Do Bonds Worth For Your Investment Portfolio?

By Author: revy
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Many investment pundits advise an allocation of bonds and other fixed income investments in a percentage that roughly equals your age. The rationale is that as we get older, we have less ability to ride out the volatility of the stock market, and should seek steady safer returns on our investments.

A fixed income investment is the act of lending some other entity your money in exchange for a return of your investment at a later time, and some interest proportional to the risk and time involved. When making a fixed income investment, consider the length of time that you are lending your money out (time and inflation risk). The second consideration is how likely you are to get your money back (the credit risk).

If you invest in bonds, you have to consider several factors. One of the factors to be considered is maturity. If you hold the bond until maturity, you get back what you paid for it (unless the issuer defaults). You should try to match the length of your investment with your need for funds. If money is required in a couple years for a big investment, choose a shorter term bond. If you have a longer investment ...
... horizon, choose a longer term bond, and, generally speaking, longer term bonds usually offer higher yields.

As the length of time (maturity) in which you agree to lend you money increases, you take on some risk that things may change in the borrower's status and subsequent ability to pay. In addition, you increase the risk that interest rate changes may affect both the worth of your underlying principal, as well as the value of your interest income stream. Finally, inflation that is higher than predicted can erode both the value of your principal when you get it back, as well as reducing the value of the interest stream you receive.

In broad terms, short-term investments are safer. This is logical, in that with all other things being equal, in short periods of time there is less chance for events that could lead to a failure to repay your investment. In addition, in the event that interest rates rise, you are getting back you money quickly, and can re-invest for a higher yield. Of course, this works both ways, and in an environment of falling interest rates, you would have been better off in a longer-term investment. Most, but not all the time, short-term investments pay a lower rate of return, which is reflective of their lower risk.

Equities do have more volatility than fixed income investments, but also a higher long term return. You must know your time horizon for investments. If it is greater than ten years, the odds favor a higher return with stocks. Are your savings needed just for you and just for the next ten years, or do you have longer to invest? Is some of the money likely to be inherited by your children, who have a very long time horizon in which to profit from investments in stocks over bonds?

The second aspect of bond investing is how safe your money is. The U.S. government is considered as a risk-free borrower, as it is able to print money or raise taxes in order to repay its debts. All other borrowers have some risk of default and offer a higher rate of interest in compensation. There are rating agencies that assess a borrower's ability to repay debt, however there is always the unknown risk of individual company situations lurking in the past. Debt holders of Enron and WorldCom probably slept well until near the end for both companies. Higher rated bonds carry a lower rate of interest reflecting their increased risk of default. Those companies who are most likely to default issue bonds considered junk or high-yield, which pay a much higher rate of interest to compensate for the likelihood that a certain percentage of the companies' default. When investing in fixed income assets besides U.S. Government securities, it is best to consider bond funds of varying maturity (or duration) rather than individual bonds in order to spread out the risk of individual company problems.