As
you know, the stock market has attracted a lot of attention – and for
good reason, as we’ve seen considerable volatility almost from the
beginning of the year. But if you own bonds, or bond-based mutual funds,
you might also have some concerns. However, it’s important to
understand why bonds should continue to be an important part of your
portfolio.
To begin with, let’s look at what’s happened with bond
prices recently. Inflation has heated up, leading the Federal Reserve to
raise interest rates to help “cool off” the economy. And rising
interest rates typically raise bond yields — the total annual income
that investors get from their “coupon” (interest) payments. Rising
yields can cause a drop in the value of your existing bonds, because
investors will want to buy the newly issued bonds that offer higher
yields than yours.
And yet, despite this possible drop in their
value, the bonds you own can still help you make progress toward your
financial goals. Consider these benefits of bond ownership:
• Income
– No matter what happens to the value of your bonds, they will continue
to provide you with income, in the form of interest payments, until
they mature, provided the issuer doesn’t default — and defaults are
generally unlikely with investment-grade bonds (those rated BBB or
higher). Your interest payments will remain the same throughout the life
of your bond, which can help you plan for your cash flow and spending.
• Diversification
– As you’ve probably heard, diversification is a key to successful
investing. If you only owned one type of asset, such as growth stocks,
and the stock market went into a decline, as has happened this year,
your portfolio likely would have taken a big hit — even bigger than the
one you may have experienced. But bond prices don’t always move in the
same direction as stocks, so the presence of bonds in your portfolio —
along with other investments, such as government securities and
certificates of deposit — can help reduce the impact of volatility on
your holdings. (Keep in mind, though, that by itself, diversification
can’t guarantee profits or protect against all losses in a declining
market.)
• Reinvestment opportunities – As
mentioned above, rising interest rates and higher yields may reduce the
value of your current bonds, but this same development may also offer
you some favorable reinvestment opportunities. If you own bonds of
varying durations — short-, intermediate- and long-term — you should
regularly have some bonds maturing. And in an environment such as the
current one, you can reinvest the proceeds of your expiring short-term
bonds into new ones issued at potentially higher interest rates. By
doing so, you can potentially provide yourself with more income. Also,
by owning a mix of bonds, you’ll still have the longer-term ones working
for you, and these bonds typically (but not always) pay a higher
interest rate than the shorter-term ones.
It might not feel
pleasant to see the current value of your bonds drop. But if you’re not
selling them before they mature, and you take advantage of the
opportunities afforded by higher yields, you’ll find that owning bonds
can still be a valuable part of your investment strategy.
Note:
Before investing in bonds, you should understand the risks involved,
including credit risk and market risk. Bond investments are also subject
to interest-rate risk such that when interest rates rise, the prices of
bonds can decrease, and the investor can lose principal value if the
investment is sold prior to maturity.