When you hear the phrase "low-risk investment," what do you think of? If you said bonds or fixed income, you aren't alone. Generally, people think of bonds as a low-risk investment and a great way to protect their nest egg before and during retirement. However, this is a very misguided assumption. Here's what you need to know about the risks involved with bonds and how to mitigate that risk in your portfolio.
Bonds are safe, right?
Why wouldn't bonds be completely safe, especially if you buy U.S. Treasuries or investment-grade corporate bonds? They pay you a steady income until the bond matures, and then give you your original investment back. What's not safe about that?
The issue is what happens between now and when the bond matures, specifically with regard to interest rates. And the current environment of near-record-low rates adds an extra degree of risk. Specifically, if rates rise, investors expect more of a return on their investments, so the bonds you own that pay very little interest won't be worth as much in the eyes of the market.
Not all bonds have the same risk
The bonds that pay the most are generally those that have the longest maturities. For example, a 30-year Treasury pays more than a 10-year.
To illustrate this, let's say that you buy a 30-year Treasury bond with a coupon rate of 3%. Given that the bond costs $1,000, you'll receive $30 in income every year. However, if 30-year Treasury rates jump to 5%, investors will begin expecting $50 in annual income for every $1,000 they invest.
In order for your bonds to attract investors on the open market, they'll need to drop in value to deliver roughly the market rate of return, or 5%. For your 3%-yielding Treasuries to deliver 5% returns, their face value would have to drop from $1,000 to about $600. Of course, this is just an estimate, and your bonds would likely be worth a little more, as they would still return $1,000 upon maturity, but the principle stays the same.
Now, if you hold your fixed-income investments until maturity, this shouldn't be too much of an issue for you, because all you really care about is the income they provide. However, what if you have to sell some of your bonds to free up some cash? If interest rates are substantially higher at that time, you could be forced to sell for a big loss.
A better way to lower risk: bond ladders
One way to take some of the interest-rate risk out of bond investing is to create a "bond ladder." Essentially, this means you stagger the maturity dates of your bonds in order to create an acceptable level of income while leaving an opportunity to take advantage if rates rise.
An example of a bond ladder would be to split your money five ways. One-fifth of your money would be used to buy bonds maturing in five years, one-fifth would mature in 10 years, and so on. The longer-dated bonds would deliver a high return, and every five years some of your bonds would mature, and you could use the proceeds to buy new long-dated bonds at the prevailing interest rates.
Of course, this is a simplified explanation. For a more in-depth look at bond ladders, read this article.
Another great way to lower risk: the right kind of stocks
A lot of investors mistakenly equate the words "stocks" and "risk," but stocks aren't necessarily risky; it depends on what kind of stocks you're talking about.
If you invest in high-quality dividend growth stocks, you'll create an income stream similar to what you can expect from bonds, with a couple of added advantages. First, if you buy stocks with strong records of dividend increases, like the "Dividend Aristocrats," your income stream will grow over time. For example, stocks like Johnson & Johnson (NYSE:JNJ) and Procter & Gamble (NYSE:PG) have averaged annual dividend increases of 8% and 9.5%, respectively, over the past decade.
And the principle value of your investment will most likely rise over time as well. Smart investors know that rock-solid companies like the two I just mentioned actually tend to outperform the market over time. On the other hand, if you invest $10,000 in bonds that mature in 20 years, your investment will still be worth $10,000 after that time passes.
The perfect income portfolio?
So which is the way to go for you -- a bond ladder or a portfolio of rock-solid stocks? Probably both, and the best combination for you depends on a few factors, particularly your age.
Younger investors should have more of their long-term portfolio in stocks. They can gradually allocate more to bonds as they get older, all while following the principles of bond ladders and high-quality stock investing. A popular rule of thumb is to take your age and subtract it from 110, and then allocate that percentage of your portfolio to stocks. More important than pinning down an exact allocation is making sure you do a good job of managing risk while giving your money the opportunity to grow.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Johnson & Johnson and Procter & Gamble. The Motley Fool owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.