Your mission, should you choose to accept it, is to build an investment portfolio that won’t self-destruct if market volatility and other economic factors blow your cover. Experts recommend getting clues from the bond market. Because bonds are typically loaded with predictability, they may shield your portfolio when the performance of other investments is compromised.
A Variety of Bonds Exposed
Bonds are simply IOUs issued by companies (or governments) that pay investors a predetermined interest rate after a set period of time. Generally, the lower the risk of default by the bond issuer, the lower the interest rate you’ll earn on the bond.
U.S. Treasury bonds are backed by the full faith and credit of the U.S. government and are considered the safest and most liquid bond investments. These bonds generally pay the lowest rate of interest.
Municipal bonds are issued by state and local governments. Because they are free from federal taxes and may be exempt from state and local taxes, they may be a smart strategy for individuals in higher tax brackets to invest money outside of tax-advantaged accounts (401(k)s and IRAs).
Corporate bonds, issued by corporations, pay higher rates in exchange for a higher risk of default.
Bond jargon can be confusing and intimidating – knowing the following concepts can get you closer to mission: accomplished.
- Par value, also known as face value, is the amount the investor will receive at maturity.
- Coupon is the interest rate the bond pays (this rate stays the same over the life of the bond). A zero-coupon bond is sold at a discount to par value, and matures at par value. One example is a U.S. Series EE savings bond. When you purchase a $50 savings bond, you actually pay $25 for it. It earns interest every year for a maximum of 30 years. How much it is worth when you sell it depends on the interest rate and when you sell it.
- Maturity refers to the length of time before the par value is paid to the investor. It may be as short as a few months or more than 50 years.
The longer the term, the more risk you take that interest rates will change. If rates increase, your bond will be worth less if you need to sell it before maturity. Because of this added risk, issuers pay higher rates for longer terms.
Bond laddering. Consider buying bonds of varying terms so a portion of your money is available to reinvest at current rates. By laddering, your investment may earn a more stable return even as rates rise and fall. For example, suppose you buy three $10,000 bonds. One is a one-year bond paying 3%, another is a two-year bond paying 4% and the third is a three-year bond paying 5%. When your one-year bond matures, you invest the proceeds in a three-year bond earning a higher rate of return. When your two-year bond matures, you use the money to buy another three-year bond. If you continue to invest this way, you'll have a bond maturing each year.
Bond funds. Simplify the process by choosing funds invested in a variety of bonds, especially if you’re a novice investor. Be sure to consider your goals, timeline and risk tolerance when determining an appropriate mix for your portfolio. To learn more about bond funds, click here.
TIPS (Treasury Inflation-Protected Securities) pay a fixed rate of interest, but their principal value is adjusted twice a year to keep pace with increases in the Consumer Price Index (CPI). Interest payments are based on the adjusted principal. You can buy TIPS through banks and brokers, or directly from the government at www.treasurydirect.gov.
Your 403(b) plan offers a variety of funds, some of which invest in bonds or a mix of stocks and bonds. To learn more about the bond funds available in your plan, visit 403bcompare.com.