For this reason, when interest rates are very high as they were in the 1980s, locking in a high long-term government bond interest payment is a smart investment strategy. Imagine locking in a 15% yield for 30 years – guaranteed by the full faith and credit of the U.S. government!
Be Wary Of High Yield Bonds
The risks of bond investing are not confined to default risk and interest rate risk. Sometimes, the most attractive bond on the surface is the one to shy away from. Novice bond investors often swoon when they come across a high yield bond that pays a high interest rate.
But these bonds often have high yields for a reason – and it’s not usually a good one! Remember higher interest payments reflect higher risk. So, when yields are high, it means that risks to investors are commensurately high.
If in doubt, look to the ratings assigned to bonds by major ratings agencies, such as Moody’s or Standard and Poor’s.
Bonds rated by Standard and Poor’s above BBB or those rated by Moody’s above Baa are generally regarded as appropriate for consideration by casual investors.
There are no guarantees however that ratings agencies will hit the nail on the head when it comes to evaluating bonds properly. During the 2007-09 stock market crash, securitized loans were notoriously difficult to analyze and even major ratings agencies found it difficult to properly ascertain creditworthiness and default risk of bond issuers. So, the takeaway is: if in doubt, steer clear. Better to stick with a lower yield bond than a high yield bond that keeps you awake at night.
How to Buy Bonds in a Retirement Portfolio
When you buy stocks and bonds, you don’t need to pour over research reports to pick the very best ones. Exchange-traded funds and index funds offer a way for stock and bond investors to diversify risk across stock and bond holdings.
If you work for an employer who has a 401(k) plan set up, you will be restricted in the choices of funds available. The bond funds made available to you will generally include a diverse group of bonds of varying maturities.
If you are curious how bond funds in your retirement accounts stack up, Blooom offers you an easy way to evaluate your 401(k) holdings and even offers to manage your allocation automatically so it is optimized.
Low Interest Rate Investments
Conversely, when interest rates are low, it is better to choose short-term and intermediate-term bonds because rising interest rates will cause bond prices to fall, which could hurt your portfolio value.
Regardless of the maturity of the bond you purchase, you don’t need to hold it all the way through to maturity. So, if interest rates are low but you expect them to rise, you can exit your bond position on the secondary market and find another bond paying a higher yield when rates rise.
If you are buying individual bonds but new to the market, err on the side of caution. You may wish to consider government Treasury bills and notes before buying municipal bonds unless you are confident your city and state are not in financial distress as Illinois has been with its pension crisis.
What Taxes Do Bond Investors Pay?
When it comes to investing, what matters most is not your gross portfolio return but your after-tax return – the amount you actually get to keep after paying Uncle Sam.
Smart bond investing allocates tax-efficient bonds to taxable accounts and tax-inefficient bonds to tax-deferred accounts.
The golden rule for new bond investors is: do not buy municipal bonds in a tax-deferred account, such as IRA or 401(k). Tax-deferred accounts are by definition not taxed, so there is no reason to buy munis, which are generally exempt from state tax if you live in the state.
Conversely, tax-inefficient bonds are bonds that require you to pay taxes on interest earned. Corporate bonds fall into this category and so, to maximize your after-tax returns, it is best to buy these bonds in a tax-deferred account, such as an IRA.
Bond Type Tax Status Best Account
Municipal Bonds Tax-efficient TaxableCorporate Bonds Tax-inefficient Tax-deferredHigh net worth individuals may also favor municipal bonds because of their tax-exempt status.
Your Bond Investing TakeawayWhen you buy bonds, examine the key factors that can affect your returns:
TaxesInterest ratesCreditworthinessMaturitiesAs you get closer to retirement, a higher portion of your portfolio should generally be allocated to bonds over stocks.
The combination of equities and bonds forms a balanced portfolio that reduces the volatility of holding equities alone so you can sleep more peacefully at night without worrying so much about the effects of a stock market crash on your portfolio.
This article has been republished with permission from Investor Mint.