Related: Why the U.S. Debt Problem is Getting Worse
Bonds Prices are Opposite to Bond Yields
Bonds are not just purchased on the day they are issued but can also be bought on a secondary market afterward issuance.
Bond prices may fluctuate in value on a secondary market so when bond prices decline, bond yields increase.
And vice versa, when the price of a bond rises above its original or par value, the yield to maturity decreases relative to the original rate when it was issued.
Interest Rates Affect Bond Prices
When interest rates rise, new bonds issued on the market have higher yields which are more attractive to investors.
Older bonds paying lower yields are less attractive to investors than newer bonds paying higher yields, and so bond prices generally decline when interest rates rise.
Retirement Investing In Bonds
As you approach retirement, it is important to become more conservative with your portfolio.
Your goal should be to protect your IRA or 401(k) nest-egg and lower risk compared to a younger investor who may have time on their side to ride out the ups and downs of the stock market.
To smooth out portfolio volatility, a larger weighting of bonds versus stocks is a good idea.
Historically, the stock market has enjoyed annual returns that average north of 7%. But behind the veil of this average return figure are a lot of ups and downs, including stock market crashes that typically happen on average at least once each decade.
So, the last thing you want when you are ready to retire is to have your entire nest-egg in a retirement portfolio of stocks just when the market is at a peak.
It is better to be safe than sorry, and create a balanced portfolio that includes its fair share of bonds.
If you want to avoid the homework of figuring out which bonds to invest in, a robo advisor might be a good option.
Robo advisors, such as Betterment, automatically adjusted your portfolio composition based on your age, time horizon and risk profile.
Taxes And Bond Investing
Municipal bond investors enjoy tax breaks that are not available to bond investors generally.
When state and local governments issue muni bonds to pay for road constructions, schools, dams, and other public projects, they incentivize investors to loan them money by offering attractive tax breaks.
When you buy a muni bond, the interest payments you earn are not subject to federal taxation.
Plus, if you buy muni bonds issued by the state you live in, interest earned is often exempt from state and municipal taxes too.
What Are The Risks Of Investing In Bonds?
The major risk when investing in bonds is default risk, which occurs when the borrower does not follow through on its obligation to repay the debt principal and interest.
Whereas shareholders in a company who have bought stock claim a share of future profits, bondholders receive a fixed interest rate that is independent of the profitability of a company.
Even if a company goes bankrupt, a bondholder may end up recouping some money because bondholders are more senior to shareholders and must be paid in full from any liquidation of assets before shareholders receive a penny.
The seniority bondholders enjoy comes at a cost, which is a limited upside. Whereas shareholders can earn ever higher returns as share prices rise, bondholders are limited only to what they can earn from the interest paid.
This article was republished with permission from Investor Mint.