Are bonds a good investment? Investors must consider several factors, including the type of bond, how much interest the bond pays, and how long their investment will be tied up. Investors must also weigh their risk tolerance with a bond's risk of default, meaning the investment isn't repaid by the bond issuer. The good news is that Treasury bonds (T-bonds) are guaranteed by the U.S. government. They can be good investments for those who are in or close to retirement as well as younger investors who seek a stable return.
Bonds are debt securities that are issued by corporations and governments to raise funds. Investors purchase bonds by putting an upfront amount as an initial investment—called the principal. When the bond expires or matures—called the maturity date—the investors are paid back their principal. In return, investors usually receive a fixed, periodic interest payment from the entity that issued the bond.
Bonds. including T-bonds, can be a good investment for those who are seeking a steady rate of interest payments. Although bonds and Treasury bonds are popular, they have some disadvantages and risks associated with them and may not be ideal for every investor. This article compares the pros and cons of Treasury bonds and whether a bond is a good investment for younger investors and those who are approaching or in retirement.
Key Takeaways
- Treasury bonds can be a good investment for those looking for safety and a fixed rate of interest that's paid semiannually until the bond's maturity.
- Bonds are an important piece of an investment portfolio's asset allocation since the steady return from bonds helps offset the volatility of equity prices.
- Investors who are closer to retirement tend to have a larger percentage of their portfolio in bonds, while younger investors may have a smaller percentage.
- Corporate bonds tend to pay a higher yield than Treasury bonds since corporate bonds have default risk, while Treasuries are guaranteed if held to maturity.
- Are bonds good investments? Investors must weigh their risk tolerance with a bond's risk of default, the bond's yield, and how long their money will be tied up.
What Are Treasury Bonds?
Treasury bonds (T-bonds) aregovernment debt securities that areissued by the U.S. Federal government and sold by the U.S. Treasury Department. T-bonds pay a fixed rate of interest to investors every six months until their maturity date, which is in 20-30 years.
However, the interest rate earned from newly-issued Treasuries tends to fluctuate with market interest rates and the overall economic conditions of the country. During times of recession or negative economic growth, the Federal Reserve typically cuts interest rates to stimulate loan growth and spending. As a result, newly-issued bonds would pay a lower rate of return in a low-rate environment. Conversely, when the economy is performing well, interest rates tend to rise as demand for credit products grows, leading to newly-issued Treasuries being auctioned at a higher rate.
Types of Treasuries
There are several types of Treasury securities that are offered with various maturity dates. For example, Treasury bills or T-bills are short-term bonds that have maturities from a few days to 52 weeks.Treasury notes or T-notes are very similar to Treasury bonds in that they pay a fixed rate of interest every six months until their maturity. However, Treasury notes have shorter maturity dates with terms of two, three, five, seven, and 10 years.The 10-year Treasury note is probably the most monitored of the Treasury securities since it is often used as a benchmark for interest rate products such as loans.
Treasury notes are often referred to as Treasury bonds, which can make it confusing since a Treasury bond is technically a bond with a maturity date between 20 and 30 years. However, a Treasury note and a Treasury bond are essentially identical except for their maturity dates.Whether the Treasury security is a bill, note, or bond, the interest earned is exempt from state and local taxes. However, the interest income is subject to federal taxes.
Buying and Selling Treasury Bonds
A Treasury note is sold by the Treasury Department via an online auction. Once the note has been purchased by an investor, there are two options. The investor can hold the bond until maturity, in which case the initial amount invested would be paid back when the bond matures.If the investor holds the bond to maturity, the amount that was invested is guaranteed to be paid back by the U.S. government.
The investor also has the option of selling the bond before it matures.The bond would be sold through a broker in the secondary market—called the bond market. However,investors should be aware that their initial investment is not guaranteed if the bond is sold early through the bond market.In other words, they may receive a lower amount than what they had initially invested.
Young Investors
The interest paid from Treasury bonds tends to underperform the returns that can be generated from investing in equities. However, the rate earned from bonds should outpace inflation or the pace of rising prices, which tends to hover around 2%. All that said, there's still room for T-bonds in a young person's retirement account, which can benefit from the steady interest payments associated with these securities.
For example, a steady return can help to reduce volatility or fluctuations in the value of an investment portfolio. Using bonds to help partially offset the risk of loss from other investments helps to achieve diversification—meaning not all of your money is in one type of investment. Also, T-bonds are backed by the full faith and credit of the U.S. federal government, meaning investors won't lose their initial investment.
However, since younger investors have a longer time horizon, they typically opt for investments that offer long-term growth. As a result, T-bonds tend to represent a minority share of a younger person's investment portfolio. The precise percentage should be carefully determined based on the investor's tolerance for risk and long-term financial objectives.
A rule-of-thumb formula for portfolio allocation states that investors could formulate their allocationamong stocks, bonds, and cash by subtracting their age from 100. The resulting figure indicates the percentage of a person’s assets that ought to be invested in stocks, while the remainder could be spread between bonds and cash. By this formula, a 25-year-old investor would consider holding 75% of the portfolio in stocks while splitting the remaining 25% between cash and bond investments.
Investors Near or in Retirement
Retirees often buy bonds to generate an income stream in retirement. Their portfolio allocation changes and tends to become more conservative. As a result, the portion of the portfolio that's composed of bonds tends to rise. A portfolio that includes Treasury bonds, bills, or notes, provides safety and helps to preserve their savings since Treasuries are considered risk-free investments.
With their consistent interest payments, T-bonds can offer an ideal income stream after the employment paychecks cease. Also, bond maturity dates can be laddered to create the continuous stream of income that many retirees seek.
One type of Treasury bond that even offers a measure of protection against inflation called inflation-protected T-bonds—also referred to as I bonds—have an interest rate that combines a fixed yield for the life of the bond, with a portion of the rate that varies according to inflation.
A bond ladder involves buying several bonds with staggered maturity dates in which each bond matures in a consecutive year. The strategy provides investors with cash on each maturity date.
Government Bonds vs. Corporate Bonds
Corporate bonds are also debt securities that are issued by a corporation. Just like Treasury bonds, corporate bonds have their advantages and disadvantages. Typically, corporate bonds pay interest payments, which can be based on a fixed rate throughout the life of the bond. The interest payments can also be based on a variable interest rate, meaning the rate can change based on market interest rates or some type of benchmark.When a corporate bond matures, the investor is paid back the principal amount that was invested.
A corporate bond is backed by the corporation that issued the bond, which agrees to repay the principal amount to the investors.However, when buying corporate bonds, the initial investment is not guaranteed. As a result, corporate bondholders have default risk, which is the risk that the company may not repay its investors their initial investment. Whether the initial investment for a corporate bond is repaid or not depends on the company's financial viability.
Since investors there is usually more risk with corporate bonds, they tend to pay a higher interest rate than Treasury securities.Conversely, Treasury bonds are guaranteed by the U.S. government as long as the investor holds the bond until maturity. As a result, Treasury bonds typically offer a lower interest rate than their corporate counterparts.
Retirees should consider their risk tolerance when making a decision as to whether to purchase a corporate bond or a Treasury security.Also, the time horizon is important when buying a bond, meaning how long the investment will be held. If a retiree is going to need the money within a few years, a Treasury bond might not be the best choice considering its long maturity date.Although a Treasury bond can be sold before its maturity, the investor may take a gain or loss, depending on the bond's price in the secondary market at the time of the sale.
Tax considerations should also be considered before purchasing any type of bond. Please consult a financial advisor before deciding whether purchasing a corporate bond or a U.S. Treasury security is right for you.
Advantages of Treasury Bonds
Although Treasury bonds can be a good investment, they have both advantages and disadvantages.Some of the advantages of bonds include:
Steady Income
Treasury bonds pay a fixed rate of interest, which can provide a steady income stream. As a result, bonds can offer investors a steady return that can help offset potential losses from other investments in their portfolio, such as equities.
Risk-Free
Treasury bonds are considered risk-free assets, meaning there is no risk that the investor will lose their principal. In other words, investors that hold the bond until maturity are guaranteed their principal or initial investment.
Liquid
Treasury bonds can also be sold before their maturity in the secondary bond market. In other words, there is so much liquidity,meaning an ample amount of buyers and sellers, investors can easily sell their existing bonds if they need to sell their position.
Many Investment Options
Treasury bonds can also be purchased individually or through other investment vehicles that contain a basket of bonds, such as mutual funds and exchange-traded funds.
Disadvantages of Treasury Bonds
Despite the advantages, Treasury bonds come with some distinct disadvantages that investors should consider before investing. Some of the disadvantages include:
Lower Rate of Return
The interest income earned from a Treasury bond can result in a lower rate of return versus other investments, such as equities that pay dividends. Dividends are cash payments paid to shareholders from corporations as a reward for investing in their stock.
Inflation Risk
Treasury bonds are exposed to inflation risk. Inflation is the rate at which prices for goods in an economy rise over time. For example, if prices are rising by 2% per year and a Treasury bond pays 3% per year, the investor realizes a net return of 1%. In other words, inflation or rising prices erodes the overall return on fixed-rate bonds such as Treasuries.
Interest Rate Risk
Just as prices can rise in an economy, so too can interest rates. As a result, Treasury bonds are exposed to interest rate risk. If interest rates are rising in an economy, the existing T-bond and its fixed interest rate may underperform newly issued bonds, which would pay a higher interest rate. In other words, a Treasury bond is exposed to opportunity cost, meaning the fixed rate of return might underperform in a rising-rate environment.
Realized Loss
Although Treasury bonds can be sold before they mature, please keep in mind that the price received for selling it may be lower than the original purchase price of the bond. For example, if a Treasury bond was bought for $1,000 and was sold before its maturity, the investor might receive $950 in the bond market. Investors are only guaranteed the principal amount if they hold the T-bond until maturity.
Pros
Pay steady interest income
Risk-free
T-bonds can easily be sold before maturity
Can be bought via ETFs and mutual funds
Cons
Lower rate of return vs. other investments
As market interest rates rise, T-bonds may underperform
Inflation can erode interest income
Bonds sold before maturity can realize a loss
Why Would Investing in Bonds Be a Bad Idea?
Whether a bond investment is bad or good depends on the investor's financial goal and market conditions. If an investor wants a steady income stream, a Treasury bond might be a good choice. However, if interest rates are rising, purchasing a bond may not be a good choice since the fixed rate of interest might underperform the market in the future. Please remember, when you purchase a Treasury bond, the fixed rate of interest for that bond never changes, regardless of where market interest rates are trading.
Also, investing in bonds and selling them in the secondary market before their maturity can lead to a loss similar to other investments such as equities. As a result, investors should be aware of the risk that they could lose money by purchasing and selling bonds before their maturities. If an investor needs the money in the next year or two, a Treasury bond, with its longer maturity date, might not be a good investment.
Are Bond Funds a Good Investment?
Bond funds can be a good investment since funds typically contain many types of bonds, which diversifies your risk of a bond defaulting. In other words, if a corporation experiences financial hardship and fails to repay its bond investors, those who hold the bond in a mutual fund would only have a small portion of their overall investment in that one bond.As a result, they would have less risk of financial loss than had they purchased the bond individually.
However, investors should do their research to ensure that the bonds within the fund are the type of bonds that you want to buy. Sometimes funds can contain both corporate bonds and Treasury bonds, and some of those corporate bonds might be high-risk investments. As a result, it's important to research the holdings within a bond fund before investing.
Can You Lose Money Investing in Bonds?
Yes, you can lose money when selling a bond before its maturity date since the selling price could be lower than the purchase price. Also, if an investor buys a corporate bond and the company goes into financial difficulty, the company may not repay all or part of the initial investment to bondholders. This default risk can increase when investors buy bonds from companies that are not financially sound or have little-to-no financial history. Although these bonds might offer higher yields, investors should be aware that higher yields typically translate to a higher degree of risk since investors demand a higher return to compensate for the added risk of default.
What Are the Best Bonds to Buy?
Knowing the best bonds to buy largely depends on the investor's risk tolerance, time horizon, and long-term financial goals. Some investors might invest in bond funds, which contain a basket of debt instruments, such as exchange-traded funds. Investors who want safety and tax savings might opt for Treasury securities and municipal bonds, which are issued by local state governments. Corporate bonds can provide a higher return or yield, but the financial viability of the issuer should be considered.
The Bottom Line
Bonds can find a place in any diversified portfolio whether you're young or in retirement. Bonds can provide safety, income and help to reduce risk in an investment portfolio. Bonds can be mixed within a portfolio of equities or laddered to mature each year, providing access to cash when they mature. Investors should consider some exposure to bonds as part of a well-balanced portfolio, whether they're corporate bonds, Treasuries, or municipal bonds. However, it would be a mistake for investors to assume that bonds are without risk. Instead, they should do their homework since not all bonds are created equal.
