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Since the market downturn in 2007, investors have put hundreds of billions of dollars into bonds as their yields left stocks and left traditional savings accounts in the dust.
Many investment professionals believe this has created a bond bubble that could burst at any moment. But is it ever a good time to invest in bonds?
Risk Outweighs Reward
When you buy a corporate or government bond, you're making a loan. The entity, or borrower, pays you interest and returns your principal when the bond matures.
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Bond values rise and fall, so you can also sell your bond like a stock. Let's say you bought a $10,000 bond that pays 4% interest. If rates fall by a couple of points, your bond will pay more interest than any new bond on the market. So another investor will pay more than $10,000 to buy it from you.
Sounds pretty good so far, right? Keep looking, though, and you'll find tons of risk.
Downgrades and Default – If a borrower's credit rating is downgraded, the value of their bonds drops. General Motors and Greece have experienced this recently. If the borrower goes under, they can take your interest payments and principal with them.
Inflation and Interest Rates – Bonds are "fixed income" securities because their interest rates remain the same until maturity. Inflation reduces the purchasing power of those interest payouts, and analysts expect inflation to become a big problem for current bond holders.
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Because bond values move in the opposite direction of interest rates, current bond values are high. When the economy gets moving again, however, interest rates have to go up, and bond values will drop dramatically.
For example, the 4% interest rate on your $10,000 won't look so great when rates go up a couple of points. Who's going to pay full price for your bond that pays 4% when they can get a new bond that pays 6%? You'll have to discount your bond, which means you'll lose part of your principal. Your other choice is to hold the bond until it matures or until rates fall again. You could be locked into your bond for decades just to keep from losing your principal. How safe does that sound?
Need To Make A Change?
When you add it all up, bonds are just as risky as stocks. But, historical average returns for long-term government bonds are a little over 5% compared to the stock market as a whole at 12%. That's why Dave doesn't own any bonds as part of his investment portfolio, and he doesn't recommend them for anyone else.
Growth stock mutual funds with a history of good returns are the best way to build up your retirement funds long term. Find out more by talking with an investing Endorsed Local Provider. Your ELP will work with you to build a strong portfolio. Get in touch with your ELP today!