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Should Younger Investors Buy Bonds?

If you’re a younger investor, you’re probably investing for growth, knowing retirement is still decades away and you have plenty of time to recover from market losses. You may believe that fixed income assets are only for older investors, or for people relying on bonds for income from their portfolios.

Contrary to that belief, bonds can play a useful role in any portfolio. For one thing, retirement probably isn’t your only goal. At any age, you may have other objectives that you hope to reach before retirement—perhaps buying a new car, a house, or investing in a child’s college fund.

Depending on when you expect to need the money for each goal—in three years, five years or longer—you may not want to invest it all in stocks. Stocks, while typically a good driver of long-term growth, are relatively volatile, and you don’t want to be forced to sell them in a down market to pay for a short- or intermediate-term goal. Because fixed income securities historically have tended to be less volatile than stocks, a high-quality short- or intermediate-term bond allocation can be a useful place to invest money you may need for shorter-term goals. A fixed income allocation also can help buffer downside risk during periods of market volatility. Here’s why you should consider including bonds in your portfolio, at any age:

Reason 1: Most bonds typically have less short-term investment risk than stocks.

High-quality investment-grade bonds tend to have less downside risk over short time horizons than other asset classes, such as stocks. Prior to maturity, a bond can move up and down in value, but at maturity—short of default—the payment amount on a bond is known.

If you think you’ll need money from a portion of your portfolio during the next few years, it would be unwise to invest 100% in stocks. Holding bonds or bond funds can help reduce the potential you’ll have to sell more-volatile assets, like stocks, during a period when prices might be down significantly.

The chart below shows average and worst total returns for various types of stocks and bonds between December 29, 1995 and February 28, 2018. You’ll notice that the bonds, even during their worst rolling 12-month periods, lost comparatively less than stocks. Notice also that cash and short-term bonds had the least volatility and downside risk compared to long-term bonds with longer maturities. If you have short-term investment goals, consider boosting your allocation to short-term bonds and cash for lower volatility over short time horizons or in a down market.

Bonds’ downside risk tends to be lower than stocks’

Between 1995 and early 2018, cash investments generated 2.3% average annual return, with zero downside risk. At the other end of the spectrum, emerging-market stocks generated an average annual return of 10%, with losses of as much as 56.6% during their worst rolling 12-month period.

Source: Data obtained from Bloomberg and Barclays, as of 2/28/18. The worst rolling 12-month total returns are from 12/29/95 to 2/28/18 using monthly data. Data for emerging market stocks is from 12/31/98 to 2/28/18 due to index limitations. Indexes used are:  Bloomberg Barclays US Treasury Bills 1-3 Months Index (cash); Bloomberg Barclays U.S. Aggregate 1-3 Years Index (short-term core bonds); Bloomberg Barclays US Treasury Index (US Treasuries); Bloomberg Barclays Municipal Bond Index (municipal bonds); Bloomberg Barclays U.S. Aggregate 5-7 Years Index (intermediate-term core bonds); MSCI EAFE® Net of Taxes Total Return Index (international stocks); Bloomberg Barclays U.S. Corporate Bond Index (corporate bonds); Bloomberg Barclays U.S. Aggregate 10+ Years Index (long-term core bonds); Bloomberg Barclays U.S. Corporate High Yield Index (High-Yield Corporate Bonds); Russell 2000® Total Return Index (small-cap stocks); S&P 500® Index (S&P 500); and MSCI EAFE® Emerging Markets Net of Taxes Total Return Index (emerging market stocks). For illustrative purposes only. Past performance is no guarantee of future results.

Bonds can be very useful for shorter-term goals. As a younger investor, you may be less interested in the income from bonds, paid as interest payments, than an investor needing or wanting income from their investments might be. However, bonds pay back a lump sum when they mature, a feature that can be useful for planning purposes.

For example, if you’re saving for a down payment in a year, a bond or bond fund can help you plan for how much money you will have when you need it with less potential short-term volatility than stocks. This attribute of bonds can be very useful, especially if you are saving for more than just retirement. More aggressive and potentially volatile investments, including stocks, have higher growth potential. But they can also fall in value much more dramatically, over a shorter period of time, than most high-quality bonds or bond funds.

However, bonds and bond funds can and do rise or fall in value as market interest rates and conditions change—the longer the maturity or lower the credit quality, the more volatile bonds or bond funds holding similar bonds can be. Choose the bonds and bond funds you own carefully, working with an advisor or fixed income specialist, based on your needs and time horizon.

Reason 2: Bonds provide portfolio diversification.

While stocks are important for growth potential, bonds help to diversify a portfolio for long-term objectives. They typically don’t move in the same direction at the same time as stocks do (in financial terms, bonds are said to usually have “low correlation” to stocks). When stock prices are down, bond prices may be up, and vice versa. This can help smooth out the ups and downs in your portfolio over the longer term.

The chart below shows how portfolios with a varied mix of stocks and bonds would have performed from 1926 through 2017.

Fixed income investments historically have lowered portfolio volatility

A portfolio with 100% stocks would have had maximum annual total returns of 54%, average returns of 10.1% and maximum losses of 43.3%. A portfolio with 40% stocks and 60% bonds would have had maximum annual total returns of 26%, average returns of 7.6% and maximum losses of 18.7%.

Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. Stocks are represented by total annual returns of the S&P 500 Index, and bonds are represented by total annual returns of the Ibbotson U.S. Intermediate Government Bond Index. The return figures are the average, the maximum, and the minimum annual total return for the portfolios represented in the chart, and is rebalanced annually. Returns include reinvestment of dividends, interest, and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.
 

Even for long-term goals, younger investors may believe that they can ride out stock market volatility. This may be true, but how comfortable would you be if your stock investments dropped 20%, 30% or more? If not, consider bonds as part of your portfolio for long-term investment goals.

Reason 3: Bonds are designed to generate consistent income and repay principal when they mature.

Fixed income securities—such as U.S. Treasury bonds, government and agency bonds, municipal bonds, corporate bonds and mortgage-backed securities—provide regular interest payments over the life of the bond, or a lump-sum payment at maturity. This is useful because it gives you control over the type of income you can expect to receive, and when.

Consistent income and repayment of principal at known maturity dates has also helped a diversified portfolio of bonds deliver very few years historically where the total return of a diversified bond portfolio—that is, the combination of interest income and any ups or downs in the value of the bonds—has been negative, as shown in the chart below (note that diversification strategies do not ensure a profit and do not protect against losses in declining markets).

Negative returns have been uncommon in a diversified bond portfolio

From 1976 through 2017, there were only three years in which the Bloomberg Barclays U.S. Aggregate Bond Index posted negative annual total return—1994, 1999 and 2013.

Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. Shown in the chart are annual total returns including price change and income for the Bloomberg Barclays U.S. Aggregate Bond Index. Returns include reinvestment of interest. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results. Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Part of the reason is that bonds’ steady income and promise of principal repayment (barring a bond default) bolsters returns over time. Even if you don’t need the income, predictable income historically has helped stabilize the value of the investment and return. This can be useful for short-term goals or to add stability to your portfolio.

In addition, the fact that a bond pays back to you a lump sum when it matures, much like a loan maturing and repaying the lender, is useful if you want the potential to earn interest income over and above what you might receive from a bank account, and have a goal or expense coming upat a definite point in the future—for example, a trip or a down payment on a home that you expect to make in a year or two—and want to know how much money you’ll receive back at that time.

Keep in mind, though, that some types of bonds—for example, high-yield bonds or bonds with very long maturities—have been more volatile historically. For the stability of returns mentioned above, consider talking with a Schwab specialist about a highly rated “investment-grade” bonds, or bond funds invested in these types of securities.

What to consider now

Funding retirement is a goal for most investors, but any investor—including younger investors —may have other goals and reasons to invest. What are your investment goals? Then, for every goal, write down your time horizon. Retirement may be 10, 20 or 30 years in the future. But do you have other goals, even for smaller sums of money, where the time horizon may be shorter?

Finally, consider an investment approach suited to each timeframe. Here are guidelines:

  • Money you may need within the next two years: Given the short time horizon, consider relatively liquid cash investments for these goals, such as certificates of deposit (CDs), money market funds or short-term Treasury bills (for more on cash investments, see “What About Cash Investments” below).

  • Money you may need within the next three to 10 years: With an investment horizon that is neither short nor long, consider a mix of assets targeting growth as well as capital preservation, such as a relatively conservative mix of bonds and stocks.

  • Money you’re saving for goals more than 10 years away: With enough time to ride out market volatility, a more aggressive allocation to stocks may be appropriate for goals you expect to reach in 10 years or more. Although stocks can rise and fall more dramatically in value in any single year, they offer the greatest potential return over the long term. But remember, some bonds can help reduce volatility in a bear market.

How to you invest? When investing in bonds, you’ve got essentially two choices: individual bonds or bond funds. In general, unless you are fortunate enough to have a sizable amount to invest, individual bonds may be more than you’ll want to manage. In our research we have found that holding investment-grade bonds from 10 or more issuers greatly improved portfolio diversification. For diversification and efficiency, you'll generally want a minimum investment of $100,000 to build a portfolio of individual corporate or uninsured municipal bonds ($10,000 per bond).

If you haven’t won the lottery, or haven’t had time yet to build wealth, you may immediately conclude that individual bonds aren’t for you. But if you have smaller amounts to invest, bond mutual funds or exchange-traded funds (ETFs) may make the most sense. A professional fund manager will manage the investing for you, and can provide a convenient way for you to reinvest interest payments you receive from bonds in the fund, to buy more fund shares and potentially grow your investment over time.

The market value, called net asset value (or NAV), of a bond fund can—and does—fluctuate each day and over time. Every day, the fund manager must estimate a market value of bonds held in the fund on that day if they had to sell them. There is no maturity date for a bond fund, and you aren’t assured a certain market price on any particular day if you have to sell. On the other hand, funds holding a diversified portfolio of investment-grade bonds, generally, will have a market price about as volatile as the changing market values of the bonds they hold.

Either way, think about both the short and longer term, even if you’re a younger investor. For shorter-term goals, or even for a small part of a retirement portfolio, you may value stability, diversification, and income to achieve investment goals.

What You Can Do Next

  • No matter your age, a diversified portfolio is important—and bonds and cash can play a role, depending on your time horizon and goals.
  • Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Investing involves risk including loss of principal.

Small-cap stocks are subject to greater volatility than those in other asset categories.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Tax-exempt bonds are not necessarily suitable for all investors. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the alternative minimum tax. Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly.

Bloomberg Barclays U.S. Aggregate Bond Index is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage backed securities, with maturities of one year or more. The

Bloomberg Barclays U.S. Aggregate 1-3 Years Index, Bloomberg Barclays U.S. Aggregate 5-7 Years Index and Bloomberg Barclays U.S. Aggregate 10+ Years Index are related indexes.

The Bloomberg Barclays U.S. Corporate Bond Index covers the U.S. dollar-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services.

The Bloomberg Barclays U.S. Corporate High-Yield Bond Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

The Bloomberg Barclays U.S. Municipal Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds. The Bloomberg Barclays U.S. Corporate Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes U.S. dollar-denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers.

The Bloomberg Barclays U.S. Treasury Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.

Bloomberg Barclays US Treasury Bills 1-3 Months Index is designed to measure the performance of public obligations of the U.S. Treasury that have a remaining maturity of greater than or equal to 1 month and less than 3 months.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

Citigroup U.S. 3-Month Treasury Bill Index is an index that  measures monthly total return equivalents of yield averages that are not marked to market. The Three-Month Treasury Bill Index consists of the last three three-month Treasury bill issues.

CRSP 6-8 Index is a small-cap index created and maintained by the Center for Research in Security Prices (CRSP) at the University of Chicago's Graduate School of Business. CRSP capitalization-based indexes include common stocks listed on the NYSE, AMEX, and the NASDAQ National Market. The CRSP 6-8 Index refers to the 6th through the 8th deciles and represents a small cap index that excludes micro-caps.

MSCI EAFE®(Europe, Australasia, Far East) Net of Taxes Total Return Index is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the US & Canada. The MSCI EAFE Index consists of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom. Net of taxes assume that dividends are reinvested after deduction of withholding tax, applying the rate applicable to non-resident individuals who do not benefit from double taxation treaties.

Ibbotson U.S. Intermediate-Term Government Bond Index is constructed from monthly returns of non-callable bonds with maturities of not less than five years, held for the calendar year.

Ibbotson US 30-Day Treasury Bills is an unweighted index which measures the performance of one-month maturity US Treasury bills.

Russell indices are market-capitalization weighted and subsets of the Russell 3000® Index, which contains the largest 3,000 companies incorporated in the United States and represents approximately 98% of the investable U.S. equity market. The Russell 2000® Index is composed of the 2000 smallest companies in the Russell 3000 Index.

S&P 500® Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity, and industry group representation.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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