Topic: How To Invest

Investing in Bonds: Here’s why we don’t think it’s the best way right now to maximize your investment returns

Investing in bonds:  Bonds are unlikely to perform as well in the next few years as they have in the past, mainly because interest rates will likely hold steady or rise further. (Bond prices and interest rates are inversely linked. When interest rates go up, bond prices go down, and vice versa.) That means bonds would only earn interest income; and instead of capital gains, they could produce capital losses

In simple terms, a bond is a form of lending whereby you lend money to a corporation or government. In return, a bond pays a fixed rate of interest during its life. Eventually, a bond matures, and holders get the bond’s face value—but nothing more. Receiving the fixed interest and face value at maturity is the best that can happen.

Furthermore, bonds also generate more commission fees and income for your broker, compared to stocks, especially if you buy them via bond funds and other investment products.

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Investing in bonds: Is it really worth it?

Back when bond rates were 8% to 10%, nearly as high as long-term historical returns on stocks, we advised investors to put between one-third and two-thirds of their portfolios in bonds. Right now, we think zero is a good proportion for bonds with a term more than two or three years. The best you can get from bonds is the 3% or 4% interest they now offer. The worst that can happen is that you’ll lose money, or at least lose purchasing power.

We’d say bonds offer you a “heads-you-break-even, tails-you-lose” situation. That’s the exact opposite of the Successful Investor ideal where the odds are more like “heads you break even, tails you win.”

Investing in bonds: Knowing their recent history helps you to understand their popularity

As mentioned, a bond pays a fixed rate of interest during its life—and when a bond matures, the holder gets the bond’s face value. Note, though, that in some cases, corporate bonds can go into default. As well, inflation can devastate the purchasing power of bonds and other fixed-return investments.

Remember that bond prices and interest rates are inversely linked. When interest rates go up, bond prices go down, and vice-versa.

Until recently, bonds were in a period of rising prices that started in 1981. That year, long-term U.S. Treasury bond yields peaked near 15%. After that, interest rates mostly moved down. However, they have now started to rise after that long downward trend.

Overall, it’s true that bonds may reduce the volatility of your portfolio. That’s because bonds and stocks do tend to move in opposite directions, up to a point. However, when interest rates on long-term bonds are so low, like they are now, that it makes no sense to hold them.

Investing in bonds: Long-term bond investing still has fans (Just not us)

Long-term bonds still have fans. You may have seen one of the handful of “asset allocation” reports that have been published in the past. These reports generally show that the top-performing investment portfolios of the past couple of decades have included a high proportion of long-term bonds—60% or more. That’s entirely true, but the reports are misleading. They leave out one of the most essential facts about investing: “Past returns are no guarantee of future results.”

Investing in stocks that follow our Successful Investor approach is a more profitable retirement strategy than investing in bonds

As mentioned, bond prices fall when interest rates rise. For example, governments injecting money into their economies could spur inflation. Higher inflation would likely prompt governments to raise interest rates.

That’s why we continue to recommend that you invest only a small part of your portfolio, if any, in bonds and fixed-income investments. Instead, focus your retirement investing on building a diversified portfolio of well-established companies with a long history of paying dividends. We recommend a number of these types of stocks in our newsletters.

We recommend this Successful Investor approach to retirement investing because equities are bound to be more profitable than fixed-return investments over long periods. That’s because equity returns are related to business profits, while returns on fixed-return investments are related to business interest costs.

A business’s profits must be higher than its interest costs in the long run. Otherwise, every business that owes money would go broke, and that’s not likely to happen. That’s why most investors should hold a large part of their money in stocks most of the time.

Returns on your stocks are sure to be more volatile than what you earn on fixed-return investments (including short-term bonds). That’s because returns on stocks are related to that part of gross profit left over after a company pays its interest costs. Still, we think stocks will continue to give you the best long-term returns.

Foreign bonds come with even more volatility due to problems with exchange controls, rate fluctuation, taxation, and nationalization. If you’ve invested in bonds before, which type have you targeted and why? Do you still have them or were they a short-term investment?

Even though bonds aren’t the profitable investment they once were, they’re still popular. If you invest in bonds, what do you like most about them?


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