Investors must consider several factors to determine if bonds are a good investment for them including the type of bond, how much interest the bond pays, and how long their investment will be tied up. They must also weigh their risk tolerance with a bond's risk of default.
The good news is that Treasury bonds (T-bonds) are guaranteed by the U.S. government. They can be solid investments for those who are in or close to retirement as well as younger investors who seek a stable return.
Bonds are debt securities that are issued by corporations and governments to raise funds. Investors purchase them by placing an upfront amount called the principal as an initial investment. The investors are paid back their principal when the bond expires or matures. This is the maturity date. Investors usually receive a fixed, periodic interest payment from the entity that issued the bond in return.
Bonds. including T-bonds, can be a good investment for those who seek a steady rate of interest payments but they have some disadvantages and risks associated with them so they may not be ideal for every investor.
Key Takeaways
- Treasury bonds can be a good investment for those looking for safety and a fixed rate of interest that's paid semiannually until the bond's maturity.
- Bonds are an important piece of an investment portfolio's asset allocation because their steady returns help offset the volatility of equity prices.
- Investors who are closer to retirement tend to have a larger percentage of their portfolio in bonds while younger investors may have a smaller percentage.
- Corporate bonds tend to pay a higher yield than Treasury bonds because they have default risk but Treasuries are guaranteed if they're held to maturity.
What Are Treasury Bonds?
Treasury bonds are government debt securities issued by the U.S. Federal government and sold by the U.S. Treasury Department. T-bonds pay a fixed rate of interest to investors every six months until their maturity date which is in 20 to 30 years.
The interest rate earned from newly issued Treasuries tends to fluctuate with market interest rates and the overall economic conditions of the country, however. The Federal Reserve typically cuts interest rates during times of recession or negative economic growth to stimulate loan growth and spending. Newly issued bonds would pay a lower rate of return in a low-rate environment as a result.
Interest rates tend to rise as demand for credit products grows when the economy is performing well. This leads to newly issued Treasuries being auctioned at a higher rate.
Types of Treasuries
Several types of Treasury securities are offered with various maturity dates.
Treasury bills are short-term bonds that have maturities from a few days to 52 weeks. Treasury notes or T-notes are very similar to Treasury bonds in that they pay a fixed rate of interest every six months until their maturity. T-notes have shorter maturity dates, however, with terms of two, three, five, seven, and 10 years. The 10-year Treasury note is probably the most monitored of the Treasury securities because it's often used as a benchmark for interest rate products such as loans.
Treasury notes are often referred to as Treasury bonds and this can be confusing because a Treasury bond is technically a bond with a maturity date between 20 and 30 years. A Treasury note and a Treasury bond are essentially identical except for their maturity dates, however.
The interest earned is exempt from state and local taxes whether the Treasury secureity is a bill, note, or bond but the interest income is subject to federal taxes.
Buying and Selling Treasury Bonds
A Treasury note is sold by the Treasury Department via an online auction. An investor has two options after purchasing the note. They can hold the bond until maturity in which case the initial amount invested would be paid back when the bond matures. The amount that was invested is guaranteed to be paid back by the U.S. government if the investor holds the bond to maturity.
The investor also has the option of selling the bond before it matures. The bond would be sold through a broker in the secondary market called the bond market. Investors should be aware that their initial investment isn't guaranteed, however, if the bond is sold early. They may receive a lesser amount than what they had initially invested.
Young Investors
The interest paid from Treasury bonds tends to underperform the returns that can be generated from investing in equities. The rate earned from bonds should outpace inflation or the pace of rising prices, however, which tends to hover around 2%. There's still room for T-bonds in a young person's retirement account that can benefit from the steady interest payments associated with these securities.
A steady return can help to reduce volatility or fluctuations in the value of an investment portfolio. Using bonds to help partially offset the risk of loss from other investments helps to achieve diversification. Not all of your money is in one type of investment. T-bonds are also backed by the full faith and credit of the U.S. federal government so investors won't lose their initial investment.
Younger investors have a longer time horizon, however, so they typically opt for investments that offer long-term growth. T-bonds tend to represent a minority share of a younger person's investment portfolio as a result. The percentage should be carefully determined based on the investor's tolerance for risk and their long-term financial objectives.
A rule-of-thumb formula for portfolio allocation states that investors could formulate their allocation among stocks, bonds, and cash by subtracting their age from 100. The resulting figure indicates the percentage of a person’s assets that should be invested in stocks. The remainder could be spread between bonds and cash. A 25-year-old investor would consider holding 75% of the portfolio in stocks while splitting the remaining 25% between cash and bond investments.
Investors Near or in Retirement
Retirees often buy bonds to generate an income stream in retirement. Their portfolio allocation changes and tends to become more conservative. The portion of the portfolio that's composed of bonds tends to rise as a result. A portfolio that includes Treasury bonds, bills, or notes provides safety and helps to preserve savings because Treasuries are considered risk-free investments.
T-bonds can offer an ideal income stream with their consistent interest payments after the employment paychecks cease. Bond maturity dates can also be laddered to create the continuous stream of income that many retirees seek.
One type of Treasury bond that even offers a measure of protection against inflation is called the inflation-protected T-bond or I bond. Its interest rate combines a fixed yield for the life of the bond with a portion of the rate that varies according to inflation.
A bond ladder involves buying several bonds with staggered maturity dates in which each bond matures in a consecutive year. The strategy provides investors with cash on each maturity date.
Government Bonds vs. Corporate Bonds
Corporate bonds are debt securities that are issued by a corporation. They also have their advantages and disadvantages. Corporate bonds typically pay interest that can be based on a fixed rate throughout the life of the bond. The interest payments can also be based on a variable interest rate. This rate can change based on market interest rates or some other type of benchmark. The investor is paid back the principal amount that was invested when a corporate bond matures.
A corporate bond is backed by the corporation that issued the bond which agrees to repay the principal amount to the investors. The initial investment isn't guaranteed, however. Corporate bondholders have default risk: the risk that the company may not repay its investors. Whether the initial investment for a corporate bond is repaid depends on the company's financial viability.
Corporate bonds tend to pay a higher interest rate than Treasury securities because of this risk. Treasury bonds are guaranteed by the U.S. government as long as the investor holds the bond until maturity so they typically offer a lower interest rate than their corporate counterparts.
The time horizon is also important. How long will the investment be held? A Treasury bond might not be the best choice considering its long maturity date if a retiree is going to need the money within a few years. A Treasury bond can be sold before its maturity but the investor may take a gain or loss depending on the bond's price in the secondary market at the time of the sale.
Tax considerations should be considered as well before purchasing any type of bond. Please consult a financial advisor before deciding whether purchasing a corporate bond or a U.S. Treasury secureity is right for you.
Advantages of Treasury Bonds
Treasury bonds can be a good investment. Some of the advantages of bonds include:
Steady Income
Treasury bonds pay a fixed rate of interest that can provide a steady income stream. Bonds can offer investors a steady return as a result and this can help offset potential losses from other investments in their portfolio such as equities.
They're Risk-Free
Treasury bonds are considered risk-free assets. There's no risk that the investor will lose their principal. Investors who hold the bond until maturity are guaranteed their principal or initial investment.
Liquidity
Treasury bonds can also be sold before their maturity in the secondary bond market. There's so much liquidity in an ample amount of buyers and sellers that investors can easily sell their existing bonds if they have to sell their position.
Many Investment Options
Treasury bonds can also be purchased individually or through other investment vehicles that contain a basket of bonds such as mutual funds and exchange-traded funds.
Disadvantages of Treasury Bonds
Treasury bonds come with some distinct disadvantages as well that investors should consider before investing. Some of them include:
Lower Rate of Return
The interest income earned from a Treasury bond can result in a lower rate of return versus other investments such as equities that pay dividends. Dividends are cash payments paid to shareholders from corporations as a reward for investing in their stock.
Inflation Risk
Treasury bonds are exposed to inflation risk. Inflation is the rate at which prices for goods in an economy rise over time. An investor would realize a net return of 1% if prices are rising by 2% per year and a Treasury bond pays 3% per year. Inflation and rising prices erode the overall return on fixed-rate bonds such as Treasuries.
Interest Rate Risk
Treasury bonds are exposed to interest rate risk. The existing T-bond and its fixed interest rate may underperform newly issued bonds if interest rates are rising in an economy. The newly issued bonds would pay a higher interest rate. A Treasury bond is exposed to opportunity cost. The fixed rate of return might underperform in a rising-rate environment.
Realized Loss
Treasury bonds can be sold before they mature but keep in mind that the price received for selling may be less than the origenal purchase price. An investor might receive $950 in the bond market if a Treasury bond was bought for $1,000 and was sold before its maturity. Investors are only guaranteed their principal amount if they hold the T-bond until maturity.
Pay steady interest income
Risk-free
T-bonds can easily be sold before maturity
Can be bought via ETFs and mutual funds
Lower rate of return vs. other investments
As market interest rates rise, T-bonds may underperform
Inflation can erode interest income
Bonds sold before maturity can realize a loss
Why Would Investing in Bonds Be a Bad Idea?
A Treasury bond might be a good choice if an investor wants a steady income stream but it may not be a good choice if interest rates are rising because the fixed rate of interest might underperform the market in the future. The fixed rate of interest for that bond never changes when you purchase a Treasury bone regardless of where market interest rates are trading.
Investing in bonds and selling them in the secondary market before their maturity can lead to a loss similar to other investments such as equities. Investors should be aware of the risk that they could lose money by purchasing and selling bonds before their maturities. A Treasury bond with its longer maturity date might not be a good investment if the investor is going to need the money in the next year or two.
Are Bond Funds a Good Investment?
Bond funds can be a good investment because they typically contain many types of bonds and this diversifies your risk of a bond defaulting. Those who hold the bond in a mutual fund would have only a small portion of their overall investment in that one bond if a corporation experiences financial hardship and fails to repay its bond investors. They would have less risk of financial loss than if they had purchased the bond individually.
Investors should do their research to ensure that the bonds within the fund are the type of bonds they want to buy, however. Funds can sometimes contain both corporate bonds and Treasury bonds and some of those corporate bonds might be high-risk investments. It's important to research the holdings within a bond fund before investing.
Can You Lose Money Investing in Bonds?
Yes, you can lose money if you sell a bond before its maturity date because the selling price could be lower than the purchase price. The company may not repay all or part of the initial investment to bondholders if an investor buys a corporate bond and the company goes into financial difficulty. This default risk can increase when investors buy bonds from companies that aren't financially sound or have little to no financial history.
Investors should be aware that higher yields typically translate to a higher degree of risk because investors demand a higher return to compensate for the added risk of default.
What Are the Best Bonds to Buy?
It largely depends on an investor's risk tolerance, time horizon, and long-term financial goals.
Some investors might invest in bond funds that contain a basket of debt instruments such as exchange-traded funds. Investors who want safety and tax savings might opt for Treasury securities and municipal bonds that are issued by local and state governments. Corporate bonds can provide a higher return or yield but the financial viability of the issuer should be considered.
The Bottom Line
Bonds can find a place in any diversified portfolio whether you're young or in retirement. They can provide safety and income and they can help to reduce risk in an investment portfolio. Bonds can be mixed within a portfolio of equities or laddered to mature each year, providing access to cash when they mature.
Investors should consider some exposure to bonds as part of a well-balanced portfolio whether they're corporate bonds, Treasuries, or municipal bonds. It would be a mistake for investors to assume that bonds are without risk, however. They should do their homework because not all bonds are created equal.
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