As you know, the stock market has attracted a lot of attention – and for good reason, as we have experienced considerable volatility almost since the start of the year. But if you own bonds or bond-based mutual funds, you might also have concerns. However, it is important to understand why bonds should continue to be an important part of your portfolio.
To get started, let’s look at what’s been going on with bond prices recently. Inflation has warmed up, leading the Federal Reserve to raise interest rates to help “cool” the economy. And rising interest rates generally increase bond yields – the total annual income investors earn from their “coupon” (interest) payments. Rising yields may cause the value of your existing bonds to fall, as investors will want to buy newly issued bonds that offer higher yields than yours.
And yet, despite this possible decline in their value, the bonds you own can still help you progress towards your financial goals. Consider these benefits of bond ownership:
Revenue – No matter what happens to the value of your bonds, they will continue to provide you with income, in the form of interest payments, until they mature, provided the issuer does not default — and defaults are generally unlikely with higher quality bonds (those rated BBB or higher). Your interest payments will stay the same for the life of your bond, which can help you plan your cash flow and expenses.
Diversification – As you’ve probably heard, diversification is the key to successful investing. If you only owned one type of asset, like growth stocks, and the stock market was down, as has happened this year, your portfolio would likely have taken a hit – even bigger than one you may have known. But bond prices don’t always move in the same direction as stocks, so the presence of bonds in your portfolio – along with other investments, such as government securities and certificates of deposit – can help reduce the impact of volatility on your holdings. (Keep in mind, however, that diversification by itself cannot guarantee profits or protect against all losses in a declining market.)
Reinvestment Opportunities – As mentioned above, rising interest rates and higher yields may reduce the value of your current bonds, but this same development may also provide you with favorable reinvestment opportunities. If you own bonds of varying durations – short, medium and long term – you should regularly have bonds maturing. And in an environment like today, you can reinvest the proceeds of your maturing short-term bonds in new ones issued at potentially higher interest rates. By doing so, you can potentially get yourself more income. Also, by owning a combination of bonds, you will always have the longer-dated ones working for you, and these bonds usually (but not always) pay a higher interest rate than the short-dated ones.
It might not be nice to see the current value of your bonds drop. But if you don’t sell them before they mature and take advantage of the opportunities presented by higher yields, you’ll find that owning bonds can still be a valuable part of your investment strategy.
Before investing in bonds, you should understand the risks involved, including credit risk and market risk. Bond investments are also subject to interest rate risk, so when interest rates rise, bond prices may fall and the investor may lose the value of the principal if the investment is sold before the deadline.
Jennifer Barrett (AAMS) is a local financial advisor to Edward Jones.
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Edward Jones, its employees and its financial advisors are not estate planners and cannot provide tax or legal advice. You should consult your estate planning attorney or qualified tax advisor about your situation.