In this section, we will discuss setting goals for investing in bonds. This section is not designed to give you a primer on bonds given the plethora of sources out there that provide sufficient overviews (I have provided links to some of the better ones below). Instead, we will focus on the key components of choosing an investment that matches your personal goals and strategy.
If you do not have a good background in bond investing, I suggest reading through the following sources:
- Investopedia – “Bonds”
- The Motley Fool – “How to Invest in Bonds: A Step-by-Step Guide”
- Project Invested – “What Factors Should You Consider When Investing in Bonds”
Furthermore, if you are not interested in investing in individual bonds (given the time and knowledge commitment required to get there), review some of the differences in investing in bonds and bond funds below (my only specific suggestion is to play close attention to bond fund fees, that could also be a critical factor outside of the actual management of the portfolio):
- CNBC – “Bonds vs Bond Funds: What you Need to Know Now”
- Fidelity – “Bonds vs Bond Funds”
- The Balance – “Investing in Bonds versus Bond Funds”
Setting Goals for Bond Investing
The sheer size of the global bond market (estimated to be over $100 trillion) provides investors with numerous investment options. Some of these investments have traditionally been seen as “safer” than investing in stocks. Some of these investments have funky features (such as call/put options, conversion features, etc.). Some of these investments provide certain tax advantages (e.g., municipal bonds). As part of your investment plan, we will focus today’s discussion on a few items:
- Time Horizon
- Risk Taking and Risk Management
Bonds can be structured to have short-term maturities (0-5 years), medium-term maturities (5-10 years), and long-term maturities (10+ years). Different investors may differentiate the categories for maturity length, but this summary should suffice to get the point across.
In the case of figuring out your time horizon, it can be as simple as counting the years until your child goes off to college to as difficult as figuring out how many bonds you will need to provide income through your retirement. A few suggestions:
- Be honest and conservative in your assumptions
- There are always multiple time horizons for your savings plan, make a plan for each one
- Think about potential scenarios where you may need money
- Think about inflation over the long run and if it will impact your time horizon assumptions
- Your emergency fund is your best friend, time horizons are meaningless if you do not have a reserve in case the market drops really fast
Risk Taking and Risk Management
For individuals entering into retirement, traditional investment theory dictates most of your portfolio should be allocated towards investment grade (discussed below in the risk taking and risk management section) bonds. A rule of thumb often portrayed is to subtract your age from 100 to determine the percentage allocation in your portfolio (e.g., if I am 75, then 75% of my portfolio should be in bonds).
However, as you will often note, real world application of finance theory often falls flat in real world applications. For example, if the size of the portfolio relative to retirement needs is quite large, an investor will often elect to invest more in stocks in order to potentially maximize their estate. In addition, different portfolios may have different goals, such as saving for an expensive purchase (Harley or a boat), children’s education, or an emergency reserve.
Although we will discuss some of the strategies in later posts, here are some of the risk-based items you will need to think through:
- Credit Rating / Default risk – What is the rating of the company and where do you expect this to trend in the future or over your time horizon?
- Credit Spread relative to comparable credits and market indices – Are you getting a good deal at the price you are paying?
- Financial and operating leverage of the company – Can small swings in the company impact your investment?
- Industry of the company – What are certain industry drivers and what part of the business cycle is the industry currently experiencing?
- Duration / Interest rate risk – How quickly will rates rise (obviously you will need to consider the opposite as well, but our low interest rate environment contributes to this specific discussion)?
- Inflation risk – Is nominal or real return more important to you?
- Liquidity – Will you be able to sell when you need to?
There are obviously a lot of factors to consider when setting up a strategy. The issue some investors have is that they read online for various bond investing strategies and try to fit their personal situation to fit the strategy. Rather, you should think more about your situation and pick the appropriate strategies to meet your goals. This will also allow you to make the right sacrifices, correctly set your risk parameters, and focus your attention on specific details you will need to succeed.