This is the eleventh article in a series that will discuss and explain basic investment concepts in hopefully an understandable and meaningful way. Whether you work with an investment advisor or choose to do your own investing, there are some things you need to know to be successful. Here is my take on what those things are.
More thoughts on owning bonds
Bond investors are lenders. Somebody pays you interest, and when the bond matures (comes due) you get your capital back. Because that interest and that return of capital are guaranteed, owning bonds makes you feel good. Understand that those guarantees are only as good as the credit worthiness of the issuer of that bond. It is safer to lend your money to the United States Government than XYZ Oil Drilling Company. That said, the United States Government, because of its good credit rating, does not have to pay you as much interest as XYZ Oil Drilling Company. The other thing about bonds is generally long term bonds that run 20 or 30 years to maturity will pay you higher interest than a shorter term bond. That sounds good, but those longer term bonds can shrink more in value than shorter term ones when interest rates rise. There is no free lunch when investing in bonds. If you want safety and peace of mind, invest in those highly rated and shorter term bonds. If you want higher interest for a long time, invest in those lower rated and long term bonds.
If you are smart, you will invest in a diversified portfolio of bonds. There are many different kinds of bonds with different ratings and maturities. A few examples would be treasury bills, treasury bonds, high yield bonds, floating rate bonds, corporate bonds, international bonds, emerging market bonds and TIPS (treasury inflation protected securities). Just like stocks, one never knows which category or maturity to invest in. So you cover your bases with a diversified portfolio of bonds and re-balance your stock and bond portfolio regularly to take advantage of the rising and falling prices of your portfolio positions. If you don’t know what re-balancing is, then you need to learn.
Understand that the prices of bonds will go up and down from time to time, just like stocks, but nowhere near as much as stocks. Don’t get caught up in the misconception that when stocks go down, bonds go up. In 1985, bonds were up 22% and stocks were down 9.6%. In 1994, bonds were down 2.92% and stocks were down 4.34%. In 2002, bonds were up 10.26% and stocks were up 32.26%. The pattern is that there is no pattern, which is why you need that diversified portfolio of stocks and bonds.
Lastly, if you read any financial news, you are likely hearing that bonds will be bad investments for quite a while to come. Historically, bond investors do well in periods of falling interest rates and less well in periods of rising interest rates. We are in a period of time where interest rates have been close to zero. It is tough to imagine them going lower. It is easy to imagine them going higher, and they seem to be heading in that direction. Why invest in any bonds? Since 1951 the U.S. bond market (as represented by the Barclay’s U.S. Aggregate Bond Index or the 10 year U.S. Treasury Bond) has had ten losing calendar years out of those sixty five years. The worst of those ten years was a -5.01% in 1969. From 1982 through 2012, interest rates fell from more than 13% to less than 1%. This was bond investor heaven, and the U.S. bond market averaged an 8.82% return for those thirty years. From 1948 to 1982, interest rates went from 1% to over 13%. During those 32 years, the U.S. bond market averaged 3.83%.
In summary, you need bonds and stocks in your portfolio regardless of what you think is going to happen in the future. The reason for that is that you don’t know. Remember that bonds will likely not make you any money at all after taxes and inflation, but they will cut down the excitement of those stocks in your portfolio. That lesser volatility will hopefully allow you to hold on to your investments through tough times and wait for those good times to come.
All articles in this series will be posted on my website www.McNamaraFinancial.com. If you have any question or comments I can be reached at mike@McNamaraFinancial.com. I promise I will respond.
Michael J. McNamara, Ph.D., CFP®
CERTIFIED FINANCIAL PLANNER™
Disclaimer: Any financial advice in this article is intended to be generic in nature. Readers should consult with their own financial advisors before implementing any advice or suggestions above.