Time to give bonds and CDs a closer look
Traditionally, financial advisers have urged investors to allocate 60% of their portfolios to stocks and 40% to debt instruments. This approach made sense during bull markets for stocks, when the average return for a diversified stock portfolio performed much better than for a diversified bond portfolio.
Lately, however, the Federal Reserve has been increasing interest rates to curb inflation. The result has been that returns for investments in certificates of deposit, money market funds, and bonds with short and long maturities have increased dramatically.
Many market forecasters predict that stock returns in the near future will be much lower than in the past. Average stock returns in the last few years have been poor.
In 2022, the returns for both stocks and bonds were poor. For most of 2023, most stock indexes had very good results, but now all of the gains have fallen back to levels at the start of 2023, so if you look at the average returns of most indexes, stock returns over the last two years have been mostly negative.
As recently as the beginning of 2022, the returns on investments in short-term debt instruments were much less than 1%.
But with the recent increases in interest rates, even very conservative debt investments — such as CDs with various maturities, money-market funds, short- and long-term Treasury instruments, and high-quality corporate bonds — carry attractive interest rates often exceeding 5%.
The current attractive interest rates, coupled with the uncertainty and risks of traditional common stock investments, are leading many investors to change their portfolio balance more in favor of bonds and fixed-income securities.
Bonds also have risks
If you are planning to invest more heavily in bonds, you need to understand the risks involved.
Interest rate risk. When you purchase an individual bond, or invest in bond funds or bond exchange-traded funds (ETFs), the value of the investment will fluctuate based on changes in interest rates. This is an inverse relationship to interest rates. That is, when interest rates increase, the value of individual bonds decreases.
If you purchase individual bonds and hold them to maturity, you will receive the par value of the bond. You receive your principal back.
But when you purchase mutual funds or ETFs, the manager is constantly buying and selling shares, so an increase in interest rates will reduce the value of your investment. You don’t have the option of waiting until the portfolio matures.
Therefore, unless you are investing on a long-term basis, you should only invest in bond funds and ETFs with short maturities to protect your principal.
Credit risk. The safest bond/debt instruments you can buy are issued by the U.S. Treasury. You can obtain higher interest rates with corporate bonds, but you incur the risk of default (in which case your interest payments are stopped or missed for a period), or downgrading (in which case the bond price may fall significantly).
You should select bonds with the highest ratings. Standard & Poor’s and Moody’s ratings are reliable yardsticks to measure credit risk.
Call risk. Many bond issues, including municipal bonds, allow the issuer to retire all, or a portion, of the bonds at premium or par before maturity. Before purchasing individual bonds, make sure you understand any call provisions.
Personally, I have increased the percentage of debt holdings in my portfolio, investing a significant portion of my portfolio in federal money-market funds, which now return over 5%.
Significant advantages of money-market funds are liquidity and safety. You can sell your shares any time.
So, if you decide that you want to increase your common stock holdings in the future, you can dollar-cost average back into the stock market by investing in diversified index funds. You can use this approach both within or outside your retirement plan.
Bottom line: There are now many safe debt instruments that provide high returns with short and long maturities. Don’t assume that your only investment option is maintaining a high proportion of common stocks in your portfolio.
Elliot Raphaelson welcomes your questions and comments at email@example.com.
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