Posted: Friday, January 18, 2013 4:28:57 PM
“I’m buying a bond because I don’t want to lose any of my principal!” Not great reasoning or logic and not exactly accurate.
An investor buys bonds (or bond funds) for many reasons but their investment objective(s) must drive that decision. The two primary reasons to invest in bonds (also called fixed income securities) are diversification and/or steady income. Although investment portfolios normally include a fixed income component, if either of these are not your investment priority, the amount allocated to them must be a consideration.
A well-constructed investment portfolio is built with components that react differently to varying market behavior. These components are investment vehicles that are expected to have positive long term performance but do not move in the same direction – said to be non-correlated - at the same time. Bonds combined with stocks in a portfolio are a good example of these (non-correlated) components because they typically react opposite of one another.
Case Example: One of worst days the stock market had in the recent past was February 28, 2007. The Wall Street Journal of March 1, 2007 reported, “Tuesday’s market drop left few financial assets unscathed. Not only did all 30 stocks of the Dow Jones Average fall, so did all but two of the stocks in the S&P 500-stock index. Of 51 country stock markets followed by MSCI Barra indexes, only two - Jordan and Morocco – didn’t fall. Emerging-market and junk bonds prices fell sharply. Even the price of gold, where investors typically run in times of trouble, fell. (US) Treasuries, another haven in times of peril, did rise.”
In a diversified portfolio, the use of high quality and US treasury bonds can mitigate even days like this one.
If your investment objective is steady, consistent cash flow over a period of time (for retirement or college funding), investing in bonds is an excellent investment alternative. It is however, very important to understand that even an investment in the safest bonds – US Treasuries – does not guaranty the return of your principal, unless you hold them until they mature. Although the income they generate will not vary over their life, their value most certainly will.
Case Example I - Retirement Income: One of my clients wanted to retire at 62. Her husband was already 65 and retired, collecting his full measure of Social Security, and they were ready to begin the rest of their lives. He had a small pension, they had some savings and proceeds from downsized their home. They calculated that they needed an annual cash flow of $65,000. The pension and their combined Social Security generated (and guaranteed them) $45,000 of that requirement. Their savings, and proceeds from the sale of their home, were pooled together and triple A, intermediate term government bonds were bought to provide the balance.
These bonds were bought for income and will be held until maturity. A fluctuation in their value is not a concern but steady income is.
Case Example II - College Funding: One of my clients passed away and left a moderate legacy to his daughter. The daughter has two children – ages 9 and 13. We calculated that her and her husband could save enough for approximately half of a public college education (in future value dollars) for both children. To make up the difference, the inheritance was divided in half and invested in US Government Zero Coupon Bonds, with a maturity date being the beginning of the junior year of each child.
Zero Coupon Bonds are bought at a discount of their face value (as US Savings bonds are) and grow to that face value over their lives.
Conclusion; invest with an objective and with good, well informed reasoning.
Marty Telles is a personal finance professional and principal of The High Tide Group (www.thehightidegroup.com). He is passionate about assisting clients in planning for their financial needs and committed to their understanding of the principles that go into the planning process.
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