds, you’re lending money to someone else. If you have student loan debt at 6.2%, and you’re buying bonds at today’s low rates of 2-4% per year, you are borrowing at 6.2% and lending at 2-4% per year. Think about this as if you were a bank – no bank would stay in business borrowing at 6.2% and lending at 2-4%. Additionally, student loans have to be paid back; there is no way around it. If you have student loans, you already have a way to invest in risk-free “bonds” by repaying your student loan debt. Repaying student loan debt makes much more sense than investing in bonds for a lower return with greater risk.
Otherwise, some bond exposure helps balance out the volatility in a retirement plan. See this post on diversification, which details historical performance of different asset allocation levels to stocks and bonds. Consider targeting a return and then picking an allocation that has historically hit your hurdle rate – the return you need to have the retirement savings you want.