Bond Investing Is Trickier Than You’d Think
Most investment portfolios include a mix of equity (stocks) and fixed income (bonds/cash equivalents). The goal is to maintain a consistent, appropriate balance between them, through good times and bad. But for your fixed income, is one “safe and secure” investment as good as the next? Decidedly not.
These days, CDs or similar cash equivalents may be an option. They’re largely “what you see is what you get.”
Bonds are trickier. What is a bond? It’s a loan from you to an issuer such as the U.S. Treasury, a corporation, or a municipality (city, county, or state). The issuer promises to pay you semiannually at a stated interest rate, and repay the loan amount after a stated amount of time.
So far, so good. But I’ve vastly simplified what’s going on when you invest in a bond. Bonds may be less “risky” than stocks. Their values are more stable if you hold them to term. But they still entail credit, currency, and interest rate risks.
Credit risk arises when the market believes the issuer might default on the loan, or fail to pay as promised. Currency risk occurs if you’re investing in a foreign bond, and that country’s currency weakens versus the U.S. dollar.
That leaves interest-rate risk, or the risk that interest rates might rise after you buy your bond. Say you just bought a $1,000, 30-year U.S. Treasury, paying 1.4% interest. What if two years from now, 30-year Treasuries were paying 3.1% interest? If you wanted to sell your bond then, rather than hold it all 30 years, you’d be hard-pressed to find a buyer unless you discounted its value to make up for its comparatively lower rate. I’ve done the math for you: You would have to sell your $1,000 bond for $682.
With interest rates at historical lows, this means bonds are riskier than usual. Again, it’s important to hold fixed income in your portfolio. But especially these days, if you invest in bonds with longer terms, be aware that the probability of future rates rising is greater than of them falling. If they do rise, the price of your bond can fall meaningfully.
John A. Frisch, CPA/PFS, CFP®, AIF®, PPC™ founded Alliant Wealth Advisors in 1995 and has over 30 years of experience as a financial professional. In his free time, he’s an avid long-distance runner, a sport that requires discipline, patience and vision. John applies these same skills to his professional pursuits: He helps families and retirement plan sponsors adopt a patient, disciplined approach to overcoming financial challenges and reaching their distant goals along a clear path. Learn more at www.alliantwealth.com.