Bonds are debt securities issued by corporations, state and local government entities, and the U.S. Treasury, among others. Bond investors are essentially loaning the issuer money and receiving interest payments during the time the bond issuer is using their money.
Stocks, on the other hand represent a level of ownership in a company. Stocks generally offer a great potential for growth, but also carry more downside risk than bonds.
Bonds generally have a fixed period until maturity at which time the bond issuer pays the bondholder the face value of the bond. Bonds are often sold at a face value of $1,000 each. During the period in which bonds are outstanding, they generally pay interest semi-annually.
Diversification Benefits of Bonds
Portfolio diversification is all about having some asset classes in your portfolio that are not highly correlated with each other. This can help provide a level of stability to an investor’s portfolio over time. For example, a portfolio that is totally invested in stocks will do well when market and economic conditions are favorable for stocks.
However, in a down stock market and a down economy, this type of stock-heavy portfolio could potentially suffer heavy losses. We saw this during the financial crisis of 2007-2008.
A portfolio that is diversified with other investments such as bonds will generally hold up better during rough patches in the markets and the economy. While bonds do suffer losses, these losses are often smaller in magnitude than with stocks. According to data from Morningstar:
- Since 1926, bonds have suffered 101 negative quarters with an average quarterly loss of 2.01%, while stocks suffered 120 negative quarters with an average quarterly loss of 7.81% over the same period.
- In terms of annual losses since 1926, bonds have experienced 15 periods of annual losses with an average annual loss of 2.4%; for stocks there have been 25 periods of annual losses with an average annual loss of 13.2%.
Morningstar’s analysis of the correlation of stocks and bonds show the correlation rarely has risen above 0.6 and that these were periods of high inflation and/or rising interest rates.
Different Types of Bonds
There are a number of types of bonds. These include:
- Treasury securities are issued by the U.S. Treasury and are considered to be riskless. They offer bonds, bills and notes with maturities ranging from a few days out to 30 years.
- Corporate bonds are debt securities issued by both public and private corporations. Investment grade bonds have the highest credit rating; these ratings can range all the way to high yield bonds which have a lower credit rating but offer a higher yield to help compensate for the added risk.
- Municipal bonds or “Munis” are bonds issued by states, cities, counties and other governmental entities. These bonds come in several varieties and are also rated by outside credit rating agencies.
With the exception of Treasurys, bonds are rated by outside credit rating agencies as to the creditworthiness of the issuer. Bonds with the highest credit ratings will likely have the lowest interest rates, as they carry the lowest risk of default. Conversely, bonds with lower credit ratings will generally carry higher interest rates to compensate bond investors for their higher risk of default.
Interest Rate Considerations
Once a bond is purchased, one of the biggest factors influencing the price of a bond is interest rates. Bond prices move inversely with interest rates. During periods of rising interest rates as we have experienced in recent years, the prices of existing bonds will fall. When rates are falling this will cause the price of existing bonds to increase.
Another factor that can influence the level of price changes of a bond is its duration. This is a measure of the bond’s level of interest rate risk that takes into account a bond’s time to maturity, its current yield, its coupon interest rate and any call provisions the bond may have. The duration calculation yields a number expressed in years. This number provides an estimate of the impact of a 1% change in interest rates on the price of the bond.
For example, if a bond’s duration is calculated to be 5 years, this means that a 1% change in interest rates would result in a 5% change in the bond’s price. This change would be positive if interest rates decline and negative if they rise. Bonds with a longer duration are more susceptible to price fluctuations due to changes in interest rates.
The Role of Bonds in Retirement Planning
Bonds can play a key role in retirement planning, especially in retirement income planning. One tactic is to build a bond ladder of bonds maturing at various intervals. This might be every six months or every year out for a number of years. As a bond on the ladder matures, the investor can buy another bond at the far end of the ladder if it makes good sense from an interest rate perspective. The bonds in the ladder generate periodic interest payments and provide a level of stability inside the portfolio.
Bonds in general can help mitigate the risk of other investments in the retirement portfolio such as stocks.
Seek Professional Advice
In deciding whether bonds are a good fit for your portfolio and which ones to own, it makes sense to consult with an experienced financial advisor. Our advisors here at Wedbush understand bonds and their potential role in all types of portfolios. Contact your Wedbush advisor to discuss investing in bonds and for help with your total portfolio.
Wedbush Securities does not provide tax or legal advice. Please consult your tax or legal advisor.
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