- Owning bonds may potentially reduce fluctuations in your portfolio.
- Diversification helps investors manage their portfolios’ risk and return.
- Many retired investors shift a portion of their portfolios to bonds to help meet their income needs.
Why investors own bonds
With interest rates as low as they are relative to long-term averages, it may be hard to get excited about owning bonds. At times bonds have been solid generators of return. That’s not the primary reason to own bonds, though.
It can be a sound strategy to own a mix of investments. Stocks, bonds, and cash alternatives are on most every short list. Even when bond yields are low, the diversification you get from owning bonds may help you maintain your portfolio’s value when there’s weakness in the stock market.
Investing in bonds can be an important element in your investment portfolio, helping to potentially:
- Reduce fluctuations in the overall value of your portfolio
- Contribute to meeting your income needs
- Prepare for future expenses (e.g., college and retirement)
Even if interest rates trend up, bonds can help add stability to your portfolio.
Can bonds enhance your financial portfolio?
Beyond diversification, investing in bonds can help with other goals as well, such as generating income.
Income generation. Traditional interest bearing bonds promise to pay interest regularly. They pay fixed interest payments typically semi-annually, quarterly, or monthly.
A regular schedule of fixed payments can be appealing to income investors. In fact, investors in retirement often move a percentage of their portfolios into bonds to meet annual living expenses.
Price appreciation. Bond prices tend to increase when interest rates decline. When overall rates fall below the rate a bond is paying, the bond will become attractive to investors, potentially driving up its market value. Investors are unlikely to see much price appreciation (in fact, they will likely experience a decrease in value) in a rising-interest-rate environment. In either case, however, assuming the bond does not default, it will mature at par/face value—so if held to maturity, increases/decreases in value are likely temporary.
High income earners often prefer tax-exempt bonds. Many bonds issued by municipal, county, or state governments (called municipal or “muni” bonds) are tax exempt, which means interest payments from these bonds are exempt from federal income tax and, in some cases, state and local income tax. Tax-exempt bonds may fit within your overall investment strategy, depending on your tax bracket and investment objectives.
Interest payments from these types of bonds are subject to taxation:
- Corporate bonds
- Government-sponsored enterprises (agency bonds; please note, some agency bonds are state and local tax-exempt)
- Mortgage-backed securities, including collateralized mortgage obligation (CMOs) and pass-through securities (Ginnie Maes or GNMAs)
- Taxable municipal bonds (taxable munis; this type of bond may be exempt from state taxes for the investors who reside in the state the bond is issued in)
- U.S. Treasury bonds (exempt from state and local taxes)
- Zero-coupon bonds (U.S. Treasury STRIPS are one type of zero-coupon bond and are exempt from state and local taxes)
Moderating interest rate risk with a bond ladder
You can use a bond ladder to invest in the bond market. You would build a bond ladder by buying a portfolio of bonds of different maturities. This would spread out the interest rate risk. As the bonds mature, the funds are reinvested into a new bond maturity.
Note: Investors should keep in mind as interest rates rise, existing bond prices of outstanding fixed-income securities tend to fall. Long-term bonds are generally more exposed to interest rate risk than short-term bonds. Bond laddering does not assure a profit or protect against loss in a declining market.
- If you are building sources of retirement income, consider shifting a portion of your assets to bonds.
- Determine whether diversifying the risk in your stock portfolio by owning bonds seems right for you.
- Consider a bond ladder to help moderate interest rate risk.
- Learn what other types of bonds can help diversify and add to income sources.
Note: Some municipal bonds may be subject to federal taxes or the Alternative Minimum Tax (AMT).
*Wells Fargo Advisors does not provide tax advice. You should consult your tax advisor for your specific situation. Investing in fixed-income securities involves certain risks such as market risk if sold prior to maturity and credit risk, especially if investing in high yield bonds, which have lower credit ratings and are subject to greater volatility. All fixed-income investments may be worth less than original cost upon redemption or maturity. Yields and market value will fluctuate so that your investment, if sold prior to maturity, may be worth more or less than its original cost.