Investors in the stock market face difficult decisions about how and which kind of bonds to place in their portfolio.
Bonds are used by investors to add stability and lower the overall risk of their portfolio. However, not all bonds are created equal and it is up to investors decide which ones make the most sense for them. In addition to many different types of bonds available, investors must think about the maturity of bonds and how that strategy fits into building a retirement fund.
The general rule of thumb is that the shorter the maturity the lower the interest rate, which is why U.S. Treasury Bills that have maturities measured in days pay the lowest rates.
The longer the maturity of a bond the more interest it will typically pay to compensate investors for the risk that during the holding of the bond conditions might change and make that particular bond a poor investment.
For example if you owned a five-year high quality corporate bond that was paying 5 percent interest and other interest rates suddenly rose so that new five-year bonds from the same company were paying 8 percent interest, you would face a difficult decision.
You have two choices: first, hold the bond to maturity and be happy with the 5 percent interest. Secondly, you could sell you old five-year bond and reinvest the proceeds, however you would have to discount the face value of the bond so that the yield still equaled the prevailing rate that new investors to get with the new bond.
While this is a simplistic examination of the problem that investors face, nevertheless it encapsules the dilemma facing investors in bonds.
Do you stick with short-term bonds which can mature quickly and give you the opportunity to reinvest your money in a possibly higher-paying bond or do you go with a longer-term bond which may pay more interest now, faces the risk of interest-rate changes.
One of the ways to address this problem is by laddering your bonds. I have an article that explains the process in detail, but here is summary.
A bond ladder is a way to stagger the maturities of your bonds so it contains some short-term bonds and some longer-term bonds. You have a bond maturing every year, which gives you the opportunity to buy a higher paying one (if available.
If there are no higher rate bonds available you know that you are getting the best interest rate available each year. Some years you may improve your overall return, while other years it may decline, but you are always doing the best you can.
Many bond investors turn to mutual funds for help with their bond portfolio. No doubt, this is the easier way.
Bond funds offer all the benefits of mutual funds: professional management, liquidity and low minimum investments. At the same time, they don't have fixed maturity date as a bond does.
If you need to fund a goal in x number of years for a certain amount, a bond virtually guarantees your principal will be available on the maturity date. With a mutual fund, you don't know what the value of your account will be in x number of years.
You should also watch out for fees, which tend to run higher than some stock mutual funds.
Some bond funds use a more sophisticated version of the bond ladder I described above. Other bond funds push hard to increase the yield, however this can be a risky and expensive strategy.
When interest rates are low, it is tempting to look at bonds and bond funds that offer and above-market yield, If you are comfortable with the risk, these bonds can make up a small percentage of your retirement fund.
Some of your bond portfolio (20% - 35%) can and should go to treasuries, but you may want to consider other higher yielding options.
Municipal bonds or munis offer a tax-free return, which can be very attractive. However, they are difficult for individuals to buy because they come in very large denominations.
Your best shot for munis is probably a mutual fund, but watch out for the quality of munis the fund buys and pay close attention to fees. Another alternative is corporate bonds.
Highly rated corporate bonds pay attractive yields, but may be difficult to find. Again, a good mutual fund may be your best alternative if you have neither the time nor patience to research bonds.
