Investing In Bonds And Municipal Bonds: Why Now Is A Good Time To Evaluate Taking Risk Off The Table
When interest rates are jumping and stocks are in a slump, how can you protect your money from risk in the market?
There's no silver bullet; protection often comes at a cost (less risk usually means less return). Cash, CDs, and Money Market are among the few investments you might turn to, but having your money all in cash has its own risks.
While all investing involves some degree of risk, there are ways in which you can hedge against that risk.
Investing in bonds and municipal bonds can be a great way to diversify your portfolio and help provide a steady source of income when stocks are underperforming. In this article, we will explore the benefits of investing in bonds, as well as why now may be a good time to invest in them.
All About Bonds
Understanding bonds is crucial for any investor looking to diversify their investment portfolio and manage risk.
What are Bonds?
Bonds are essentially loans made to a government or corporation in exchange for regular interest payments and the return of the principal amount at maturity.
With the current turmoil in the global economy and higher interest rates, bonds have become a popular investment. In January 2023, U.S. bond markets saw $10.52 billion in investments, the biggest weekly inflow in 18 months.
What are Municipal Bonds?
State and local governments issue municipal bonds to fund public projects such as hospitals, schools, or highways.
Municipal bonds are not a small market. At the end of 2021, the total net outstanding debt for U.S. municipalities stood at $2.13 trillion.
Why do Investors Buy Bonds?
Bonds and municipals are generally considered low-risk investments when compared to stocks, as they can provide a fixed income stream and have a predetermined maturity date.
Since 1926, large stocks have returned an average of 10% per year, and long-term government bonds have averaged 5-6% per year. Municipal bonds about 3%, and corporate bonds around 5.4% before taxes.
Investing in bonds can be a smart strategy to mitigate risk in an investment portfolio. These assets tend to be less volatile compared to stocks, providing a steady income stream and stability to the overall portfolio. Additionally, municipal bonds can offer tax advantages, which are often exempt from federal and state (if purchased from your home state) income taxes.
How Bonds Work
The issuer (government, corporation, etc.) issues bonds to raise funds for various purposes, such as financing infrastructure projects, expansion, or refinancing existing debt. Each bond has a face value, also known as the par value or principal amount. This is the amount the bond will be worth when it matures.
The bond's coupon rate is the annual interest rate that the issuer agrees to pay to bondholders. This rate is applied to the bond's face value to calculate the annual interest payments.
Bondholders receive periodic interest payments, typically semiannually or annually, based on the coupon rate and the face value of the bond. These payments can provide a consistent income stream to investors.
Bonds also have a specified maturity date, which is when the issuer repays the bond's face value to the bondholders. When the bond matures, the principal is returned to the investor.
The yield of a bond reflects the total return an investor can expect, combining both the interest payments and any potential capital gains or losses if the bond is sold before maturity. Yield can vary based on the bond's price, interest rates, and time to maturity.
Bonds can be bought and sold on the secondary market before they mature. The market value of a bond can fluctuate based on changes in interest rates, the issuer's creditworthiness, and market conditions.
Credit rating agencies assess the issuer's creditworthiness and assign a credit rating to the bond. Higher-rated bonds are considered lower risk, while lower-rated bonds may offer higher potential returns but come with increased risk.
It's important to research and understand the issuer's financial health, credit rating, and current interest rate environment before investing in bonds.
The Risks of Investing in Bonds
Just because bonds are low-risk investments doesn't mean they are no-risk investments. Potential risks of investing in bonds include:
Interest Rate Fluctuation: When interest rates rise, the value of existing bonds and municipals may decrease, potentially resulting in a loss if you need to sell before maturity.
Credit Default: This occurs when the issuer of the bond or municipal is unable to make interest payments or return the principal amount. Therefore, they default on the loan.
Inflation Risks: If inflation rises faster than the interest rate on your bonds and municipals, the purchasing power of your investment may decrease over time.
To mitigate these risks, it's important to carefully evaluate the creditworthiness of the issuer, consider the maturity of the bonds or municipals, and diversify your investment portfolio.
Why Now Is a Good Time to Reevaluate Your Investment Strategy
Anytime your circumstances, goals, or economic environment changes is a great time to revisit your investment strategy. With today’s higher interest rates and bond coupon rates, now is the perfect time to take a step back and reevaluate if you should increase, maintain, or change the bonds in your investment strategy. Higher coupon rates can mean healthier income streams, which can help boost overall returns in your investment portfolio.
In addition to healthy income streams, the importance of managing risk in your investment portfolio cannot be overstated, especially in times of uncertainty. Bonds and municipals can offer a low-risk alternative to stocks that can provide stability and steady returns to your portfolio. However, there is generally a cost, which typically comes in the form of lower total returns. Bonds have historically provided lower total returns than stocks, so while bonds can add some form of return to your investments, they are unlikely to be the driving factor.
Investing in bonds and municipals can often reduce your portfolio's overall risk and help protect your investments from market volatility. These assets tend to be less volatile when compared to stocks, which can provide a much-needed cushion in times of economic turbulence.
Maintaining a well-diversified investment portfolio is one of the best ways to hedge against risk. The right balance between stocks, cash, and bonds, however, is generally dependent on the circumstance, the individual, and your goals.
Reevaluating your investment strategy now is also a great time to ensure your investments align with your long-term financial goals. Whether you are investing for retirement, planning for your children's education, or considering your legacy and wealth transfer, bonds and municipals can be a part of the strategy to help you achieve these goals.
Benefits of Municipal Bonds for Risk Management
Municipal bonds can offer many of the same benefits as other bonds when it comes to managing risk in your investment portfolio.
Additionally, municipal bonds can offer tax advantages, particularly for those in higher income tax brackets. The interest earned from these bonds is frequently exempt from federal and state income taxes, providing an additional benefit to investors.
Furthermore, municipal bonds can provide an additional layer of diversification for your investment portfolio. By including these bonds in your investment mix, you can spread out your risk and potentially increase your after-tax returns. Diversification can be especially important during times of market volatility when certain investments may be more susceptible to swings in the market.
Overall, municipal bonds can be an excellent tool for risk management in your investment portfolio. Their low-risk nature, tax advantages, and diversification potential can make them a valuable asset for an investor looking to protect their investments while seeking steady after-tax returns.
“Safer” Investments That Aren't Bonds
While bonds are a common choice for stability, they are not the only option. Here are a few alternatives you might consider:
Certificates of Deposit (CDs): CDs are time-based deposits with a fixed interest rate and maturity date. They provide a predictable return, and as they are offered by banks, CDs are insured by the Federal Deposit Insurance Corporation (FDIC) up to certain limits, which helps ensure you get your money back at maturity.
Money Market Funds: Money market funds are mutual funds that invest in highly liquid, short-term debt instruments like Treasury bills. They can offer stability, liquidity, and a competitive yield compared to traditional savings accounts.
Annuities: Annuities are insurance products that can provide a guaranteed fixed income stream during retirement. Fixed annuities offer a predictable return, while indexed and variable annuities link returns to market performance.
Savings Accounts with High Yields: While traditional savings accounts offer minimal interest, high-yield savings accounts available through online banks often provide better rates, allowing your money to grow more effectively while maintaining liquidity.
Each of these alternatives have pros and cons, so you'll likely want to learn more and consider each in light of your overall goals.
How to Evaluate the Right Low-risk Investments for You
As you consider how to diversify your portfolio, you need to evaluate your risk tolerance. This involves understanding your comfort level with market fluctuations, your financial goals, and the time horizon for your investment. Are you willing to absorb more risk for the possible benefits of higher returns? Or do you prefer a more conservative approach?
Next, consider the specific types of bonds and municipals that align with your investment goals. Whether it’s individual bonds or bond funds consider the characteristics, their credit quality and ratings, and the overall financial health of the entities. This will help you gauge the level of risk associated with each investment option.
Additionally, don’t assume higher yield bonds and municipals automatically mean higher returns. Higher yields may indicate higher risk, so it's important to strike a balance between risk and return that aligns with your investment objectives.
By carefully evaluating these factors, you can make informed decisions and, if appropriate, choose the right bond and municipal investments that align with your investment portfolio risk and financial goals. Most importantly, you'll want to discuss any prospective changes in your portfolio with your wealth management advisor before making your investment.