Bonds are issued by governments, municipalities and companies to provide needed capital to fund short- and long-term operations or specific projects. When investors purchase bonds, they are essentially loaning money to the lending entity, and receive periodic interest in the form of coupons in return. When the bond matures, investors then receive the full principal amount. This differs from the purchase of common stock, in which shareholders actually own a piece, albeit a small one, of a company. Unlike shareholders, bondholders also have a priority claim on assets in the event of a liquidation or bankruptcy.
So when and how should you add bonds to your portfolio? In this article, we'll show you how investors at any stage of life can keep these fixed-income investments.
Phases of an Investor's Life
As there is no perfect asset allocation for any investor, there is no magic answer for which bonds to purchase for any specific age group. It is more important to diversify a bond portfolio across various sectors, maturities, types and countries of origin. In general, while the correlation between bonds themselves is higher than with equity-based classes, a diversified bond portfolio will most likely be less volatile than sector-specific bond portfolios.
There are some guidelines for building a portfolio framework depending on which stage the investor is in. During the starting, accumulating, spending and gifting phases, an investor has different time horizons and objectives. Strategic shifts in overall asset allocation can be complimented with shifts inside the bond portfolio to accommodate these objectives and constraints.
Most people enter the starting phase during the early stage of their careers. During this stage, the investor will have a relatively long horizon and will typically have a higher tolerance for risk as well. With higher risk tolerance, the investor will seek a higher long-term rate of return.
Along with a core weighting in investment-grade bonds, an investor can also add high-yield and international bonds to a portfolio. Although those two types of bond have higher risks, they provide higher returns than traditional U.S.-based government bonds.
High-yield bonds, also known as junk bonds, were made famous - or infamous depending on how you look at it - in the 1980s. Michael Milken, who some claim invented the junk bond market, served time in prison for his mistakes in handling the fund raising process.
But while junk bonds had a rocky start, there is no doubt that this market provides a valuable venue for companies with less-than-perfect credit to obtain needed financing. This market for risky bonds can provide the higher returns sought by investors in the starting phase. With a longer term horizon, younger investors can be more patient and weather storms as the value of their bonds swing up and down. They will also earn higher income from the typically higher coupons paid by the high-yield market.
As the starting phase in investing tends to coincide with the lower earning phase of a person's career, the higher income of this type of bond might be tolerable. Additional benefits can be achieved by placing the high-yield bonds in a retirement account, allowing the income from coupons would grow tax deferred.
As with any asset class, the higher historical returns from non-U.S. bonds do not come without additional risk. Non-U.S. bonds tend to be more volatile than U.S. bonds in developed markets and even more so in emerging markets. Like the high-yield market, the higher historical return comes in the form of total return, driven by a higher average coupon rate.
Non-U.S. bonds also provide some flexibility as they can be managed as a hedged or un-hedged vehicle depending on the investor's preference. This can be a double-edged sword as the portfolio can have two different strategies, one on the bonds and one on the currency. This can turn small profits into large ones and vice versa if the currency bet is wrong.
The starting phase is an excellent time to invest in high-yield or international bonds due to the longer time horizon and higher risk tolerance. It is also a good idea to use portfolios with multiple holdings to achieve proper diversification.
This phase in an investor's life typically occurs the mid- to late stage in one's career, when income generally exceeds expenses. The individual commands a higher wage as his or her skill level and capacity increases. The time horizon at this stage is shorter than that of the starting phase, but is still long enough to consider some riskier investments like high-yield and international bonds. This is also a time when investors in higher tax brackets tend to seek out income from municipal bonds to save on taxes.
Municipal bonds are generally considered exempt from federal and state income tax. Yields on municipal bonds are typically lower than their taxable counterparts and should be evaluated based on their after-tax yield. This marginal rate will be different for each investor depending on his or her tax bracket.
Municipal bonds offer steady streams of income. As with other segments of the bond market, diversification is key. It is important to diversify the portfolio by maturity, type and geographic location. While some states still require the income to come from a state-specific bond to be exempt, most states have adopted an open policy allowing for diversification. This is very important for a municipal bond investor as the issuing entities are subject to the credit rating of their local government and can be susceptible to downturns in the local economy or even natural disasters.
The spending phase occur when investors are relying on retirement income. Their risk tolerance is very small and so is their required return. It is common practice for financial planners to suggest taking less risk at this stage as the investor cannot afford to take losses, especially for those who have a relatively small portfolio and little income. They should consider Treasury bills or treasury bonds, which considered risk-free for the most cases.
The gifting stage of an investor's life is usually categorized by the realization that the assets gathered in the previous stages will outlive the investor's needs over his or her lifetime.
The key, and perhaps the point that's most often misunderstood, is that while the time horizon seems shorter, the risk/return profile does not differ much from accumulating phase. The misnomer here is that the time horizon stops at one's death, when in reality the portfolio now has a lifetime horizon of the legacy where the assets will end up. For example, if an investor has decided to pass wealth on to his or her children or charity, the portfolio's time horizon becomes that of the beneficiary. Therefore, keeping some risk in the portfolio is acceptable and similar investments would be suggested as accumulating phase.
The Bottom Line
Asset allocation for individual investors has always been part science and part art. Long-term capital market assumptions and cross correlations provide the science, while personal preferences provide the art. Constructing a bond portfolio for various stages of the investor's life cycle is no different. Basic risk-return guidelines are a great place to start and evaluating one's individual objectives and constraints can provide a framework for portfolio construction.
Although the bond market is much more complex than many investors assume, bonds can be appropriate in any stage of an investor's life cycle.