How bonds fit in retirement planning

When planning for retirement, looking at bonds can fundamentally shift how secure you feel about your financial future. At the age of 50, bonds become a crucial part of diversifying your portfolio, given their ability to provide steady income and reduce overall risk. Compared to stocks, bonds offer lower returns on average, but they come with a lot less volatility—making them ideal as one draws closer to retirement.

Thinking back, remember the 2008 financial crisis? People who were largely invested in stocks saw their portfolios hit rock-bottom. In contrast, those who had a healthy mix of bonds managed to safeguard a portion of their wealth. Let’s look at some numbers. During that period, the S&P 500 Index fell by approximately 38%, whereas investment-grade U.S. bonds, represented by the Barclays U.S. Aggregate Bond Index, had a positive return of about 5.24%. Quite a difference, right?

Now, you might wonder why bonds offer a sense of stability. The answer lies in their structure. Bonds essentially are loans you give to the government or corporations in exchange for regular interest payments and the return of principal at maturity. For instance, Treasury bonds (T-bonds) issued by the U.S. government are considered some of the safest investments because they are backed by the “full faith and credit” of Uncle Sam. Given a T-bond’s low-risk profile, these securities often carry a modest yield of around 2-3% annually. Despite the lower return, the assurance of your principal amount back makes bonds a go-to for conservative investors.

So, how many bonds should you hold? That’s a common question that doesn’t have a one-size-fits-all answer. Generally, financial experts suggest that your bond allocation should be around your age. For example, at age 60, having 60% of your portfolio in bonds can offer a good balance between growth and income. John Bogle, the founder of Vanguard, advocated for the “age in bonds” rule; that is how he built the entire philosophy of his investment strategy.

Concerning different types of bonds, let’s touch on corporate bonds. While these carry higher risk than government bonds, they also offer better returns. Companies like Apple or Microsoft issuing bonds tend to be very reliable albeit with a slightly higher risk compared to government bonds. The yield on these bonds can sometimes range from 3% to 7%, depending on the credit rating of the issuing company. In 2021, Apple issued bonds with yields varying from 0.55% to about 2.7%, offering investors different choices based on their risk appetite.

Municipal bonds (or munis) are another attractive option. Issued by states or local governments, these bonds often come with the added benefit of being tax-free, which can be particularly advantageous for high-income earners. For example, with a yield of around 2-3%, the tax-adjusted equivalent return might be higher depending on your tax bracket. In 2020, municipalities issued over $456 billion worth of bonds indicating a strong, ongoing interest in this relatively low-risk investment.

One critical consideration is the bond’s maturity. Short-term bonds, maturing in less than three years, offer lower yields but also less risk. Long-term bonds, maturing in 10 years or more, offer higher yields at the expense of greater interest rate risk. Suppose you bought a 10-year Treasury bond at a yield of 1.8% in 2016. If you decide to sell it in 2019 when interest rates have risen to 2.5%, you’d likely face a loss due to the inverse relationship between bond prices and interest rates. Timing matters!

If you’re wondering about the costs associated with investing in bonds, they are generally low. Most online brokerage accounts offer bond trading with minimal fees—sometimes as low as $1 per bond. Given the features of bonds, even accounting for inflation, an investment in bonds in 2020 had an inflation-adjusted yield near zero but still guaranteed more capital preservation than an investment heavy on stocks.

Additionally, consider bond funds or ETFs if you prefer not to buy individual bonds. These instruments offer immediate diversification. The Vanguard Total Bond Market ETF (BND), for example, has an expense ratio of just 0.035%. These funds track a broad index of bonds and can be a hands-off way to gain exposure to the bond market.

So, why are bonds a good fit for your retirement plan? The answer revolves around their stability, regular income, and role in diversifying a portfolio. If you’re looking to dip your toes into bonds, this Investing in Bonds guide offers actionable insights. Given their various forms and roles, bonds adapt seamlessly to different investor needs for ensuring financial security as one ages.

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