6 Things You Should Know About Investing in Long-Term Bonds
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Bonds are one of the most secure investments you can make. However, this $43.1 trillion market (as estimated in 2019), inclusive of multiple securities, complex rules, and varying yields, can often be overwhelming for many investors. But the importance of including bonds in your overall portfolio is indisputable. According to experts, the ratio of bonds and equity should be a balance of 60-40, where 60% of the portfolio comprises stocks, and 40% of bonds. Some of the major reasons that establish the popularity of bonds are diversification, guaranteed returns, and minimum risk. That said, there is still a big debate on which types of bonds – short or long-term – should be a part of the portfolio. The deciding factors are the investment approach, risk-appetite, and the requirement of funds.
If long-term bond investments are your choice, here are some things that you should know of:
1. High returns at high risk
Long-term bonds usually offer high returns but at considerably higher risk. In 2011, the Vanguard Extended Duration Treasury ETF (EDV) performed exceptionally well and garnered yields of 55% for its investors. This clearly establishes that, in most cases, long-duration bonds offer similar benefits as associated with high-risk asset classes like small-cap stocks. This is because when overall bond earnings fall in the short term, long-term bonds usually perform better, making them a perfect trading vehicle. However, this does not imply that lengthy tenure bonds are the best investment. Long-term bonds experience extreme volatility in phases, which might persuade you into selling them at a loss. Thus, compromising on your overall financial target. This was evident in the epic decline of the same EDV fund yields to 7.18% from March 7 – March 14, 2012. During this period, many investors exited the bond market. However, the meltdown was only a week-long, and the funds gained full power soon thereafter.
That said, when choosing your bonds investments, be careful about the underlying holdings. Opt for a long-term bond fund which consists of lower-risk market instruments like AAA-rated bonds and treasuries, rather than high-yield but low-rated corporates.
2. Broader rate cycles
Another thing to remember when investing in long-term bonds is to understand its association with the broader interest rate cycle. In general, it is hard to predict how the economy will perform over the tenure (15, 20, 25, or 30 years) of long-term bonds. Hence, an investment that might appear lucrative at the time of purchase could lose its value eventually. So, hypothetically, a bond with a two-year lock-in period will lose $2 for every 1% rise in interest rates, because broader rate cycles cannot be accurately predicted. Even though yield curves pay better returns on long-term versus short-term maturity bonds, there is an inherent longevity risk. Interest rates can potentially increase over the investment tenure. When the interest rates go up, the bond value falls, and new bonds become more attractive than older long-term bonds. This makes the lengthy duration bonds less attractive for trading.
That said, to accommodate such risk, long-term bonds are compensated with a higher return value to absorb these rate shocks of the future.
3. Delayed returns
A critical thing to know about long-term bonds is that these investments do not offer immediate or near-future returns. Hence, you should choose to allocate your hard-earned money in this specific market instrument only if you have at least 20 years or more before you officially retire. If you do not have this considerable time before you stop working, you might be making the wrong choice with long-term bonds. These market investments need time to potentially grow and provide you with the expected gains. These are a decent class of assets that allow you to build your wealth over time. Moreover, the greater the length of time, the easier for you to recover through market downturns.
4. Potential protection from inflation
Even though long-term bonds are more susceptible to rate of interest volatility, which might undermine their overall return, these market assets are still efficient to combat inflation in the future. Bond issuers usually offer high returns to compensate for the risk of the interest rate rising over the bond tenure. Thus, these long-term bonds can beat inflation or provide you with optimum protection from inflation, helping you maintain your purchasing power. Moreover, if your investment motive is to overcome future price rise, you can consider investing in I-bonds. An I-bond is an interest-bearing, government saving bond, which offers a fixed interest rate return and a variable inflation percentage, which is adjusted semi-annually. I-bonds are a low-risk investment, specially offered with the aim to provide a return plus protection to depositors.
5. Taxes on capital gains
It is also critical to understand the tax implications of long-term bonds. If you buy a lengthy tenure bond at par value and hold it until its maturity, there is no capital gain on the transaction. Hence, consequently, there is no capital gains tax. However, if you sell the same bond before its maturity and generate a profit from the sale, there is a capital gain, and you would be liable to pay tax on it. Long-term capital gains are charged a lower tax rate than short-term profits tax rates. That said, the interest on bonds is taxed according to the type of bond. Corporate bond interest payments attract both federal and state taxes. However, federal bond interest earnings are subject to only federal taxes and no state taxes. Additionally, municipal bonds fare better than others. Interest receipts on qualifying municipal bonds do not incur any federal, state, or local taxes. These are also known as ‘triple tax-free’ bonds. But they have a slight glitch. Municipal bonds often pay lower yields as compared to taxable bonds. Hence, it is good to invest in them for a long duration only if you are a high-tax bracket investor.
6. The regularity of income
Long-term bonds secure your investment for considerably more time. Hence, you do not get any receipts for that specific time. Therefore, these are not the type of market assets that you should invest in if you want a regular stream of income. Instead, while you may consider investing in short-term bonds that offer stable earnings, you may also consider shifting your portfolio towards more high-rated bonds. The profits in this investment type might not be as high as stocks, yet it could be a source of revenue that you can rely on. Alternatively, you should think of long-term bonds only when you have sufficient funds that can be forgone for a considerable duration of time.
To sum it up
Overall, a long-term bond has its pros and cons. You must be wary of all factors before choosing these market instruments and always make an informed choice. Generally, when you define your investment strategy, it is advisable to strike a fair balance between short-and long-term bonds in your portfolio. The former will enable you to achieve monetary objectives closer at hand, while the latter will allow your wealth to grow significantly and fulfill goals that are several years or even decades in the future.
If you need professional guidance on how to structure your portfolio to best meet your financial objectives, consider consulting a professional financial advisor. The sooner you begin planning, the better your returns will be. So, be informed and decide wisely.