Your 20s and 30s are a good time to invest heavily in stocks, which have historically generated much higher returns than bonds. But as you inch toward retirement, you'll need to start shifting some of your investments into a safer, less volatile alternative to stocks. That's why your 40s are a great time to dabble in bonds.
How much to invest
Though it's a good idea to invest in bonds in your 40s, because retirement is still pretty far off, you shouldn't jump to unload all of your stock positions in favor of bonds -- just some. You see, you'll need a substantial nest egg to cover your living expenses in retirement. Though bonds are generally safer than stocks, they don't offer the same growth potential. And if you want to grow your retirement savings balance enough to outpace inflation, you'll need to keep the majority of your investments in stocks until you're knocking on retirement's door.
Imagine you're able to invest $5,000 a year starting at age 45. With a bond-heavy portfolio, you might only generate a 4% average annual return, which means you'd be looking at a balance of about $160,000 by the time you reach 65. On the other hand, if you keep most of your portfolio in stocks and score an 8% return, you'll be looking at $252,000 when you reach 65 -- over $90,000 more.
Of course, you'll need to balance your desire for growth with your appetite for risk. If the idea of losing money is enough to induce a panic attack, then a portfolio that's 30% to 40% bonds might be best for you. On the other hand, if you're comfortable taking on risk, then you might opt to put just 10% of your assets into bonds. Fall somewhere in the middle? Consider a 20% bond allocation in your 40s. (Keep in mind that these figures assume that your investments are earmarked for retirement, rather than a shorter-term objective like paying for college, in which case you might adopt a different strategy.) Remember, bonds are a lower-risk alternative for building wealth, but they can't take the place of stocks.
Municipal vs. corporate bonds
Once you decide to invest in bonds, your next move is deciding which type. There are corporate bonds, which are issued by public companies, and municipal bonds, which are issued by cities, townships, and states. While corporate bonds have historically outperformed municipal bonds, municipal bonds offer the distinct advantage of paying interest that's tax-free at the federal level. Buy municipal bonds issued by your home state, and your interest is exempt from state taxes as well.
Let's say you want to invest $10,000 and find a corporate bond paying 4% versus a municipal bond issued by your home state paying 3%. Your corporate bond will pay you $400 annually in interest, whereas your municipal bond will pay just $300. But if your effective tax rate is 30%, then you'll fork over $120 of that corporate bond interest to your pals at the IRS, which means you'd actually come out ahead buying the municipal bond. At a time in your life when you're conceivably earning more money than you were, say, a decade ago, lowering your tax burden has some appeal.
If you're stuck between municipal and corporate bonds, it pays to calculate their tax equivalent yields to determine which makes the most sense.
Individual bonds vs. bond funds
Another decision you'll need to make is whether to buy individual bonds versus bond funds. The benefit of individual bonds is that generally, you know what you're getting into. Assuming the bond issuer doesn't default, you can anticipate how much interest you'll get each year, when you'll get it, and when you'll receive your principal investment in return.
Bond funds work differently. When you invest in a bond fund, you're buying a stake in the various bonds that fund holds. One major benefit of bond funds is diversification. If you own an individual bond and it defaults, you might take a big financial hit, but if you own a fund holding dozens of bonds, then you may not even notice if one defaults. Another advantage of choosing a fund is that its managers do all the research for you. That said, your income stream will be less predictable, as you won't be able to sit back and collect interest payments as you would with an individual bond, and you'll lose some of your proceeds to fees.
If you're looking for a good starter fund, consider the Vanguard Total Bond Market ETF (NYSEMKT:BND), which offers a wide range of U.S. investment-grade bonds at a relatively low cost. Its expense ratio is a minuscule 0.07% of assets, and its holdings consist of U.S. government bonds and other bonds with ratings of "Baa" or higher.
Bonds are not risk-free
There's also interest rate risk to consider. Whenever you buy bonds, be it individually or through a fund, you risk losing money if interest rates go up (the logic being that if newly issued bonds offer higher returns, then yours will automatically decline in value). If you buy individual bonds and hold them until maturity, you won't lose money off their face value. But because bond funds don't tend to hold bonds until maturity, if you invest in a fund, you have less control in eliminating interest rate risk.
No matter which bond investments you choose, if all goes well, you'll generate a steady, reliable source of income while offsetting some of the risk that comes with buying stocks. It's a smart move to make at a point in your life when time is still mostly, but not completely, on your side.
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