Bonds can be a great, safe investment for your portfolio. But they're often misunderstood.
You've probably seen the TV show, MythBusters, where two tough, gruff guys do hands-on experiments to settle important questions such as whether firing a flaming arrow into a car's gas tank will cause an explosion. Or whether a super-high-powered fountain could lift and suspend a human being. (It works in cartoons all the time.)
Let's do our own version of myth-busting right here but without any film crew or props. Today, we're debunking five common myths about the bond market. There will be no explosions, but there may be some surprises, so let's jump in.
Myth #1: Bonds Are Boring
Here's probably the most common myth about bonds: Investing in them is about as exciting as watching paint dry.
Stock prices jump around all day. Some soar so high it makes you clap and cheer; some fall with a big thud. Bond prices don't do that. Bonds are primarily designed to pay you interest no matter what the market is doing. But just because a rollercoaster ride is exciting doesn't mean a satisfying dinner at a restaurant you trust is a snooze. You probably don't want to ride that roller coaster all the time, but a good meal? You wish for that every day.
Just like a good restaurant, the bond market offers a full menu of choices. You can choose from super-safe bonds with low returns. These include short-term Treasury securities and Series EE Savings bonds. Or you could go for some meatier options like high-grade corporate bonds. And maybe add on a side dish of mortgage-backed securities, high-yield bonds, municipal bonds and even emerging market bonds.
If you're worried about higher inflation, look into Treasury Inflation-Protected Securities, or TIPS. These are Treasuries whose payouts increase with inflation. Remember, bonds are not designed to offer the thrills of the stock market, but when your heart is pounding because your stock portfolio is swinging around like a circus acrobat, your plate of bonds serves up income and stability. That's not boring; it's comfort food.
Or you might choose to go with a bond fund. Unknown to most people, owning a bond fund is not the same as holding actual bonds, as we discuss below.
Myth #2: You Can't Lose Money With Bond Funds
Many people assume that since bond funds receive the interest payments on bonds held by the fund, investors only get their share of that interest. It seems like bond funds should always generate a positive return.
That's not how bond funds work. Without going into the nitty-gritty, when an interest payment comes into the fund, it is used primarily to buy more bonds. Each share in the fund then represents ownership of a larger pool of bonds. That makes the fund's share price go up by roughly the amount of the interest payments.
However, keep in mind that when the Fed interest rate goes up, bond prices often tend to go down. With some bond funds, growth can stop as interest rates rise. And with some, the fund can lose money. Bond funds usually provide positive returns but not always.
Myth #3: Bonds Are a Safe Place to Be When the Stock Market Goes Down
Stock and bond prices almost always move in opposite directions, right? So if the stock market goes down, your bond investments will cushion the blow, right?
Don't feel too bad if you thought this was true; many pros are also wrong on this one. It turns out that, over the 388 months between July 1986 and October 2018, the U.S. stock market and the U.S. bond market (excluding high-yield bonds) moved in opposite directions — positive returns for stocks and negative returns for bonds, or vice versa — 61% of the time. That's more than half of the time, but you probably wouldn't say that's “almost always.”
When the stock market had a negative return (in 132 out of those 388 months), the bond market return was positive only 80 times. Sorry, we didn't mean to ruin your day.
Myth #4: Municipal Bonds Are Best if You Want to Minimize Your Tax Bill
This one is more myth-fracturing than busting. It is true that you do not pay federal income tax (and in many states, no state income tax, either) on interest payments from most municipal bonds, and you do pay taxes on interest from other bonds. But you can earn more overall from other bonds that are equally safe, even after paying tax.
Imagine that a bond issued by State X pays 2.5% interest, and a bond issued by Corporation Y pays 3.2%. (Everything else is equivalent between the two bonds, including their prices.) Let's say you are in the 22% tax bracket. (We'll ignore state taxes since some states have no income tax.) In this case, you should be equally happy with either bond, because after paying 22% of Bond Y's interest to the federal government, you'll still have an interest of 2.5%, the same as you would from Bond X.
Myth #5: Investments That Pay Big Dividends Are Good Bond Substitutes for Investors Who Want More Income
This is an excellent idea that works much of the time but often don't when you need it most. Stocks that pay big dividends can be a smart investment for many reasons, but they're not a substitute for bonds.
Stock prices fluctuate with the market. And a company can reduce its dividend to save money. Bond prices change mostly due to movements in interest rates, not the stock market. And payments from a bond cannot be reduced except in a bankruptcy situation.
Other investments, such as REITs (real estate investment trusts) and MLPs (master limited partnerships) typically offer big payouts based on income from the real estate or oil and gas properties owned by the trust or partnership. Still, they're not bond substitutes. In a recession, prices of REITs and MLPs can fall substantially.
Because real estate tends to do poorly in a recession, office buildings and shopping malls lose tenants, and hotel rooms go unused as business and leisure travel drop. That makes the value of shares in REITs and MLPs decline.
And the income you, as an investor, would receive from them would also drop. Not what you expect from an investment that is supposed to be “bond-like.” Interest rates usually fall when the economy is bad, so bond prices often go up in a recession. And bond interest payments keep coming unless the company goes bankrupt.
We shattered some myths about bonds and didn't need a blowtorch or a sledgehammer. We hope that busting these myths helps you better understand how bonds behave and appreciate the truth about what they can do for you.