A lot of people are putting money into long-term bonds these days, purportedly for good reason. Following an extremely volatile, gut-wrenching August that saw the S&P 500's worst monthly performance since May 2012, investors of all ages are contemplating the notion of dumping their money into ostensibly safer long-term bonds.
It sort of makes sense. When all goes well, bonds can provide a steady, predictable income stream regardless of market conditions. Put simply, if you invest in a bond and the issuer has the money to pay you, it is obligated to do so regardless of whether the economy is on the verge of collapse. Who wouldn't want to sign up for that?
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Stocks tend to do betterHere's the downside: If you limit yourself to long-term bonds, or lock up a huge chunk of your money in them, then you may wind up losing out on higher long-term returns. With the exception of the period between 1981 and 2012, during which bonds edged out stocks by delivering an 11.03% return compared with 10.98% for stocks, stocks have historically performed better than bonds. Between 1928 and 2010, stocks averaged an 11.3% return, while bonds averaged only 5.28%. In the past decade, stock investors have enjoyed similar outperformance.
Long-term rates mean long-term risksLet's say you opt to invest in a 30-year bond. By doing so, you're locking yourself into a fixed interest rate for the next 30 years. The problem? A lot can change over 30 years. Interest rates can fluctuate. Inflation can cause the price of goods and the cost of living to skyrocket by today's standards. When you purchase a 30-year bond, you're essentially throwing caution to the wind and assuming that whatever rate you've managed to lock in is high enough to help you ride out the next three decades, come what may.
Let's say you buy a highly rated 30-year bond paying 2% interest. Even if all goes smoothly and you collect your 2% interest in the form of semiannual payments, you could wind up losing out if you hold that bond to maturity. All that needs to happen is for interest rates to rise, or for that same issuer to offer up new bonds paying twice as much interest a few years after you buy them. Suddenly there you are, collecting your piddly 2% while new bondholders get to bask in the glory of their 4% returns, and your cash-hoarding friends get to boast of the risk-free 3% interest payments they're getting from their banks.
And let's not forget that even highly rated bonds present some degree of default risk. A bond can easily start out with a favorable rating and find itself hovering in junk territory years later.
Use bonds to diversifyYou don't need to banish long-term bonds from your portfolio completely. In fact, long-term bonds can be an appropriate means of diversification, complementing investments in the ever-fickle stock market. But if you're decades away from retirement, consider focusing your investment dollars on stocks for their long-term growth potential. You can always shift some of those assets over to bonds as your retirement approaches and you find yourself craving stability (which, at that point, you should be).
Remember, there's a reason bonds with longer maturity dates typically pay more than those with shorter terms. The longer you tie up your money, the more you miss out on a chance to do better. When you put money into long-term bonds, especially early on in your investment career, what you're essentially doing is settling. And really, don't you deserve better?
The article The Dangers of Long-Term Bonds originally appeared on Fool.com.
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