To get more returns on bonds, you have to accept more risk
Q. I am a very conservative investor with most of my money in bonds. One of them has matured and the rates I see offered on the new ones are very low. How can I get more interest?
– Chuck to Viera
A. Chuck, you can increase your interest income, but be careful. Always remember that in order to get more return you have to accept more risk. There are thousands of outfits out there that will try to convince you that they’ve created a magical way for you to get more back without giving up anything. Do not be fooled by such illusions. High interest is much more likely to be a red flag than a good opportunity.
That said, the basic tradeoffs for bonds have not changed. Bonds are obligations to pay certain amounts at certain times. When you buy a bond, you become a lender. The issuer owes you interest and value at maturity. Since the terms of the bond are contractual, you can assess their risks more reliably than determining the risk / return tradeoffs in something like stocks or commodities, which makes bonds attractive to conservative investors. .
One way to get larger interest payments is to buy bonds with longer maturities in the future. In return for agreeing to be a lender for a longer period of time, bonds with a longer maturity usually offer higher yields than bonds with an earlier maturity, but not always. As of this writing, even the 30-year Treasury is yielding less than 1.5%.
A significant risk of holding long-term bonds is that the value of the bond falls when interest rates rise. Even safe American treasuries have this interest rate risk. For example, a 30-year US Treasury bill has an effective term of approximately 25 years. This means that if interest rates were to rise by 1%, you would expect the value of the bond to drop by about 25%.
Another common way to get more yield is to buy bonds from issuers with lower credit ratings. If you tried to buy a car but had a bad credit rating, the interest rate on your loan would be higher than what would be offered to someone with exceptional credit. You should keep this in mind when looking at bonds. You are the lender. If a bond offers a higher interest, it is because there are doubts about the ability of the issuer to pay on time. If they could borrow at lower rates, surely they would.
The prices of corporate bonds, for example, can fluctuate dramatically based on perceptions of the health of companies or fears of a recession. Earlier this year, when stocks fell, many people were surprised that their bonds also lost value. For example, on March 23, the day stocks hit their low this year, JNK – an exchange-traded fund that tracks high-yield bonds – also lost more than 22%. A similar thing happened during the 2008 financial crisis. It is not what conservative investors would have wanted to experience.
Investors who want more returns should be prepared to take more risk of loss. Buying bonds comes with other risks, but changes in interest rates or credit quality are among the most dangerous. These risks are a classic example of how markets compromise between risk and reward. So when looking for returns, don’t go overboard.
Dan Moisand, CFP®, has been touted as one of the top independent financial planners in the United States by at least 10 financial planning publications and practices at one of the most decorated independent firms in the United States. For more information, email him at [email protected], visit moisandfitzgerald.com or call 321-253-5400, ext. 101.