Last Updated Feb 5, 2010 11:27 AM EST
Why bother with bonds when I could just buy a bank CD?
Certificates of deposit are the very best choice for people who want total simplicity, no fees, and guaranteed principal at all times.
But bonds have other advantages. Some are fully or partly tax free, whereas CDs are fully taxable. And they usually yield higher returns than comparable CDs.
Use high-quality bonds to:
1. Preserve your purchasing power. For this you want intermediate-term bonds (maturing in roughly five to seven years), with all the income reinvested. Your money won't grow very much, after taxes and inflation. But 'll hold on to the value of what you have. You could also buy Treasury Inflation-Protected Securities.
2. Reduce the risk of owning stocks. Bond prices tend to rise and fall at different times than stocks, and at different rates of speed. So if you own both stocks and bonds and average their performance together, you have a more stable portfolio than if you owned only one of them. Put another way, bonds secure your financial base so that you can afford to take the risk of stocks.
3. Provide income to live on. Bonds pay interest you can count on. But exactly how to invest for income isn't as clear-cut as you might think. You might want a mutual fund withdrawal plan instead of straight interest income from bonds.
4. Protect you in an emergency. If you lose your job or face some other financial emergency, you'll need your savings and investments to get you through. If you own only stocks and the stock market is down, you'll be selling at a loss to raise the funds you need. If you own bonds as well as stocks, however, you can sell the bonds instead — probably at no loss or just a little one. You'll be able to leave your stocks alone to recover when the market turns up again.
5. Improve the yield on money you'd otherwise keep in cash. Prudent investors hold cash for unexpected expenses or expenses they know they'll have in the next two or three years. Treasury bills, money market funds, or bank CDs are the safest places for your "prudence fund." But you can pick up a half point or even a full point in yield by switching to short-term (two-year) bond funds. When stocks tumble, short-term bond prices may also decline. But the drop may be small, provided that the fund is managed conservatively. If you have no emergency need for cash, you can hold your short-term bond fund until it recovers and earn more than if you had stuck with money market funds. If an emergency does overtake you at a time when bond prices are down, selling your short-term fund should result in only a modest loss.
For bonds and bond funds, I emphasize conservative — meaning yields in line with AAA to A securities. Funds with higher yields can be as risky as stocks.
Excerpted from Making the Most of Your Money Now by Jane Bryant Quinn
Copyright 1991, 1997, 2009, by Berrybrook Publishing, Inc. Reprinted by permission of Simon & Schuster, IncBuy the Book