Where do bonds fit within a portfolio? Do they still make sense even though interest rates are near historic lows?
Today’s episode is a basic primer on bonds and how they are a key building block in a diversified portfolio.
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As a result of the Great Recession a few years ago, the Federal Reserve lowered short-term interest rates to historically low levels. The thought was by lowering rates, it would make it easier for companies to borrow money to reinvest in their business and jumpstart the economy.
Well, the low rates have, to some degree, helped the economy but it created another problem. With low rates it’s hard for savers to find places to get a decent return on their savings.
In today’s episode, we’ll explore various aspects of bonds as well as answer some questions we’ve been receiving lately.
Five Insights on Bonds
1. Owning a bond means you are loaning your money to someone else and in return, they pay you interest and payback your principal at some point.
There are many different types of bonds. Three common types include: corporate bonds, which are issued by companies, municipal bonds, which are issued by states, cities, and other governmental entities, and treasury bonds, which are issued by the federal government. Some bonds may offer tax benefits.
2. Typically, but not always, longer maturity bonds will pay higher interest rates than shorter maturity bonds.
One of the key factors that determines interest rates is inflation expectations. If investors expect inflation in the future, they will require higher rates on their savings because a dollar five years from now is worth a lot less than a dollar today when adjusted for inflation. If investors expect a recession is on the horizon, you will sometimes see what’s called an “inverted yield curve.” This means longer-term rates are actually lower than short-term rates.
3. The price of a bond moves inversely to the interest rate on the bond.
To explain this inverse relationship, imagine a teeter-totter. If you have interest rates on one end and the bond price at the other end, when one goes up the other one has to go down. That’s just the relationship between them, and it’s called the inverse relationship. In a rising interest rate environment, bond prices are dropping because there are new bonds being issued with higher coupon payments. For example, assume a bond is priced at $1,000 and it pays a 3% interest rate. That’s $30 per year in interest. Fast forward a year and assume interest rates rise to 4%. Now, if a new bond is issued at a price of $1,000 that pays 4% interest, this new bond generates $40 per year in interest. Nobody would want that old bond paying 3% if they can buy a new bond paying 4%, right? In order to get a 4% return on that old bond if somebody bought it today in the secondary market, the price of the bond would have to drop to roughly equate to getting a 4% interest rate on the amount invested in the bond. Now, this is an oversimplified example and there are other factors that affect the price of the bond, but this should give you an idea of why bond prices move inversely to the interest rate on the bonds.
4. The longer the maturity on the bond, the more potential fluctuations you may experience in the price of the bond.
If you compare the volatility on a bond that has just 1 year left to maturity versus one that has 20 years left to maturity, you’ll find that for any given change in market interest rates, the price of the longer-maturity bond will fluctuate much more. That’s partially because the time value of money is spread over more years. In an environment where interest rates are near an all-time low, it could make sense to keep your maturities a little shorter to avoid some of that interest rate risk in the longer-term fixed income securities.
5. Bonds play an important role in providing income and diversification to a portfolio.
Bonds typically pay interest so that generates a stream of income for the owner of the bond. In addition, bonds oftentimes move independently of the stock market. For example, if there’s a big selloff in the stock market, we often see the price of bonds go up, and that helps cushion the blow of a drop in stock prices. Bonds don’t always act this way but it often makes sense for investors to allocate a reasonable percentage of their portfolio to bonds. Each investor is different so please make sure you work with your advisor to determine the appropriate allocation for you.
Bill Keen on emergency savings…
We typically recommend investors set aside in savings at least 6 months worth of your income needs.
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Bill Keen is the founder and CEO of Keen Wealth Advisors, an independent Registered Investment Adviser serving affluent clients preparing for retirement and the host of the Keen On Retirement podcast. Bill brings more than 20 years of financial services experience and holds the CHARTERED RETIREMENT PLANNING COUNSELOR designation. Bill created Keen Wealth Advisors to build one of the country’s most personal and trusted wealth and retirement advisory firms.