Ah, bond haiku. There's nothing else quite like it (thankfully). And while National Poetry Month continues here at the Fool, the first haiku above raises a real question asked by many Fools, often as they near retirement: What's the best way to invest in bonds?
Many long-term investors aren't all that familiar with bonds. They've focused on stocks, and with good reason: The stock market has been a great wealth-builder for millions of investors over the years. As they near retirement, and start to think about a strategy for making withdrawals from their nest egg, often their first instinct is to look at bond mutual funds. This makes sense -- most stock investors know quite a bit about how mutual funds work and how to select them. They check fees, look at Morningstar ratings, read commentary on the Fool's discussion boards, choose a fund to invest in, and then check returns every quarter. It's easy and convenient, and it's not necessarily a bad choice. But a bond mutual fund differs in some important ways from a direct investment in bonds, and understanding those differences might inspire you to consider learning more about bond investing.
The advantages of bonds
Bonds are often recommended to investors nearing (or in) retirement because they're a good place to invest money you'll need in the near-ish term -- within the next five or six years, as a general rule. When you buy a bond, you get a fixed, regular income stream and a contractual guarantee that you'll get your money back when the bond matures. That's why we like bonds: The income stream is predictable, and assuming you choose investment-grade bonds, there's not a lot of default risk -- and you know exactly how much you'll be paid on the bond's maturity date. With a bond mutual fund, on the other hand, the income stream will vary because the portfolio manager continually makes changes to the portfolio. What's more, those income variations won't be predictable. And since the portfolio's day-to-day value fluctuates over time, you won't know in advance what your investment will be worth on the day you need it -- and it may be worth less than you'd hoped.
But bonds are complicated
Not necessarily. If you've ever had a bank loan, bond basics will seem very familiar because a bond is really little more than a standardized loan contract. In return for a loan (the bond's par value), the issuer makes regular interest payments (the coupon) at a predetermined interest rate (the yield) until a specific date (the bond's maturity date), at which point the loan is paid back. Every bond issuer has a credit rating assigned to it by one or more independent agencies, and (generally speaking), the lower the credit rating, the higher the yield: Just like stock investors, bond investors want to be compensated for taking extra risk.
That credit rating is another reason to consider buying bonds directly: With a portfolio of bonds from three or four issuers, it's easy to monitor the health and credit rating of those issuers. That way, you know that you'll get paid in full on that maturity date. In contrast, you don't ever really know what's in a bond fund from day to day, and you can be taken by surprise. With many funds, only 65% of assets have to be invested according to the fund's stated investment objective. Your manager may be taking additional risks in an effort to juice the fund's performance -- risks you may not want to share.
Moving bondward
Now that I've (hopefully) piqued your interest in learning about bonds, I suggest you spend some quality time with the Fool's bond primer. You'll get much more detail on how bonds work, how risk is determined and graded, the all-important tax considerations, and the factors that drive bond prices (hint: Interest rates are key). If you still have questions, head on over to the Fool's friendly bond discussion boards and ask away. You'll find plenty of bond-investing veterans who will be happy to help you out.
A couple of quick final notes: If you do decide to invest in bond funds, index funds should be at the top of your list of candidates. (Robert Brokamp explains why.) A fund like the Vanguard Total Bond Market ETF (AMEX: BND) combines many different kinds of bonds, from agency debt issued by Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) to corporate bonds issued by companies like DaimlerChrysler (NYSE: DCX) and JPMorgan Chase (NYSE: JPM). Lastly, if you want to buy U.S. Treasury bonds, don't buy them in a fund or from a broker: You can get them straight from the government by using the Treasury Department's Treasury Direct program, commission-free.
Our Rule Your Retirement calculators can help you figure out how much you need to retire, and you can try them free for a month -- and get advice on the newsletter's discussion boards.
Fannie Mae is an Inside Value recommendation and JPMorgan is an Income Investor pick.
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