investing

Young people: Buy bonds or bond funds now?

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Highlights
  • Bonds are subject to two types of risk: credit and interest rate risk.
  • Interest rate risk doesn't affect individual bonds unless you want to sell before maturity.
  • Bonds and bond funds have their pros and cons.

These days, few investors hew to the old rule of holding the equivalent of your age, in percentage terms, in bond investments. This is particularly true for those on the younger end of the spectrum. While some advisers and fixed-income experts recommend bond allocations for all investors, others say young people can do just fine with no fixed-income investments.

So what should investors younger than 40 do about investing in bonds or bond funds? As usual when it comes to investing, the answer is "it depends."

Isn't there a looming bond apocalypse?

Unlike stocks, which represent ownership shares in companies, bonds are debt instruments issued by businesses, governments and municipalities. An investor trades the price of the bond for interest payments over a specific period of time. When the bond matures, the issuer forks over the principal.

When an investor holds an individual bond to maturity, the only way to lose money is if the issuer goes belly up and can't repay creditors. That possibility is known as credit risk.

Bonds are also subject to interest rate risk. With interest rates as low as they are now, rates have nowhere to move but up. And outstanding bonds will drop in value when interest rates rise. Think about it this way: Why would you buy a $1,000 bond paying 1 percent when the same price could buy you a 2 percent coupon, or interest rate payment?

Someone in the market for bonds would say, "I'll buy your bond for less than the face value so that when the bond matures and the issuer pays back the principal, I'll get a value closer to prevailing rates."

Interest rate risk comes into play when you want to sell bonds before maturity or in a bond fund where few bonds are held until they mature.

That's one reason some experts advise caution when moving into the fixed-income area right now.

"If I were a young person, I would not be buying bonds right now. I would be much more likely to buy stocks or commodities," says Jeff Sica, president and chief investment officer at Sica Wealth Management in Morristown, N.J. "Bonds are the least attractive for a longer-term investor because unless you're buying high-yield or emerging-markets debt or something that has some capital appreciation (potential), you're going to be stuck with a bond that declines in value because of interest rates moving up."

Bonds or bond funds?

On the one hand, buying individual bonds is preferable because interest rate risk is not a factor unless you want to sell before maturity. On the other hand, buying a bond fund is a good choice because it generally holds a large assortment of bonds, and credit risk is diffused with diversity.

As bonds are typically sold in bigger chunks than young investors can afford, bond funds are typically preferred.

"You certainly can buy individual Treasury bonds and savings bonds," says Jim Wright, CFA, president and chief investment officer at Harvest Financial Partners in Paoli, Pa.

"They do have some small lots through the Schwabs, Fidelitys and TD Ameritrades of the world, so you can put smaller amounts of money into bonds. For people with smaller investment balances who want to put some money in fixed income, funds or (exchange-traded funds) definitely make more sense," adds Wright.

 

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Why have bonds?

As with all investments, taking more risks can lead to greater rewards. On the very safe end, bonds can be highly predictable, stable investments, as in Treasury securities issued by the U.S. government. At the other end of the spectrum, in the high-yield or junk category, bonds can be fairly risky.

In general, the steady interest payments and high likelihood of getting your money back make bonds less volatile than stocks.

"My financial planner got all over me for being slightly underallocated in bonds, even though I'm a bond manager. And the reason is, long-term benefits of bonds are not only the returns -- which, during varying periods, may underperform stocks -- but they're much more stable. So they provide that ballast for the other risks you're taking in an allocation," says Eddie Bernhardt, CFA, managing director and senior portfolio manager at SNW Asset Management in Portland, Ore.

"That additional benefit is probably hard to quantify at times but is very important, even for young investors who aren't expecting the need for cash anytime soon," he says. "The stabilizing impact of bonds in the portfolio is important."

Arguments for bonds for young investors

Young investors typically get their first foray into investing by saving for retirement in their workplace plans. With many years to invest and probably little money, it can be tempting to go pedal-to-the-metal with an all-stock portfolio. But adding some bonds can mitigate some of the stock market turbulence without overly decreasing returns in some cases.

"(Being all in stocks) will increase a portfolio's volatility. It most likely will raise returns slightly, but if a person can get the (same net) return and lower the volatility, then that person should do that," says Donald Cummings, founder and portfolio manager at Blue Haven Capital LLC in Geneva, Ill.

Just because you are able to stomach maximum risk doesn't mean you must do it.

If you're interested in adding bonds to your portfolio and plan to do it through mutual funds, the experts recommend sticking to short- to intermediate-term maturities.

"We would prefer that if you are going to invest in a fund, that you pick a shorter duration or a fund with a shorter maturity built in because those funds will be a lot less volatile when interest rates go up," Wright says.

Cummings recommends bond funds specializing in the midterm range.

"I would recommend something like an intermediate maturity, high-grade corporate bond fund for someone if they have that option," he says.

"We're in a low-rate environment and a relatively steep (yield) curve, so you get reimbursed," says Cummings. The yield curve refers to the relationship between yield and maturity when plotted on a chart. Typically, longer maturities sport higher rates, so the graph resembles an upward-sloping line.

"You get compensated, not as much perhaps as a few months or a year ago, but you are compensated for going out on the curve. I think the seven- to 12- or 13-year sector on an ETF or index is probably a great place to put some money," says Cummings.

While there may be some turbulence through the years, it will likely be less capricious than the movement in equities. The predictability and steady returns of bonds or bond funds could help younger investors sleep better at night and smooth volatility on the way to retirement.

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