Bonds are an important part of any investment portfolio, but they've fallen out of favor with some investors. For years, many people were told that stocks were the best method for making money in the long term. That mindset still persists today, even in the wake of two stock market crashes in the past few decades.
Those who downplay the role of bonds may be missing out on the chance to make money. Learn more about why you shouldn't overlook bonds as part of your investing strategy.
1. Bonds Provide Income
While many investments provide some form of income, bonds tend to offer the highest and most stable cash streams. Even at times when rates are low, there are still plenty of options you can use to build a portfolio that meets your income needs. These methods may include high-yield bonds or emerging market debt.
Most importantly, a strong bond portfolio can provide decent yields with a lower level of volatility than equities. They also can make more income than money market funds or bank instruments. This all means that bonds are a good option for those who need to live off of their investment income.
2. Bonds Offer Diversification
Almost everyone has heard the phrase “Don’t put all your eggs in one basket.” This is very true for investors. It may be a cliché, but it's wisdom that has stood the test of time. As time goes on, greater diversification can provide you with better risk-adjusted returns than narrow portfolios can. In other words, it reduces the amount of return relative to the risk.
More importantly, bonds can help preserve capital for equity investors during times when the stock market is falling.
3. Bonds Preserve Principal
Fixed income investments are very useful for people nearing the point where they will need to use the cash they have invested. For instance, this could apply to someone who is within five years of retirement or a parent whose child is starting college. Stocks can face huge levels of volatility in a brief period, such as the crash of 2001 and 2002 or the financial crisis of 2008 and 2009, but a diversified bond portfolio is much less likely to suffer large losses short-term.
As a result, it may be a good idea to increase your allocation to fixed income and decrease your allocation to equities as you move closer to your goals.
4. Bonds Offer Tax Advantages
Certain types of bonds can also be useful for those who need to reduce their tax burdens. The income on bank instruments, most money market funds, and equities is taxable unless the assets are held in a tax-deferred account, but the interest on municipal bonds is tax-free on the federal level. If you own a municipal bond issued by the state where you live, it's tax-free at the state level as well.
The income from U.S. Treasury securities is tax-free on the state and local levels. Tax reasons shouldn't be the main reason you choose an investment, especially if you're in a lower tax bracket. but the fixed income universe offers a number of ways you can minimize your tax burden.
The Bottom Line
Bonds don’t make for interesting conversation at dinner parties, and they don’t receive proportionate coverage in the financial press relative to stocks, but they can serve a wide range of uses for investors of all stripes.
Frequently Asked Questions (FAQs)
When are bonds a good investment?
Bonds are a good investment when the benefits listed here are your primary goals. In other words, if your primary goals with investing are capital preservation and income, then bonds may be worth considering. If, on the other hand, you're a younger investor with a longer timeline who wants to prioritize capital appreciation, then bonds might not be worth considering.
What are the benefits of a long-term bond over a short-term bond?
Long-term bonds offer higher yields than short-term bonds. There is more risk associated with locking up your investment dollars for a longer period, so investors are compensated for that risk with more income.