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The stock market is on the rise. Stocks are giving a year’s return in a month. Money is being easily made. In such a market, investing in bonds might seem like a fool’s idea.
But any financial advisor you meet will always advise you have at least some part of your portfolio invested in bonds. Why? Because bonds are fixed-income assets considered to be one of the safest investments around.
So, what exactly is a bond, and how does it works? You can think of a bond as an IOU between a lender and a borrower. Bonds are mostly issued by corporates, governments, municipalities, etc., to raise debt from the public.
In simple words, when you buy a bond from the US government, you’re essentially lending them money that they’re liable to pay you back with interest. Since the interest rates are fixed, bonds are called fixed-income assets.
Bonds issued by the government and big, financially sound companies are considered the safest investment because the default rates are negligible.
An important thing to know is that you can buy bonds directly from the issuer as well as from the secondary markets, where they trade just like stocks. Similarly, you don’t have to hold on to your bond till maturity. You can sell them in the secondary market if you’re getting a higher price.
Now that you know all the basics of what a bond is and how the bond investing ecosystem works, it’s time to learn how to start investing in bonds.
And for that, we have an expert, Joseph Hogue from Let’s Talk Money YouTube channel and the author of step-by-step bond investing for beginners.
Investing in Bonds
According to Joseph, Investing in bonds is really about understanding bonds, how they work, and why every investor needs them in their portfolio.
The actual steps to investing are surprisingly easy because most investors can get everything they need with a bond fund. You can just buy an ETF from an exchange, just like a stock, and that ETF will hold thousands of bonds within it, giving you all the pros and benefits.
Why Invest in Bonds
This is the most expected question because after the last couple of years we’ve had in the stock market, you would have to be a fool to invest in something that’ll give you a 5% return every year. You can literally buy Tesla and get that return in a day, right?
Well, equity investment is good for a large part of your portfolio, but there are reasons why every investor does need to invest in bonds.
The most important one is the stable cash flow that no other asset gives you. Your stock might give you a 100% return, but none of that is cash until you sell it. As you get older and come close to retirement, you wanna make sure that money is there when you need it.
Bonds, especially treasury bonds, government bonds and highly rated corporate bonds issued by huge companies like Microsoft, Apple and IBM, have default rates of less than a percent. That means it’s almost a guarantee that you’ll get your money back along with your interest payments on these bonds.
A lot of people, especially retirees, use the cash flow from their bonds to pay the bills, and they make profits when prices in the bonds market go up.
However, it’s not that only retirees or older people should invest in bonds. Even younger investors need some bond exposure. It may be as little as 10% of your portfolio, but you need them for stability.
For example, if you look at the chart of any long-term bond fund like the Vanguard Long-Term Bond Fund (BLV), you’ll see that it’s steadily increasing all the time while also consistently paying a 3 to 5% annual rate of return.
Comparing that with stocks, we saw a 35% sell-off in three weeks last year. If you do have some money in bonds, those bond funds are gonna maintain your portfolio and keep your money safe.
This way, when you see the stocks bottoming out after a sell-off, you can take advantage of that by releasing the money in bonds and investing that into the stocks.
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How to Start Investing in Bonds
The truth of investing in bonds is that for the majority of people, just buying a Bond ETF is the best route to go.
Now, you can invest in individual bonds, which means buying these bonds directly from the company through a broker. But in that case, the commissions tend to be a lot higher. They can range anywhere from 3 to 5% of the value of the bond.
ETFs also give you much-needed diversification, because just like stocks, you need to have bonds from different companies, different industries, and different sectors to really balance out and reduce the risk of any one company failing.
If you’re buying individual bonds, then any investing strategy would require you to buy at least 15 to 25 bonds from different sectors of the economy, which obviously, can get very expensive with all those commissions.
For anyone having less than $150000 to invest in the bond portion of their portfolio solely, Joseph would recommend you to just go with one of the ETFs.
The best thing about ETFs is they trade just like stocks, and you can buy them on many platforms commission free, or $5 per trade at the most on others.
A lot of these ETFs hold thousands of these bonds from different industries, sectors, and economies. So they are, by definition, diversified.
A couple that Joseph would recommend to most people are some of the longer-term corporate bonds like the Vanguard Long-Term Bond Fund ETF (BLV), which invests in long-term corporate bonds issued by these very safe corporations, and the other one is BSV, which is the Vanguard Short-Term Bond Fund ETF to invest in shorter-term bonds.
You do need short-term bonds because even when the interest rates are rising, those shorter-term bonds don’t move as much as the long-term bonds do.
A good strategy while investing in bonds is to divide your money into three parts and then investing one in a long-term bond fund like BLV, another one in a short-term fund like BSV, and the third part into emerging market debt, meaning bonds of the emerging market governments like Latin America, Asia and European nations since they pay a high interest rate.
Taxes on Bonds
Bonds are taxed as regular income. Which means if you fall in those high-income categories, taxes can suck a lot of your interest income.
That’s why Joseph recommends that unless you’re taking that cash out actively and using that to pay your bills, you should keep those bonds in retirement accounts, tax-deferred or nontaxable accounts.
Basically, you wanna have those bonds when you’re maxing out your IRA, Roth, or any retirement account contributions each year. You want your highest-yielding stocks and bond investments in those first and then in a regular taxable account.
One exception there, especially for the high-income folks, is municipal bonds. These are the bonds issued by local governments, and they are tax-free on the federal level as well as on the state level. So a little bit lower interest rates, but since you’re not paying taxes, it might be a good deal.
Relation Between Bonds and Stocks
Bonds and stocks are generally inversely related to each other, so when the stock prices go up, bonds go down, and vice versa.
However, in the last 5 years or so, the correlation has actually started to converge to a little more positive, which obviously, is a problem for people who’re trying to balance the risk in their portfolio.
But still, there is an element of safety that when the stock market crashes, bond prices go up and so it helps you manage the risk.
Who Should Invest in Bonds?
As mentioned before as well, everybody needs at least some part of their portfolio invested in bonds, but it is especially important for those who’re close to retirement.
Because anyone within 10 years to retirement, you cannot afford a stock market crash. We’ve all been a little bit spoiled over the last year with the stock market crash that lasted only 45 days, and we rebounded within a few months.
But that is abnormal because if you look back at any crash in history, the stock market took a years-long time to recover those losses. In fact, the tech-heavy Nasdaq index couldn’t get back to its pre-dot com crash levels until 2014. That’s nearly 1.5 decades.
So if you’re just 10-15 years away from the time you will be needing that money in your portfolio, you can’t afford to have it all in stocks. You definitely need more bond exposure to keep your money safe.