If you've needed a mortgage or another type of loan over the past several years, you've probably appreciated the historically low interest rates we've experienced. But if you've wanted to own fixed-rate investments, such as bonds, you might have been less pleased with the low-rate environment.
Now, interest rates may be moving up somewhat, but even if they don't hit the heights we saw in previous decades, you can still gain some key advantages from owning bonds.
One of the biggest benefits provided by bonds is their ability to help you diversify a stock portfolio. Stocks and bonds often move in different directions. In fact, the same economic or political forces that can be bad for stocks might be good for bonds, and vice versa. Consequently, if you own a reasonable percentage of bonds, you may not be as vulnerable to the impact of those inevitable downturns in the stock market. Keep in mind, though, that diversification can't guarantee profits or protect you against losses.
Of course, the other major attribute of bonds is the regular income they provide through interest payments. Unless the issuer defaults — an event that's generally unlikely, assuming you purchase quality, "investment-grade" bonds – you can count on receiving the same payments for the life of your bond. Then, once your bond matures, you'll get back the original principal, again assuming the issuer doesn't default.
The ability to receive regular payments may help improve your cash flow and possibly help you avoid selling stocks to meet unexpected costs, such as an expensive car repair. And holding your bond until maturity can help you plan to meet specific goals. For example, if your child will be starting college in five years, you can buy a bond scheduled to mature at the same time, providing you with an influx of cash you can use for tuition and other school expenses.
Still, despite the benefits of diversification, steady income and the repayment of principal, you may find it hard to ignore the relatively low interest rates you're seeing on your bonds. This is especially true if market rates rise, causing the value of your bonds to fall. (Investors won't pay you the full price — that is, the face value — of your bonds when they can buy new ones issued at higher rates. So, if rates have risen and you want to sell your bonds before they mature, you'd have to offer them at a discount.)
One way of coping with interest-rate movements is to build a "ladder" of bonds of varying maturities. When your short-term bonds mature, you can reinvest the proceeds in newly issued bonds that may offer higher rates, while your longer-term bonds continue to pay you greater income. (Generally — but not always — longer-term bonds carry higher interest rates than short-term bonds.)
Even within this type of bond ladder, though, you will want to diversify your holdings among different types of bonds from different issuers. In any case, be sure to evaluate whether a bond ladder and the securities held within it are consistent with your investment objectives, risk tolerance and financial circumstances. Don't ignore bonds when constructing and maintaining your investment portfolio. No matter what interest rates are doing, you'll find that bonds can play an important role in your portfolio.
This article was written by Edward Jones on behalf of your Edward Jones financial adviser.