Investing in Bonds

US Savings Bond certificates in various dollar values.
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Bonds are as important to an investment portfolio today as ever. For years, investors were told that stocks were the best vehicle for long-term savings, and that sentiment persists today even in the wake of two stock market crashes thus far in the 21st century. But those who downplay the role of bonds may be missing out on significant opportunities.

Bonds Provide Income

While many investments provide some form of income, bonds tend to offer the highest and most reliable cash streams. Even at times when prevailing rates are low, there are still plenty of options (such as high-yield bonds or emerging market debt) that investors can use to construct a portfolio that will meet their income needs.

Most importantly, a diversified bond portfolio can provide decent yields with a lower level of volatility than equities, and with a higher income than money market funds or bank instruments. Bonds are, therefore, a popular option for those who need to live off of their investment income.

Bonds Offer Diversification

Almost every investor has heard the phrase “don’t put your eggs in one basket.” It may be a cliché, but it's time-tested wisdom nonetheless. Over time, greater diversification can provide investors with better risk-adjusted returns (in other words, the amount of return relative to the amount of risk) than portfolios with a narrower focus. More important, bonds can help reduce volatility—and preserve capital—for equity investors during the times when the stock market is falling.

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, an investor within five years of retirement or a parent whose child is starting college. While stocks can experience huge volatility in a brief period—such as the crash of 2001-2002 or the financial crisis of 2008-2009—a diversified bond portfolio is much less likely to suffer large losses short-term. As a result, investors often increase their allocation to fixed income, and decrease their allocation to equities, as they move closer to their goals.

Bonds Possess Tax Advantages

Certain types of bonds can also be useful for those who need to reduce their tax burdens. While the income on bank instruments, most money market funds, and equities are taxable unless held in a tax-deferred account, the interest on municipal bonds is tax-free on the federal level and, for investors who own a municipal bond issued by the state in which they reside, on the state level as well.

Also, the income from U.S. Treasuries is tax-free on the state and local levels. While tax reasons shouldn't be the foremost reason to choose an investment, especially for investors in lower tax brackets, the fixed income universe offers a number of vehicles investors can use to minimize their 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. Still, bonds can serve a wide range of uses for investors of all stripes.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.