How bonds work, and why they may belong in your portfolio.
You've probably heard the advice: As you approach retirement, it's a good idea to move money gradually from stocks to bonds. "Shifting your portfolio more toward bonds reduces volatility and increases the consistency of returns," says James R. Schaffer Jr., an investment advisor at Waypoint Beacon Retirement Partners in Cleveland, Ohio.
Bonds are likely to play an increasingly important role in your portfolio as you move closer to retirement — a time when investment dividends and savings may be your primary sources of income. Consider the points in this bonds primer:
How bonds work
Bond features are relatively straightforward:
- When you buy a bond, you're effectively lending money to a company or other borrower. You are then repaid the principal plus interest.
- The interest rate and payment schedules of bonds are predictable. Because of this, they are potentially a stabilizing element in an investment portfolio.
- Bond funds own many securities, and the interest they pay varies depending on the securities they hold. Unlike individual bonds, bond funds don't have a maturity date — so while they're typically stable, there is no guarantee that you'll get your initial investment back.
Types of bonds
These securities come in a few major varieties:
- Treasury bonds are issued by the U.S. government. They are the safest kind of bond and typically offer the lowest potential return.
- Agency bonds, issued by some government agencies or government-sponsored entities, such as Federal Home Loan Mortgage Corp (Freddie Mac), aren't quite as safe as Treasuries, but may offer slightly greater returns.
- Investment-grade corporate bonds are debt securities of companies with strong finances. Their return potential and risk generally are higher than Treasury or agency bonds.
- High-yield bonds are issued by companies with weak finances. They offer the potential for strong returns — as well as large losses.
- Municipal bonds are issued by state and local governments. The interest they pay is exempt from federal tax and, in some cases, from state and local tax as well.
Factors that impact pricing
Bonds can be traded among investors, and a number of factors affect a bond's price when it changes hands.
- Interest rates. When interest rates rise, prices of existing bonds generally fall. The reason: New bonds pay higher interest rates than older bonds, making the older bonds less appealing to investors. Conversely, when rates fall, prices generally rise for existing bonds.
- Inflation. Inflation erodes the buying power of a bond's payments. When investors expect inflation to rise, the price of bonds usually drops.
- Credit risk. This is the risk that the issuer may not be able to repay the face value of the bond.
Typically, a retirement portfolio needs a source of stability. In many cases, bonds may be an important part of the source.
Fast Fact: It's easy to get confused by the term "U.S. Treasury Securities" because there are several types. Here are three examples:
- Treasury bonds pay interest every six months and mature in 30 years.
- Treasury bills are short-term government securities with maturities ranging from a few days to 52 weeks. The bills are sold at a discount from their face value.
- Treasury notes are government securities that are issued with maturities of 2, 3, 5, 7 and 10 years and pay interest every six months.
What's right for you?
Bonds can be one way to help diversify your portfolio as you get closer to retirement. In retirement, they can be part of a strategy to provide part of your income, while other retirement funds may be invested for growth potential.
Investors should carefully consider mutual fund's investment objectives, risks, charges, and expenses prior to investing. A prospectus, or summary prospectus if available, containing this and other information can be obtained by contacting a financial professional, visiting principal.com, or calling 1.800.547.7754. Read the prospectus carefully before investing.
Investment options are subject to investment risk. Shares or unit values will fluctuate and investments, when redeemed, may be worth more or less than their original cost. It is possible for an investment option to lose value.