Fixed-income investments, such as Treasurys and corporate and municipal bonds, can provide both income and stability to a portfolio.
While overall returns of fixed-income tend to be lower than the stock market, the amount of volatility also is much lower and offers steady returns over a longer period, which is attractive to retirees and investors who want less risk.
Bonds tend to maintain a low correlation to stocks, says Viraj Desai, senior manager of portfolio construction at TD Ameritrade, an Omaha, Nebraska-based brokerage firm.
"Historically when stocks have sold off, bonds have outperformed and when stocks have rallied, bonds have underperformed," he says. "When paired with stocks in a diversified asset allocation, bonds can potentially reduce the volatility profile of a portfolio and may also improve the portfolio's risk adjusted returns."
Here are important things to know about bonds:
-- Ways to invest in bonds.
-- How bond mutual funds compare to bond ETFs.
-- How to use target-maturity bond funds.
-- Potential pitfalls of adding bonds in 2020.
Ways to Invest in Bonds
Investors can opt to add either bond mutual funds or exchange-traded funds to a portfolio. Adding bond funds provides diversification to a portfolio that contains equities. Mutual funds include thousands of bonds with different maturity dates and lower the amount of risk an investor faces even more. ETFs perform more like a basket of stocks and offer broader exposure while providing a steady income.
"Mutual funds and ETFs are similar in that they are large pools of investor capital that invest across thousands of bonds providing diversification for investors," Desai says.
Government and corporate bonds have maturity dates that range from a few months up to 30 years. The issuer pays the principal value of the bond to the investor when the bond matures. A shorter maturity has less risk to interest rates rising and results in the investor receiving a lower yield.
Toggling between stocks and bonds in a portfolio can help investors lower their risk.
"Investors with shorter time horizons may benefit from higher allocations to bonds and vice versa," Desai says.
A portion of clients' portfolios have been allocated to corporate bonds to lessen the volatility, says Ron McCoy, CEO of Freedom Capital Advisors in Clermont, Florida.
"We typically invest in shorter maturities of seven years or less and caution clients about going out too far on the yield curve," he says. "The run-up in bonds this year is mostly due to the Fed cutting rates three times due to a slowing economy."
Municipal bonds are considered a safe asset because their debt is issued by a government agency or city or state. The issuer pays the face value of the bond when it matures, plus the annual interest. Municipal bonds are tax-free if you meet certain residency rules.
How Bond Mutual Funds Compare to Bond ETFs
Many mutual funds are managed actively while ETFs replicate common benchmarks like the Bloomberg Barclays Aggregate Bond Index.
"Due to the passive nature of these ETFs, they tend to have lower fees and expenses associated with them compared to mutual funds," Desai says.
Some investors prefer to choose several individual bonds to add to a portfolio to have more control over the types and maturities of bonds, but the strategy is a more complex process, he says.
"With individual bonds, investors can have more control over the timing of their income and maturity streams and also do not have to worry about day-to-day fluctuations in net asset value," Desai says.
One commonly used investment strategy is bond laddering, which diversifies a portfolio by purchasing bonds with staggered maturities, says Mike Loewengart, vice president of investment strategy at E-Trade Financial, a New York-based brokerage company. "Building a bond ladder requires discipline and some homework, but a bond fund with a similar strategy can be simpler to implement."
How to Use Target-Maturity Bond Funds
Target-maturity bond funds determine a maturity date and invest only in bonds that mature at that set date.
"In this way, the fund acts as a bond for investors that value the liquidity of holding something that is easily traded," Desai says. "When the fund matures, it is liquidated to investors rather than cash flows being reinvested. In theory, the funds may help investors build bond ladders if they cannot access individual bonds and provide them with more control over their income streams at a higher liquidity."
These funds have their own risks because they are subject to fluctuations in net asset value and as investments "come in and out at different times over the course of the fund's life, the principal that is returned when the fund matures may be less than the original investment," he says.
In addition, any return of principal is impacted by the fees charged by the fund.
Potential Pitfalls of Adding Bonds in 2020
Bonds typically do well in periods of falling economic growth while equities perform better in periods of economic growth, says Jodie Gunzberg, chief investment strategist at Graystone Consulting, a Morgan Stanley business.
The main risk to most bonds is how interest rates move.
"Generally as interest rates rise, bond prices fall," she says. "Given the low level of rates to start 2020, some people are concerned rates have a higher chance of rising than falling."
Interest rates have been persistently low in 2019 and this has affected bonds, Desai says.
"This has been due to a cycle defined by accommodative monetary policy that has suppressed rates over the course of the business cycle," he says.
One potential risk to bonds is the prospect of additional interest rate hikes. A less accommodative monetary policy could move rates higher, which would lead to underperformance in bonds.
Both corporate and high-yield debt face even more potential pitfalls because underperformance could also arise if the macroeconomic picture of the economy continues to weaken, "leading to a rise in defaults and higher spreads charged to assume credit risk," Desai says.
While including bonds is typically a conservative investment strategy, they are not without some risk, Loewengart says. Bonds are traded in the securities markets and there is always the chance that your bonds can drop in price, especially in low interest rate environments.
"Keep in mind that the duration of a bond is a measure of a bond's price sensitivity to interest rate movement," he says. "With a longer duration you could be more susceptible to interest rate risk. In a low interest rate environment, investors are on the hunt for yield and might give into the temptation of sacrificing quality for returns with lower rated bonds. These bonds have amplified credit risk and are even more vulnerable to changing economic conditions."
The current "rich valuations translate into lower expected long-run returns," Gunzberg says.
Given the yields and expected returns at record lows, bonds may no longer be as effective.
"Bonds still provide a volatility buffer, but extreme valuations create a drag on portfolio returns in normal times and a hurdle to decorrelation and hedging in bad times," she says.
More From US News & World Report