When you learn about the basics of personal investing, you hear about stocks and bonds.
Most people know that when you buy a stock, you are getting a tiny share of ownership in a publicly traded company. Over time, the company’s performance determines if the value of that share goes up or down. In your portfolio, stocks and the financial instruments created by combining them into things like mutual funds and ETFs (exchange traded funds) are known as equities.
However, many people are a little fuzzy when it comes to bonds. In very simple terms, a bond is debt that a company or municipality has incurred to obtain cash. Like any loan, a bond has a defined amount borrowed, an interest rate (the yield it pays), and a due date for when it will be paid off.
Also like a loan, a bond will have a higher or lower interest rate based on the riskiness of the borrower. At the low-risk end of the spectrum are government issued bonds. At the high end are so-called “junk bonds,” issued by companies on a shaky financial footing.
So why might you want to own bonds?
Christine Benz, director of personal finance and retirement at Morningstar, explains that bonds bring two benefits to peoples’ investment portfolios. “They bring some level of income,” she says, “often a higher level of income than equities infer, and they also bring a diversification benefit, which can help lower your portfolio’s volatility.”1
In your preretirement years, when you’re concentrating on accumulating money in your nest egg, bonds can act as a counterbalance to stocks. During major corrections, when equities are down, bonds tend to gain in value, helping to stabilize your portfolio.
When you’re in retirement, in addition to providing diversification, the yield from bonds can help provide consistent cash flow.
Like any financial instrument, bonds are available in a wide variety of types and combinations, which can be tailored to meet specific investor needs. For example, Benz says that while municipal bonds are not as attractive in terms of diversification, they can make sense for investors in high tax brackets looking for a place to park short-term money.
Bonds have both advantages and disadvantages as an investment. And when used correctly, they can play a role in helping to lower your overall risk by more broadly diversifying into asset categories intended to counterbalance future uncertainty.
Your trusted advisor will first look at your unique living situation, financial resources, and retirement goals, and then use his or her experience to find the combination of investments that will give you the best chance for long-term success. Along the way, your advisor will adjust your financial plan as needed, providing guidance and accountability.
Sources:
1. http://go.pardot.com/e/91522/d-bond-types-it-can-do-without/976wxb/3047771961/h/MtTSvOzS011JKLi3JUDMHo5_NVm-XFCT_KKXx6bsph4
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