Most investors during the past several years have focused their attention on the stock market. And why not? The Standard & Poor’s 500 index of large-company stocks gained an average of 28.6% annually during the five years through 1999. But stocks recently have stumbled: The S&P 500 is down almost 7% this year, and some sectors — including formerly high-flying technology and telecommunications stocks — have fared far worse.
Stocks’ recent decline has caused many investors to consider shifting some assets to bonds. Bonds typically are far more stable than stocks. And while they offer less long-term growth potential, bonds provide a steady stream of income in the form of regular interest payments. That money can help smooth out investment returns when stocks are volatile. What’s more, many investment experts say that the investment environment for bonds looks good right now.
What is a Bond?
A bond is a loan that you give the government, a government agency or a corporation. In return, the institution promises to pay back all of your money at a given date and to provide you with regular interest payments in the interim. The amount of those payments is called the bond’s yield.
For example, say you invest $1,000 in a 10-year Treasury note with a 6% yield. The federal government promises that it will pay back your initial $1,000 investment — called your principal — in 10 years. Meanwhile, the Treasury will pay you 6% of your $1,000 investment — $60 — every year.
Bonds also can offer some growth potential. Say investor demand increases for your 6%-yielding 10-year Treasury note. Your $60 annual payments might start to look very attractive to other investors if, for example, stocks are likely to suffer from a slowing economy. Those investors may be willing to pay you more than $1,000 for your bond — providing you with a capital gain.
Treasury bonds are backed by the full faith and credit of the U.S. government, so your principal and interest payments are guaranteed. But not all institutions that issue bonds are so reliable. Corporations that fall on hard times sometimes have trouble meeting their payments, leaving bondholders in the lurch. For that reason, credit-rating firms such as Standard & Poor’s and Moody’s Investor Services help investors figure out how likely a company is to default on its loans. The two firms evaluate the strength of corporations’ finances, and use that information to rate the companies’ credit-worthiness. AAA is the highest rating; most investors avoid bonds rated less than BBB.
Why You Should Consider Bonds
The number one reason to consider investing in bonds is diversification. Stocks provide the best way to grow your money to meet long-term financial goals, and for that reason you probably should keep the bulk of your portfolio in stocks or stock mutual funds. But the stock market can be bumpy in the short term, as anyone who invested in technology stocks last January can attest. Bonds’ stability can smooth out that ride, and their interest payments can help you meet your short-term financial needs.
What’s more, experts say the coming months look good for bonds. They point out that the economy is expected to slow, which should benefit bond holders: A slowing economy reduces the likelihood that inflation will rise and decrease the value of interest payments, and it also makes stocks’ returns less promising — meaning investors are more likely to put money into bonds, driving up their prices. Experts also cite the Federal Reserve Board’s neutral monetary policy and the federal government’s plan to buy back long-term Treasury bonds as good news for the bond markets.
Bond Fund Recommendations
Financial planners generally recommend mutual funds for investors with less than $100,000 or so to devote to bonds. Most people choose the safety of Treasury bond funds. One good fund: Vanguard U.S. Treasury (800-662-7447; $3,000 minimum investment; no load; 6.14% yield). Corporate bonds offer higher yields, so investors willing to take on slightly more risk in their fixed-income holdings might want to consider a fund such as Fremont Bond (800-548-4539; $2,000 minimum; no load; 6.67% yield).
Whichever type of fund you choose, bonds’ added stability and regular interest payments can help your portfolio — while also helping you rest easier when the stock market gets rocky.
