The closer to retirement you get, the more you hear about bonds. The conventional wisdom is that bonds are safe and stocks are risky, but is that true? If you’re figuring out how to invest your retirement money, you first have to understand your choices. Here’s the truth.
What Is a Bond?
The financial academic types will have a really long explanation, but the short version is that a bond is a loan. You aren’t investing in the company and getting a minute equity stake (that’s why stocks are also called equities); you’re letting a company or government entity borrow your cash.
It's as if you were a bank granting a home mortgage to the company. You lend the company money and it pays you back with interest. (For more, see 5 Basic Things to Know About Bonds.)
Some bonds really are safe, but others are riskier. Just as your personal credit rating affects your interest rate, different types of companies and entities command higher or lower interest rates based on their perceived safety.
Treasury bonds are about as safe as they come because the U.S. government isn’t going to go out of business. A company such as Apple, with more cash in the bank than many countries, has plenty of money to pay back its debts. The interest rate, called “the coupon” in bond terms, is quite low, but your money is safe.
On the other hand smaller companies or governments that are known to be volatile pay a higher coupon, but there’s less of a guarantee that you’ll get your money back. If the entity defaults, most or all of your money will be lost.
What’s Your Risk Tolerance?
Bonds, like all other investment classes, come in different varieties. Some stocks are less risky than some bonds. When you decide how to invest your money, it’s not just a stocks vs. bonds question – it’s more about risk tolerance. And since we're talking about retirement, you'll probably want to be more safety oriented than you might have been in earlier years, when the upside of making a higher yield was worth the risk that sometimes you'll hit a bad investment.
Let's say you decide, maybe with the help of a professional, that 40% of your portfolio should be invested in bonds, that's just the first step. The next question is which bonds: What is the weighting of risky (often called high-yield or junk bonds) to ultra safe? The bond market ebbs and flows just as the stock market does, making it not as simple as picking up a few bonds and forgetting about them.
Bonds or Bond Funds?
You can invest in bonds by buying individual bonds directly or putting your money in bond funds, such as ETFs or mutual funds. A bond fund is a basket of bonds of a certain type. Because there are multiple bonds in the fund, if one bond ends up in default, there are plenty of others in the fund to soften the blow. You don’t have that protection with individual bonds.
On the other hand, bond funds involve management fees: Any time you invest in a fund, you have to think about fees. Every fund has an expense ratio: the amount of money taken from your earnings to manage the fund. Sometimes it’s very little; other times it can take a huge bite out of your earnings.
Tax and Inflation Implications
From a tax standpoint not all bonds are created equal. Municipal bonds, used by U.S. state and local governments generally to fund big projects, are free from federal and most state and local taxes. That’s a lot of money over time. But municipal bonds will normally have a lower coupon rate. (For more, see Why Retirees Can't Count on Muni Bonds.) It also means you should keep munis out of IRAs and other investments that are already tax advantaged. In fact, you will likely owe unnecessary taxes on a municipal bond if you withdraw it from an IRA.
Corporate bonds aren’t tax exempt. Bonds issued by large companies are safe, but that safety can mean they don't yield much. In fact, if the coupon isn’t higher than the rate of inflation, your investment is losing money. There is such a thing as too safe. Consider inflation whenever you’re evaluating how to put your money to work.
The Bottom Line
Yes, absolutely, you should invest in bonds in retirement, but choose carefully. Like any investment class, there are safe and risky bonds. Bonds are more complicated than stocks. Consider getting the help of a financial advisor to construct a bond portfolio.