Most investors should own bonds. They’re even more critical for retirees. A firm foundation with bonds will give you the confidence to include more stocks—the growth vehicle—in your portfolio.
Because there are a lot of bond options out there, you need to understand some basics and read some scary stories. The goal of this article is to demystify the process of selecting bonds for your investment portfolio. Fortunately, this is a lot easier than you might think.
Use Bonds for the Right Reasons
Resist any temptation to make a killing by trying to guess interest rate movements or chase unusually high yields.
Use bonds to generate a steady income in retirement and to reduce the risk of your portfolio. When a portfolio’s fixed-income foundation is fortified against financial earthquakes, investors can feel more confident about taking risks with stocks. You’ll use stocks to supply a portfolio’s octane and bonds to provide the stable foundation.
Stocks—not bonds—are the proper asset for taking risks.
You can also use the safest bonds, including money markets, to stash cash that you can’t afford to lose. For instance, U.S. Treasury bonds are the nation’s safest bonds; the entire government would have to go bankrupt before they would default.
American investors commonly sabotage their stock portfolios by chasing hot stock returns. When financial talking heads start raving about a mutual fund or stock that’s generating eye-popping returns, investors rush to buy it. Of course, the overheated returns come with a price: vastly increased risk.
The same phenomenon occurs with bonds. Plenty of conservative fixed-income investors fall in love with speculative bonds for their outsize yields, but they ignore their sizable risk.
Compare Similar Bonds
Often the bonds providing the most alluring returns are generated by portfolio managers who expose their clients to extra risk. For instance, when one intermediate-term bond fund is offering a 7 percent yield and the competition is offering 3 percent, the manager with the better yield isn’t necessarily superior; he’s likely playing with fire. While others might be heavily invested in U.S. Treasuries and other safe bonds, he’s juicing his returns with dicier bonds, like emerging market debt or junk bonds.
Even managers of staid short-term bond funds have been caught trying to juice their returns.
Ignore Individual Corporate Bonds
That’s right—you don’t need individual corporate bonds. You have to look only at the Wall Street carnage that began in 2008 to see why individual corporate bonds are too hot to handle.
The problem with blue chip corporate debt is hardly a recent phenomenon. In the spring of 2002, telecom giant WorldCom had an excellent bond rating; within a few weeks, the rating had dropped into junk bond status, and WorldCom declared bankruptcy.
Beyond the scary anecdotes, investment-grade and high-yield corporate debt share a troubling characteristic: Corporate bonds tend to flounder during the same periods as equities—and when stocks have tanked, you want bonds to step up and serve as the life raft.
Your bond investments should be limited to low-cost bond index funds that track the performance of a broad, market-weighted bond index. The bond funds in my recommended portfolios meet these criteria. They are highly diversified, with minimal exposure to corporate debt.
Diversify the Risk
Except for U.S. Treasuries, you’re tempting fate if you invest in individual bonds. Retirees can safely invest in Treasuries because they are backed by the full faith and credit of the U.S. government. Other types of issuers, even those with seemingly impeccable fiscal track records, pose a credit danger. If you hold a few municipal bonds (tax-free bonds issued by city and local governments), for instance, you face the risk of one or two of them blowing up and gutting your portfolio.
If you think municipal bonds never default, think again. In 1991, more than $5 billion in municipal bonds defaulted. In 2008, notable municipal bond defaults included a $3.8 billion sewer bond default by Jefferson County, Alabama, and a Chapter 9 bankruptcy filing by the town of Vallejo, California, involving $280 million in bonds.
Diversification shrinks risk. The best way to diversify is to invest in bonds through a low-cost bond index fund, which may own hundreds of different issues.
Many bond funds have yearly expense ratios in the 1 percent range. That’s way too high. My recommended Vanguard Total Bond Market Index Fund has an expense ratio of only 0.19 percent.
Morningstar is an excellent resource for investors wondering about the quality of the bonds in a particular mutual fund. Just call up a fund’s profile and click on “Portfolio.” You can also find this information in a fund’s annual report.
Most investors should invest in a broadly diversified, low-cost, bond index fund.