Are bonds right for you? Q&A with Betterment Investing
We sat down with Betterment Director of Investing Mindy Yu to have her explain what bonds are and if they are right for your investing goals.
Question 1: What's the difference between bonds and stocks?
Mindy: A stock represents a share of ownership in a company. Depending on how a company performs, the stock value can rise and fall.
A bond is like a loan that you provide to an entity such as a business or government. The entity issuing the bond promises to pay your money back by some specified date (called the bond’s maturity), plus interest that is typically distributed to you on a consistent schedule, such as on a monthly, quarterly, semi-annual, or annual basis.
Question 2: Are there risks to investing in bonds?
Mindy: First, all investing involves risk. However, bonds have historically been less risky than stocks—but keep in mind with less risk typically comes a lower return on your investment over time.
Two common risks associated with bonds are credit risk, the likelihood of a bond issuer paying you back, and interest rate risk, a bond’s sensitivity to changes in interest rates. Bond prices and interest rates historically have moved in opposite directions, as one rises the other falls.
Question 3: What are the different types of bonds?
Mindy: Some common types of bonds that can be used to create a portfolio include:
- Investment-grade bonds: These are bonds issued by relatively more creditworthy (less risky) entities. Because they are less risky, these bonds typically have lower interest rates and thus lower income potential.
- High-yield bonds: These are bonds issued by relatively less creditworthy issuers and because they are less creditworthy, these issuers’ bonds typically carry higher interest rates and enhanced levels of potential income.
- Treasury bonds: These are bonds issued by the U.S. government which is considered to be one of the most creditworthy issuers. Treasury bonds include T-bills (0-1 years to maturity), Treasury notes (1-10 years to maturity), and Treasury bonds (10-30 years to maturity).
Question 4: How do I know if I should invest in bonds?
Mindy: There are a few financial goals that bonds may be suited for:
- Diversification: If you own stocks, bonds could help reduce volatility. This is because the values of stocks and bonds have historically moved in opposite directions. When one rises, the other typically falls.
- Consistent income: If you are looking for income, bonds may be able to help. This is because the entity issuing a bond typically pays the bondholder interest on some regular schedule.
- Putting cash to work: If you are looking to preserve the value of your savings, while potentially earning some return over a traditional savings account or CDs, bonds, especially short-maturity bonds, may be a viable option.
Question 5: Betterment offers two bond portfolios. Can you explain how they work?
Mindy: Sure, both portfolios are built with bond ETFs, so let me explain that first. A bond ETF may contain hundreds, sometimes thousands of bonds, and offer broad or targeted exposure to various areas of the bond market without the investor needing to invest in the bonds directly.
We’ve created two types of portfolios using a range of bond ETFs:
- The BlackRock Target Income portfolios include a diverse set of bond ETFs with a range of risk levels, helping to mitigate exposure to volatility in the stock market, aiming to preserve wealth, while seeking to generate income.
- The Goldman Sachs Tax-Smart Bonds portfolio is built by Goldman Sachs using 100% short-term bond ETFs. Betterment then personalizes the portfolio based on your tax situation with the aim of generating after-tax yield.
In both portfolios, all interest payments, also called dividends, are automatically reinvested to help grow the portfolio’s value.
Question 6: Who are these bond portfolios best suited for?
Mindy: The BlackRock Target Income portfolio may be better suited for investors looking for lower risk compared to stocks, with the option to choose one of four portfolio strategies targeting increasingly higher yields. The portfolio strategy should be selected based on your risk tolerance. Keep in mind, getting more income from a specific target portfolio also means taking on more risk.
The Goldman Sachs Tax-Smart Bonds portfolio is designed for higher-income individuals, especially in the 32% or greater federal tax bracket, looking for a potentially higher after-tax yield than a cash account with less risk than a traditional stock-and-bond investing portfolio.
Just a reminder, bond portfolios carry more risk than cash management accounts, which are generally FDIC-insured and provide the stated yield. Bonds are securities that are exposed to market volatility but, in return, provide the opportunity to increase after-tax yield, which is the money you actually get to keep after paying taxes.