Hey! Wanna buy a bond?
In bull markets, selling bonds to retirement investors is a tough job. Most folks -- especially those more than a few years from retirement -- tend to want to stick with stocks. And with good reason. Over long periods and through a full range of market cycles, stocks beat bonds.
But that hasn't always been the conventional wisdom. Once upon a time, the sages of Wall Street preached old-fashioned asset allocation. You should hold both stocks and bonds in your retirement portfolio, the old wisdom went, because bonds tend to be up when stocks are down.
Sages and Fools alike still preach asset allocation, but the new wisdom has more data at its disposal. These days, we diversify among different classes of stock and (usually) reap higher returns as a result. The advisors of the Fool's Rule Your Retirement newsletter service don't recommend holding bonds at all until you're within 10 years of retirement.
For most people, that's good advice.
But if market volatility is keeping you up at night -- and if you're nearing retirement and still mostly invested in stocks, it should be -- the bond market could be your new best friend.
Complementing your stocks, not replacing them
To be clear, I don't think you should sell all of your stocks -- or even the majority of them -- and replace them with bond investments. Unless you're already in retirement, your bond exposure probably shouldn't exceed 30% of your overall retirement portfolio. At that level, well-chosen bonds complement your stock investments and lower your portfolio's overall volatility while you still keep pace with inflation.
Bonds remain a mystery to many investors, but the basic concepts are pretty simple:
- When you buy a bond, you're buying a piece of a loan. The borrower -- the bond's issuer -- pays a particular interest rate over a set term, at which point the principal is repaid.
- The value of that piece-of-a-loan will fluctuate over time as prevailing interest rates and the creditworthiness of the issuer change.
- Inflation can also drive down the value of a bond -- but some bonds have inflation-protection features to compensate.
To help you find your way, most bonds have ratings, third-party assessments of the risk of the bond. These take into account both the creditworthiness of the issuer and the details of the bond itself and are generally very reliable, despite the messes that rating agencies Moody's (NYSE:MCO) and McGraw-Hill (NYSE:MHP) unit Standard & Poor's found themselves in as the subprime-mortgage market collapsed.
Some bonds, particularly municipal bonds and complex derivatives, also come with insurance. Generally, issuers use insurance to get higher ratings for their bonds. But watch out -- those ratings can be deceptive, as leading insurers Ambac (NYSE:ABK), MBIA (NYSE:MBI), and Assured Guaranty (NYSE:AGO) are currently finding out the hard way.
Spurred by those troubles, Warren Buffett is bringing Berkshire Hathaway's (NYSE:BRK-A) (NYSE:BRK-B) treasure chest and high standards into the bond insurance business, which should shield straight-ahead issuers such as municipalities from the worst of the subprime fallout.
Which bonds to buy?
There are many different types of bonds, with different characteristics depending on the term (how long until you get your principal back), issuer, rating, and inclusion of various features such as insurance or inflation protection. Although bond basics are not complicated, sorting through the huge array of bonds available can be a tedious struggle -- unless you have some help.
In the new issue of the Fool's Rule Your Retirement, lead advisor Robert Brokamp cuts through the confusion and offers up straightforward advice on bonds for retirement investors. I'll direct you to the new issue for the full scoop -- yes, it's a paid service, but you can get a free 30-day pass with no obligation, so click with confidence -- but briefly, his article walks through the pros and cons of direct bond investments, bond funds, municipal bonds, Treasuries, and short-term investments.
You can also look at the bond recommendations in Rule Your Retirement's "Asset Focus" section, where you'll find specific, ready-to-go investments. Check it out at no cost with a 30-day trial subscription -- there's no obligation to subscribe.
