If you read our article Bonds: balancing risk with reward, you’ll have seen that investing in bonds isn’t entirely risk-free. We also discussed how market conditions dictate that some times are better than others when you’re deciding whether to invest in bonds. But what about your own circumstances? They also play an important role when you’re deciding when and if you should consider bonds.
When you should consider bond investments
Bonds are typically held alongside equities as part of a long-term – 10 year plus – portfolio, by people saving up for a long-term goal such as retirement. The balance between equities and bonds within a portfolio will depend upon your own attitude to risk and how much you’re prepared to risk losing. Our article Shares: are there good and bad times to buy? tells you more about this.
People who choose to draw income over the course of their retirement (income drawdown), also typically hold a portfolio comprising a mix of equities and bonds. However, it is important in this situation to also hold at least one year’s worth of income as cash and ideally two or three years’ worth.
Investing your whole retirement income drawdown fund in bonds is likely to produce a lower lifetime income than buying an annuity. The reason for this is that annuities also invest in fixed income investments but people who hold annuities gain an ‘extra’ return from those who die earlier than average. That said, income drawdown offers more flexible income withdrawal options and death benefits than annuities.
Another way retired people use bonds, particularly in the US, is to match their income needs with bonds of a similar duration. For example, to fund next year’s income, they buy a one-year bond, for the year after that, a two-year bond, and so on. This approach is called a ‘bond ladder’. Because you are buying a known income yield, and a known return of the face value on a given date, you can plan with some confidence – although inflation might eat away expected returns, particularly over longer periods. Remember also that the overall return may be reduced by issuers of the bonds you hold defaulting on the coupon or repayment of the nominal value.
Bonds historically have a low correlation with equities, meaning the price of these two types of investment don’t usually move in a similar way at the same time. This means that in a balanced portfolio that includes equities and bonds, a rise in one asset may offset a fall in the other. However, you should always remember that past performance is not a guide to the future, and there have been periods in the past when equities and bonds have moved in the same downward direction at the same time. As with many types of investment, you should remember that you may not get back what you invest.
When you should avoid bond investments
In general, bond investments can be volatile. Although bonds may feel like cash deposits, their price can fall substantially and over a relatively short period. However, if you are happy with the redemption yield at the time you buy the bond and you think the risk of your return being negatively impacted by defaults is low, then bonds could still be considered.
If your goal arises within the next five years, consider cash as an alternative. Although returns are very low at the moment, when you hold cash, the risk to your capital is low. Examples of this sort of goal might be funding a child’s higher education costs where they are due to go to university within the next two or three years.
If bond investments are outside your risk tolerance or your capacity for loss, they are also best avoided. Instead, you might go for solutions that are more predictable, such an annuity, where the insurer bears the investment risks.
There are very few situations where investing all of your savings in bonds makes good financial sense. Diversifying your investments and holding some rainy day savings as cash gives you more options when markets are turbulent.
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