Risk vs Reward
Face it, savings bonds just aren’t all that exciting. Unlike buying stock in a company, which makes you part owner, when you buy bonds you’re purchasing a company or government’s debt; in short, you’re acting as a banker and loaning them money. The more likely you are to get paid back, the lower the interest rate is; US government bonds, for example, are extremely safe, but often return less than the rate of inflation.
Whereas stocks only make you money if the company pays out a dividend or if you sell the stock at a higher price than you purchased it for, a bond is a legal obligation to repay a loan. If you buy corporate bonds and the corporation ends up in financial trouble, you’ll be in better shape than the stockholders as the bondholders are legally required to be paid first.
Aside from the perceived creditworthiness of the bond issuer, the return is also determined by the length of time the bond must be held before it can be redeemed. Short-term bonds are less risky, so they pay out less. A long-term corporate bond can pay out quite a lot of interest, but you risk the company going out of business in a few years and having no money left to pay off their loans. Possibly a bigger risk, though, is inflation; if you buy a long-term bond when inflation (and thus interest rates) are low and inflation then rises, you can end up losing money in real terms, even if the bond pays out as promised. The US government offers TIPS, or Treasury Inflation-Protected Securities, where the return is pegged to inflation; this removes inflationary worries, but naturally the extra protection means a lower interest rate.
Selling Bonds Early
Of course, you don’t always have to hold a bond for the entire maturity period; if you need money, you can sell it to someone else, or the original borrower might even buy it back (at a discount, of course). If you’re holding a bond and interest rates fall, your bond becomes worth more because it (generally) pays a fixed interest rate that is now higher than a new bond would pay. On the other hand, if interest rates rise, your bond is now worth less. When a bond is held to maturity, this doesn’t really make a difference, as it will pay out the same either way. The market value of the bond only matters if you want to sell it.
So what do you do if you want to keep money in bonds for safety, but don’t want to be forced to either sell the bond, redeem it early at a loss, or wait until maturity to access your money? One option, which we’ll discuss next, is called a bond ladder.
Bond, Government Bond..
The idea behind a bond ladder is simple: rather than buying a single large bond, you build a bond ladder by spreading your money out over a number of bonds with different maturity dates. Rather than invest $50,000 for ten years, for example, you could have a $5,000 bond mature every year, which means that you’ll always have some cash becoming available in the near future.
Short-term bonds pay less, but if you reinvest the money in new bonds, eventually you own only ten-year (or greater) bonds while still being able to redeem one every year. Having more bonds also means you can take a bit more risk, buying corporate bonds rather than only government bonds, as your portfolio is more diversified.
Of course, building a bond ladder doesn’t completely shield you from risks. Inflation is the big one; if interest rates are low when you buy a bond (at least, one that doesn’t adjust for inflation) and later rise, you could end up with less money than you started with after adjusting for inflation. Another risk is that a bond will mature when there are no attractive places to reinvest the money, whereas if you had invested in something more liquid, you could have jumped into something offering a higher return when the opportunity arose.
Remember how the market value of bonds goes up when interest rates drop? If you’re expecting inflation in the future, you might want to sell the bonds at a profit while you can, but this destroys your bond ladder, which depends on having another bond reach maturity every so often. As such, by locking yourself into this structure, you may end up losing out on opportunities for profit.
Finally, even municipal bonds can go bad, sometimes, and a single bond becoming worthless can wipe out a significant amount of your portfolio. Investing in a mutual fund, on the other hand, can let you hold a share of thousands of bonds, which significantly lessens your risk…but you’re giving up on your ladder.
Should You or Shouldn’t You?
In the end, whether to buy bonds at all and whether to use them to build a ladder depends on your goals. Putting your money into a bond ladder is likely to leave you with a lower return than other investments that are nearly as safe, but you might be willing to accept that loss for more peace of mind. What are your financial goals?