Bonds provide something few other investments can bring. The slow horse to equity's fast car, bonds, specifically bond funds, have a place in a diversified portfolio. The question however lies in determining the how much and the risk you run if you don't get it quite right.
Risk is a hard thing to pinpoint, even for the seasoned investor. It is particularly difficult for the BlueCollarDollar investor. We have the firm belief that we can achieve great wealth with our investments for retirement, and while that is a comforting thought, it is far from a realistic one. You are working to earn enough money to enable you to retire comfortably in a manner that is somewhat similar to the lifestyle you led while you worked. To do that, you need to grow your money while at the same time, protecting it.
You must have the lion's share of your portfolio in equities if you are just beginning this long investment road. This should however begin to taper off as you age. By the middle of your working career, provided you have invested consistently from an early age, you should consider the protection that bond funds provide.
Everyone's circumstances are different. But the need to incorporate bond funds in some percentage, even if they are hidden inside of a balanced fund, a fund that invests in both equities and bonds, is important.
Bond Funds invest in bonds, which essentially are investments that invest in debt. The purchase of the debt these funds buy is directly related to the "yield". You will hear those two
terms used when looking at bonds, price and yield, because they tell a
great deal about the fund.
This debt, and those who issue it, will determine the Credit risk. The
better the credit risk, the government being the best borrower, the higher the
letter rating the bond is given. Try to avoid funds that invest in bonds
that hold debt with a "B" or less rating. Companies issue bonds because
they need money. Money they cannot get on the open market any other way.
So they make a deal with the bondholder. I will pay you "x" amount in
interest if you buy this bond. Which essentially makes you the lender.
The risk in this type of investment comes three ways, which makes the individual investment in bonds a particularly treacherous road for the inexperienced investor. Each of these three factors can undo a perfectly good plan and undermine a good investor's intentions.
The first consideration is a default on the bond. When a company cannot pay back the loan you have given it and defaults on the bond, you lose. Although, as a bond holder you are first in line for repayment, ahead of shareholders, the money you get back from a defaulted bond, something that usually happens when a company goes bankrupt, can be pennies on the dollar, depending on the judge's decision.
On the flip side, when the company pays back the bond and the
interest due, you win. The higher the likelihood a company might default
and not pay back the money due, the lower the letter rating, the higher
the yield, and of course with anything risky, the higher the profit
potential.
There is always the chance that the debt will be paid off early and the
bondholder will be denied the potential for any additional income from the
bond. This is referred to as a callable bond and this can add to your loses in the form of unrealized returns as the borrower refinances their loan.
Interest rate risk also affects bonds. In a bond fund, this risk is lessened as the investments carry different maturity dates (when they are due to be paid) and
interest rates will have a greater impact on bonds with longer maturity
bonds than the short. This is where the fund manager has a decided advantage over the individual. beating the risk of interest rates comes from laddering, a process that involves investing a wide variety of bonds with different maturity dates. Individual bond holders have a difficult time with laddering. The ability to avoid sudden drops in price or yield, or having to re-invest when the markets are not favorable, are all offset by laddering.
It should be noted that risk is further lessened for insured or
government bonds. This particular risk has the greatest downside potential.
Bonds with high yields can be a telling sign of risk. It is highest when the risk is greatest. The risk is greater because of the kind of the debt the bond holds and who issued it. Pay
close attention to this because this risk indicates the potential for
greater returns/losses.
The inclusion of bond funds into your portfolio will diminish your risk in the equity markets but should be a small part of a young investor's portfolio. If, however, you have started late including a good balanced fund should provide you with enough diversity to weather any sudden downturns in the market.
Fixed Income funds do come with real risk and depending on the
investment strategy of the fund, some reward. From the contact that I have
had with many of you, your investment plans are involved in making your
money do the most for you while you are still working. Bond funds can protect a portion of this investment adequately and for the long term.
If you have additional questions about these investments, you can find the answers on rates here and on definitions here.
