Investing in bonds and CDs. People buy bonds and CDs primarily for safety and income. If you own high quality bonds and FDIC insured CDs, and hold them to maturity (or to when they are redeemed or “called” early), you should get your money back and steady interest income along the way. These are valuable qualities when the stock market is in a swoon like it was in 2008 and early 2009, as well as when you are retired and need steady income.
In fact, if you buy them right, bonds and CDs can be an effective counterbalance to the part of your portfolio that’s invested in stocks. That’s because many of the conditions that make the stock market go down can cause bond prices to be stable or even go up. Most of the time, the higher the percentage of your portfolio that you have in bonds, CDs, and cash, the lower the up and down volatility you experience, which means you’ll have less risk of loss in a given year than investors with a heavy weighting in stocks. Of course, over long periods of time stocks tend to give higher returns than bonds, so investors with a greater need for growth often have to have more invested in stocks and less in bonds.
So, how should you buy bonds and CDs for your portfolio? Is there a good strategy for buying them? Are there any risks? What about the growing amount of government debt, inflation, and the economy—don’t those things have an effect on bonds? Are bond funds better than individual bonds? Let’s address these questions one by one.Strategy for buying bonds and CDs. Most of the time, the best practice is to “ladder” (or spread out) the maturities of the bonds and CDs you are buying. The reason for owning some short and intermediate maturities is so that every year or two you’ll have a CD or bond maturing. Every time one matures, you can reinvest in a new long term bond. That way, you’ll constantly be walking your bond portfolio forward, and be somewhat insulated from the effects of changing interest rates.
The reason for having some bonds with longer maturities is that they generally pay higher interest rates than bonds and CDs with shorter maturities. Also, if interest rates go down for a few years (as has been the case recently), the longer maturity bonds you bought earlier will continue paying the higher interest rates they had when you purchased them.
Risks of buying bonds. There are two main risks to consider. The first is that you buy a bond from a corporation, municipality, or state that goes bankrupt. This is called credit risk, which is really the risk of defaulting (not paying interest and principal) at some point in the future. Lower credit quality bonds (also called “junk bonds” or “high yield bonds”) usually pay higher interest rates, but the risk to the safety of your principal is rarely worth it (unless you have a small amount in a junk bond mutual fund). It’s much better to get a lower interest rate from a high quality company or municipality than a higher interest rate from a questionable or struggling company. If you invest in quality, and diversify among various issuers, your portfolio’s overall risk of losing money from a default should be very low.The second risk is that interest rates will rise in the future, causing the resale value of the bonds you’ve already bought to go down. This can be caused by a pickup in inflation or by a massive increase in government debt, among other things. If you’ve laddered the maturities in the bonds you’ve already bought, you’ve done most of what you can do to protect your portfolio. However, during periods of extraordinarily low interest rates, like now, it’s best to invest new money in very short maturity (up to two years) bonds and CDs. At some point the current appetite of the world for more and more bonds (particularly the large supply of new U.S. treasury bonds being issued each year to fund the deficit) will probably diminish, and interest rates will likely have to move higher to continue attracting buyers. This will, in my opinion, push yields up (and prices down) in all types of bonds, with the biggest effect on the longest maturity bonds. So, for now, I recommend keeping your maturities short for new bond and CD purchases.
Which to buy: bond mutual funds or individual bonds? Each one has its benefits and drawbacks. A bond fund is invested in many different bonds, so if one bond goes bad (defaults) it shouldn’t have a major impact on the fund. Also, it’s the responsibility of the fund’s manager to monitor the bonds in the fund and sell any whose risk of default is increasing. This diversification and professional management is valuable when you are investing in complicated bonds (like convertibles), or in riskier bonds (such as junk bonds or bonds from emerging markets), or in your 401(k) where CDs and individual bonds aren’t available. It’s not as valuable, and may not be worth the cost, when you are investing in high quality bonds like treasuries, or investment grade corporate or municipal bonds, where the risk of default is very low.Bond funds have one major disadvantage, in my opinion. Unlike individual bonds, funds do not have a maturity date with a promise that you’ll get your principal back at that time. If interest rates rise after you invest in a bond fund, the price of the fund’s shares will go down and may or may not come back up to the full value of your original investment when you eventually sell the fund. Individual bonds, on the other hand, do mature at full face value on a certain date (or on a predetermined “call” date). If you’ve bought high quality bonds with a low risk of default, you can be confident of getting the full face value of your bonds if you hold them to the call or maturity date. Therefore, in general, I recommend owning individual CDs and high quality bonds with laddered maturities. Of course, each investor’s situation is unique, and for some people bond funds are more comfortable and appropriate.
As you work hard and invest to rebuild your wealth, make sure you are on solid ground. In the last four blogs, we’ve outlined the most important steps:- Part 1. Start with a good investment plan based on your personal needs.
- Part 2. Have the right mix of stocks vs. bonds and cash – for you.
- Part 3. When you invest for growth in stocks – diversify and keep your costs low.
- Part 4. When you invest in bonds and CDs – ladder maturities (but stay short term for now) and buy quality.
