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Bonds have long been a staple for retirees because of their reputation as a solid way to keep cash secure while also getting some yield from the bond issuer. However, bonds aren't perfect -- or a perfectly safe -- holding for retirees, and they can actually cause you to outlive your savings if you rely on them too heavily. At the same time, bond mutual funds can create more risk than owning individual bonds if you need to sell them at inopportune times.
Here's a close look at three facts about bonds that retirees need to know. Factoring these realities into your retirement saving and planning could go a long way toward making sure you have enough money for your entire life.
Don't let these facts about bonds catch you off guard. Image source: Getty Images.
Fact 1: You can lose money with bonds (and in two ways)
The first way you could lose money with a bond is if the issuer has financial troubles. For instance, if you own a bond issued by a company that files for bankruptcy, you almost certainly won't get all your money back. The best way to reduce this risk is to buy only government-issued and investment-grade corporate bonds. These issues tend to pay lower yields than so-called "junk" bonds, but if keeping your risk of losses low is a priority -- which it should be for retirees -- then these lower-risk bonds should make up the bulk of your fixed-income investments.
The second way you could lose money with a bond is by selling before it matures. This is a very real concern bondholders should consider in the current interest-rate environment, as rates are likely to increase by 75 basis points -- that's 0.75% -- or more per year for the next several years.
Here's an example of how that could affect the value of a bond on the secondary market. If interest rates have increased 100 basis points -- that's a 1% increase in the rate -- since a bond you own was issued, and you sell it five years before maturity, you may have to discount it by 5% or more to offset the lower yield versus newly issued bonds. If the bond was worth $10,000, that's a $500 loss by selling early. Not a small amount.
What can retirees do to reduce this risk of losses? Buy bonds with maturity dates that align with when you'll need to cash out. This may include a mix of short-term bonds or cash for income within one or two years. You may not capture as much yield from short-term bonds, but you'll reduce your risk of losses thanks to rising rates.
Fact 2: Bond funds expose you to more interest-rate risk than owning bonds directly
For many investors, bond funds are a good way to own bonds. However, every time you sell shares of a bond fund, you're exposed to the same market risk as selling a bond before it matures: interest-rate risk. This means you'll face more risk of losses when interest-rate conditions change, and it can be exacerbated if you invest in the "wrong" type of bond fund for your needs.