Have you ever heard coworkers talking around the water cooler about a hot tip on a bond? No, we didn’t think so. Tracking bonds can often be about as thrilling as watching the grass grow, whereas watching stocks can have some investors as excited as NFL fans during the Super Bowl. However, don’t let the hype (or lack thereof!) mislead you. Both stocks and bonds are essential to investment diversification and both have their pros and cons.
Here, we’ll explain some of the advantages of bonds and offer some reasons you may want to include them in your portfolio.
- While less exciting perhaps than stocks, bonds are an important piece of any diversified portfolio.
- Bonds tend to be less volatile and less risky than stocks, and when held to maturity can offer more stable and consistent returns.
- Interest rates on bonds often tend to be higher than savings rates at banks, on CDs, or in money market accounts.
- Bonds also tend to perform well when stocks are declining, as interest rates fall and bond prices rise in turn.
A Safer Haven for Your Money
Essentially, the difference between stocks and bonds can be summed up in one phrase: debt versus equity. Bonds represent debt, and stocks represent equity ownership. This difference brings us to the first main advantage of bonds: In general, investing in debt is relatively safer than investing in equity. That’s because debtholders have priority over shareholders—for instance, if a company goes bankrupt, debtholders (creditors) are ahead of shareholders in the line to be paid. In this worst-case scenario, the creditors might get at least some of their money back, while shareholders might lose their entire investment depending on the value of the assets liquidated by the bankrupt company.
In terms of safety, bonds from the U.S. government (Treasury bonds) are considered risk-free (there are no risk-free stocks). While not exactly yielding high returns (as of 2020, a 30-year bond yielded an interest rate of about 1.7%), if capital preservation, in nominal terms, means without considering inflation—a fancy term for never losing your principal investment—is your primary goal, then a bond from a stable government is your best bet
if capital preservation – a fancy term for never losing your principal investment – is your primary goal, then a bond from a stable government is your best bet. However, keep in mind that although bonds are safer, as a rule, that doesn’t mean they are all completely safe. There are also very risky bonds, which are known as junk bonds.
More Predictable Returns
If history is any indication, stocks will outperform bonds in the long run. However, bonds outperform stocks at certain times in the economic cycle. It’s not unusual for stocks to lose 10% or more in a year, so when bonds make up a portion of your portfolio, they can help smooth out the bumps when a recession comes along.
Also, in certain life situations, people may need security and predictability. Retirees, for instance, often rely on the predictable income generated by bonds. If your portfolio consisted solely of stocks, it would be quite disappointing to retire two years into a bear market. By owning bonds, retirees can predict with a greater degree of certainty how much income they’ll have in their later years. An investor who still has many years until retirement has plenty of time to make up for any losses from periods of decline in equities.
Better Than the Bank?
The interest rates on bonds are typically greater than the deposit rates paid by banks on savings accounts or CD. As a result, if you are saving and you don’t need the money in the short term (in a year or less), bonds will give you a relatively better return without posing too much risk.
College savings are a good example of funds you may want to increase through investment, while also protecting them from risk. Parking your money in the bank is a start, but it’s not going to give you any return. With bonds, aspiring college students (or their parents) can predict their investment earnings and determine the amount they’ll have to contribute to accumulating their tuition nest egg by the time college starts.
Bonds do have credit risk and are not FDIC insured as are bank deposit products. Therefore, you do have some risk that the bond issuer will go bankrupt or default on their loan obligations to bondholders. If they do, there is no government guarantee that you'll get any of your money back.
How Much Should You Put Into Bonds?
There is no easy answer to how much of your portfolio should be invested in bonds. Quite often, you’ll hear an old rule that says investors should formulate their allocation among stocks, bonds, and cash by subtracting their age from 100. The resulting figure indicates the percentage of a person’s assets that should be invested in stocks, with the rest spread between bonds and cash. According to this rule, a 20-year-old should have 80% in stocks and 20% in cash and bonds, while someone who is 65 should have 35% of his or her assets in stocks and 65% in bonds and cash.
That being said, guidelines are just that: guidelines. Determining the optimal asset allocation of your portfolio involves many factors, including your investing timeline, risk tolerance, future goals, perception of the market, and level of assets and income.
The Bottom Line
Bonds can contribute an element of stability to almost any diversified portfolio – they are a safe and conservative investment. They provide a predictable stream of income when stocks perform poorly, and they are a great savings vehicle for when you don’t want to put your money at risk.