Investing in bonds is one way to create an income stream for retirement that is both insulated from stock market volatility and able to increase over time so your spending can keep up with inflation. First, it's important to understand how bonds work.
How Bonds Work
When you invest in bonds you enter into a legally binding contract with the issuer, which is the corporation or government entity that created the bond. You are essentially lending money to the issuer for a specific period of time in exchange for payments of interest on the loan.
The issuer, on the other hand, is legally bound to pay you a fixed rate of interest and return your principal at the end of the agreed on time period. This period of time is known as the term. The principal is the amount of money you initially invested.
When you invest in bonds the first payment is made six months after the bond is issued and successive payments are made every six months afterwards. On the date of maturity, the last interest payment is made and the principal is returned to you.
Because the amount of money you receive in your interest payments will always be the same, or fixed, bonds are known as fixed-income investments.
Bonds As An Investment Tool
To sum this all up, when you invest in or buy bonds, you are lending money to the issuer in exchange for two dividend payments every year until the bond matures. On the date the bond matures, you will receive your last dividend payment, and your original investment will be returned to you.
Also, because bonds are a legal obligation of the issuer, you can have greater confidence that all your payments will be made on time and that your principal will be returned in full at the end of the term.
However, a legal obligation is only as good as the issuer. Just like in your everyday life, if you lend money to an unreliable person you could get burned even though you both signed a contract. If the other person is unable fulfill their end of the bargain, you might not receive the income you expected.
The same goes for bonds. If you lend money to a company by investing in their bonds and discover later that the company has financial problems, you might not get the payments you were expecting. Even worse, you might lose part or even all of the principal you invested.
However, if you lend money to a reputable entity like the United States government by investing in Treasury bonds, it’s likely you will get all your dividends on time as well as the prompt return of your principal at maturity.
This is why bonds come with ratings that cover a spectrum of credit worthiness. These ratings make it easier for us to rank bonds from highest to lowest quality, so we can better understand how much risk we are taking on.
Now you may be wondering, if there is a ratings system that could help us avoid investing in riskier bonds, why would we ever buy them? One reason is that riskier bonds pay higher amounts of interest. This is because bond interest rates are driven by market forces.
Lower rated bonds are riskier but they pay higher rates of interest. Think about it this way: if an unreliable person were trying to borrow money, he would need to pay more interest to attract a lender than someone with a sterling reputation would. It works the same way with bonds. One way a company with a less than ideal balance sheet can entice an investor to buy their bonds is by offering a higher rate of interest.
Meanwhile, secure lenders like the U.S. government are able to pay lower rates of interest because investors believe there is very little risk to their interest payments and the return of their principal.
Bonds Are Not a Complete Retirement Income Solution
You will probably not be able to replace your paycheck with just a bond portfolio. The reason bonds alone cannot provide the income most of us need in retirement is because most of us don’t have enough money to invest in bonds to generate the income we need to cover our expenses.
Here is an example: if you had $1 million to invest in bonds and wanted to be conservative, you might invest it all in 30-year U.S. Treasury bonds. The problem with this approach is that you would only receive about $33,000 per year in interest. This is because the rate on the 30-year Treasury is about 3.3% at this time. For most of us, $33,000 on top of our Social Security payments will not be enough to retire comfortably.
The other problem with this approach is inflation. Just think about how much more it costs to buy a car or a house today than it did 30 years ago. How in the world are you going to maintain your lifestyle if all your money is tied up in bonds and your income never increases? Not to mention that your principal won’t grow either. At the end of the 30-year term, you will have exactly as much money as you started with.
Although bonds alone will not solve your retirement income dilemma, they do have many qualities and characteristics that can help you create a resilient income stream in retirement. You are just going to need a couple of other investment tools to work alongside your bonds.
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Disclosure: Securities and investment advisory services offered through NEXT Financial Group, Inc. Member FINRA SIPC. Hafner Financial Group is not affiliated with NEXT Financial Group, Inc.