Bonds for Retirement
Despite being a common investment for retirement, bonds can often be misunderstood, in our experience. Many investors think bonds are a simple way to earn a safe return, but the reality can be quite different for those preparing for retirement. Bonds (often called fixed income) have many nuances, complexities and unique characteristics. Understanding some basics about bonds can help you decide whether they have a place in your portfolio strategy.
What is a Bond?
A bond is effectively a loan—a debt security issued by a company or government seeking capital. When you buy a bond as an investment, you own a contractual promise by the bond issuer to pay you interest (called a yield) at scheduled times over the bond’s life and repay you the principal amount borrowed at the end of the contract period (called the bond’s maturity date). Unlike the returns of a stock investor, the bond issuer is required to pay investors according to the terms of the contract or indenture of the bond. For this reason, bonds generally have lower expected volatility risk and historical returns than stocks. In our view, when investing for retirement, bonds’ primary purpose in a retirement portfolio should be to help mute some of the short-term volatility associated with stocks. However, much of the long-term growth of your portfolio generally will come from stocks and not from bonds.
Investing for Retirement: Bond Risks to Understand
Because bonds are often less volatile than stocks in the short term and potentially provide a relatively steady income source over time, they are often considered a “safe” asset class. But bonds aren’t free of risk. No investment is. Bond investors should be aware of the specific risks that might be associated with the bonds they own. Following is more information about many of these risks to help you determine if this asset class suits your financial goals and investment strategy.
Credit or Default Risk: A bond’s yield, or coupon rate, is often correlated to the bond issuer’s credit risk (also known as default risk). If default risk is high, that means there is a higher risk the bond issuer will not be able to meet all obligations of the contract. If a bond issuer’s default risk is high, they will likely offer higher yields to attract bond investors who are willing to accept the higher default risk in exchange for a higher yield. Just as banks charge higher loan rates to risky borrowers, higher bond interest rates (or coupon rates) can indicate a higher risk of default; lower-rated bonds tend to offer higher yields.
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Bond issuers are obligated to pay an investor the yield in accordance with the contract and pay back the principal amount at the maturity date. But what happens when the issuer cannot pay back their debt? The worst-case credit risk scenario would be an issuer defaulting on a bond you were planning to hold through its maturity. When this happens, you can lose your entire principal investment and the anticipated interest payments.
Liquidity Risk: Some bonds aren’t as easily sold as others. This is called liquidity risk. This may be due to no interested purchasers at all for a specific bond, or simply not enough trading volume to get the desired price. In a market with few buyers, bondholders may be forced to sell at a steep discount.
Interest Rate Risk: Interest rates and bond prices move inversely—meaning when interest rates fall, the value of fixed income investments rises, and when interest rates go up, bond prices fall in value. If an investor sells their bond holdings before maturity in a rising interest rate environment, they could realize significant losses. This is called interest rate risk. Because of their lengthier time exposure to maturity, long-term bonds tend to be more vulnerable to interest rate risk than short-term bonds.
Re-investment Risk: Suppose you are holding a high-coupon bond from a solvent issuer and plan to hold it until maturity. It may seem like a low-risk, foolproof investment. But if interest rates fall as your bond matures, you might not be able to find another bond that pays out at a comparable rate and you might have to invest your principal in bond with a lower yield. To continue your stream of comparable bond income, you may end up paying more for a bond that yields much less. This is known as reinvestment risk.
Inflation Risk: Even if you hold a bond to maturity, the actual value of your return may be different than you initially envisioned. Consider that most bonds aren’t indexed to inflation. Instead, your principal and coupon payments are set at issuance. If inflation rises, it could erode the purchasing power of your interest income. This means that your coupon payment may not cover as much as you initially expected, and the final payback of the principal amount may not go as far as you anticipated at the time you made the purchase.
With a large universe of fixed income securities globally, differentiating between bonds is crucial. There are many ways to break down the bond market—here are a few common categories.
Government Bonds: Government bonds are those issued by a sovereign nation—US Treasurys, UK Gilts, Japanese Government Bonds (JGBs) and German Bunds are some examples.
Agency Bonds: Agency bonds are those issued by divisions of (or organizations sponsored by) the US Federal Government. Many have characteristics similar to Treasurys, as there is a presumption an Agency would be backed by the US Government in the event of financial trouble.
Municipal Bonds: Sometimes called “munis,” these bonds are issued by states, cities, counties, and other government entities. In general, the interest on a municipal bond is free from federal tax.
Corporate Bonds: These bonds are issued by a private or public company. An investor purchasing a corporate bond is lending a corporation money for a specified period of time. Corporates can generally be broken down into two broad categories: High-yield (junk) corporates and investment-grade corporates. High-yield bonds carry more credit risk (a greater likelihood of default). They, therefore, tend to carry higher interest rates and see greater volatility. Investment-grade firms are more established and generally carry less credit risk and pay less interest.
What are the Characteristics of Bonds?
Yield: The amount of realized return on a bond.
Duration: A measurement of a bond’s price sensitivity to changes in interest rates.
Maturity: The time from issuance until the principal of the bond is paid back.
Coupon: The annual amount of interest paid on a bond, usually expressed as a percentage (or coupon rate).
Issuer: The issuer of a bond can be a corporation, municipality, government or government agency, each of which carries different risk and return characteristics.
As an investment manager, Fisher Investments doesn’t focus on any one asset class—we manage a variety of strategies including stocks, bonds, cash and other securities. The optimal portfolio strategy for you will depend on your specific investment objectives, time horizon, cash-flow requirements, outside income and assets, and any restrictions or customizations you may have. Contact Fisher Investments today to learn more about bond risks and whether bonds are right for you.