The Best Bet for Retirement Income: Bonds or Bond Funds?

With interest rates hovering at historic lows and the stock market still flying high, many people are reconsidering their investment portfolios and this is especially true for retirees. The well known 60/40 portfolio, where investors invest 60% in stocks and 40% in bonds, is also being questioned. In the past the stock portion of your investments, although more risky, allowed you to grow your money — especially if you invested for a long period of time. Bonds, on the other hand, are typically lower risk though with lower returns.

What should you do with your money in 2016? If you are retired and interested primarily in income you may be looking into bonds. But which bonds are best suited to you or are bond funds a better idea? (For more, see: What After the 60/40 Balanced Portfolio?)

Types of Bonds

When you invest in stocks you own equity in companies. With bonds you, as an investor, loan money to a corporation, government or municipality to help them fund projects or growth. As a bondholder you are paid a fixed interest for an agreed period. Depending on your needs, there are various types of bonds available.

  • Government bonds are issued by the government and are considered the safest, because the U.S. government backs them.
  • Municipal bonds are issued by a municipality to fund projects like roads, schools, stadiums, airports etc. These bonds are particularly attractive to people with a higher tax bracket because of the opportunity for your money to grow tax free. These bonds are exempt from federal taxes and from most state and local taxes.
  • Corporate bonds are issued by corporations. They have more risk (especially with lower-rated high-yield or 'junk' bonds) but offer better yields. (For more, see: Bond Basics Tutorial.)

Bond Funds

Bond funds invest in bonds, such as municipal or corporate, and offer diversification. However, there are other factors to consider such as interest rate and default risk. Marc Proser, contributor to Forbes, warned in his article, “Should You Invest in Individual Bonds or Bond Funds?” of the potentially negative side of bond funds when it comes to interest rate risk. “All bonds and bond mutual funds have interest rate risk, which is the risk that interest rates will rise, causing the value of the bonds in a portfolio to fall," Proser wrote. "If interest rates increase, an investor having to sell a bond or bond fund would receive less than their initial investment. With individual bonds however, you can eliminate interest risk by simply holding the bond to maturity. When a bond matures, assuming there is no default, an investor will receive the bond’s full face value. As bond mutual funds do not generally hold bonds until maturity, bond mutual fund investors do not have the option of eliminating interest rate risk.” (For more, see: The Top 5 Bond Mutual Funds for 2016.)

John H. Robinson, financial advisor with Financial Planning Hawaii in Honolulu advises: “With interest rates hovering near historic lows, I generally eschew bond mutual funds. Assuming the bonds are highly rated corporate or municipal bonds (or certificates of deposit) and maturities are in the short-intermediate range (10 years or less), the individual securities offer less volatility and some assurance that the investor will receive all interest and principal if held to maturity. Bond mutual funds offer no such assurances.”

Diversification

Even though some financial advisors suggest investing in individual bonds versus bond funds, investing solely in bonds may not give you enough yield, especially when you consider the rate of inflation. You still need to diversify and, in addition to bonds, should look into other types of investments. Although the 60/40 asset allocation has come into question lately, there is no alternative formula that will work for everybody. (For more, see: Why a 60/40 Portfolio is No Longer Good Enough.)