Should I Buy Bonds Now?
Bond Investing or Cash-Which is Better?
Reader question from Joe at Retire by 40
Joe asked 2 bond related questions:
“Should I still invest in bonds, knowing there’s a decent chance I will lose money over the short to intermediate term?
If I don’t want to invest in bonds at the moment because it looks like the price will fall. What should I invest in instead? Just keep in cash?”
Should I Buy Bonds? Personal Confession
Before I get into the direct answers to Joes’ questions, here’s my personal “bond” story, which goes in the face of traditional wisdom.
Advisors Recommend Avoiding Individual Bonds-Here’s Why
The rule of thumb for individual bond investing is don’t buy individual bonds unless you have $50 to $100 thousand to invest in the bond portfolio.
- The reason for this steep recommendation is diversification. The bond sellers worry that if you buy a few individual bonds, and one issuer defaults, then your money will go away.
- Or on a less drastic note, maybe the individual bond gets downgraded and it’s value drops.
- Or interest rates go up, and the value of the bond subsequently falls.
- Another deterrent to purchasing individual bonds is that you may be paying a higher commission than you would in a bond index fund.
- Many issuers won’t sell one individual bond (usually priced at $1,000) and require the buyer to purchase 5, 10 or larger lots.
I’ve bought individual bonds for decades and have never experienced a bond default.
What are the default rates for highly rated bonds?
According to Stephen J. Huxley and Brent Burns in the “Safety of Investment Grade Bonds” whitepaper, “The incidence of default for high quality municipal and corporate bonds is generally very low. 99.97% of all Aaa and Aa rated municipal bonds and 98.96% similarly rated corporate bonds have generated coupon payments and redemptions as promised over the past 40 years without a single missed or even late payment.”
So, advisors and financial professionals suggest that small investors avoid individual bonds because they can’t buy enough to adequately diversify their bond portfolio.
Wait a minute, if high quality bonds almost never default (1% of the time or less), why should you worry about defaults and diversification?
When I was 24 and beginning to invest, I started investing with bonds. Not bond funds, individual bonds. I purchased a few highly rated bonds for $1,000 each. When I bought the bonds, interest rates were quite high and I was receiving high single digit interest payments. Today, it’s difficult to image buying an investment grade bond with an 8% coupon. But several decades ago, interest rates were much higher than today’s rates.
After a few years, interest rates began to drop. I was still receiving the 8% per year interest payments, and the value of the individual bond’s increased from their purchase price of $1,000. (There’s an inverse relationship between interest rates and bond values). Although I could have sold the bonds before maturity and realized a capital gain, I decided to hold on to them. I held the bonds until maturity because of the secure 8% return. Had I sold the bonds at $1,000+, I would have needed to find another place to invest the proceeds which offered at least an 8% return. And that’s why I didn’t sell the bonds before maturity.
In my mid 20’s I didn’t have a $50 or $100 thousand dollar bond portfolio, but I still bought a few individual bonds.
Why I Disagree With Advisors’ Suggestions to Avoid Individual Bonds
1. High quality bonds have low default rates.
2. You can hold the bond until maturity to make certain that you’ll receive the promised interest (coupon) payments.
3. Even if the value of the bond declines with an increase in interest rates, you don’t have to sell.
4. Buying bonds through a discount broker keeps commissions relatively low.
In short, if you buy a bond and hold it until maturity, you know the trajectory of future interest payments and redemption value, and that equals control. Although defaults can happen, they’re unlikely. With cash paying practically nothing, a bond squeezes out an extra few percentage points of interest.
Individual Bond Funds Versus Bond Funds
Joe’s first question was, “Should I still invest in bonds, knowing there’s a decent chance I will lose money over the short to intermediate term?”
If Joe bought an individual high quality bond at par (face value), and held that bond until maturity, as mentioned above, it’s unlikely that he would lose money. That is exactly what I’ve been doing with much of the bond portion of our family portfolio. I’ve bought several 3-5 year maturity bonds with the expectation that I’ll hold them until they mature.
At today’s rates, you can buy a 5 year high quality bond with a 2-3% interest rate. In fact, if you’re in a high tax bracket a 3% municipal bond promises a better return than a comparable corporate bond.
If interest rates go up in the interim, and the bond value drops, it doesn’t matter, because you don’t need to sell the individual bonds.
Buying a bond fund is different than buying an individual bond. There is no maturity date on most bond funds.
So if you buy a diversified bond fund, and interest rates rise, the value of the fund will drop. How much the fund price actually declines depends on a concept called “duration”. Simply, duration is the weighted average of the maturity of all the bonds in the fund. In general, funds with shorter maturities are less volatile than those with longer maturities.
If you buy a bond mutual fund with no “end date”, Joe’s fear is true; there’s a decent chance he might lose money, if he sells. After all, with the low interest rate environment, it’s more likely interest rates will rise than fall.
Bond funds aren’t all bad.
With a bond fund, you get broad diversification. With a short duration bond fund, the principal value shouldn’t drop too much with an increase in interest rates. Plus, when the bond’s interest payments within the fund are reinvested, they will be reinvested at the lower price (with higher interest payments). Research has shown that the impact of the reinvested dividends can temper the loss of principal from an increasing interest rate environment.
In summary, in the short run Joe may lose a little value if he invests in a bond fund and interest rates go up. Over the long haul, with reinvested dividends, the short term bond fund return should be similar to the individual bond investor’s return (if the investor buys individual bonds of the same maturity as those within the fund). After all, the investor must reinvest her cash dividends as well.
If Joe has several thousand dollars to invest, he may want to consider investing in several individual bonds through his discount brokerage account.
Should I Invest in Bonds or Cash?
This was a long trip to get to Joe’s question:
“If I don’t want to invest in bonds at the moment because it looks like the price will fall. What should I invest in instead? Just keep in cash?”
This bond and bond fund discussion leads me to a controversial response, if you want a certain payout and have at least a few thousand dollars, you may want to consider buying individual bonds and holding them until maturity.
One of my favorite fixed investments are I bonds. Although not “traditional bonds” these government issued inflation protected securities are created to protect the purchasing power of your cash. The interest payment adjusts every six months in sync with the inflation rate.
My personal approach is invest in individual bonds, hold some cash out to invest when interest rates go up, and buy the maximum amount allowed by law of government I bonds.
Investing is an art, not a science. Learn as much as you can, create a plan, and invest through thick and thin.
This article is for information only and not a recommendation to buy or sell a particular security.