The U.S. stock market lost 7.29 percent in October, translating to a $2.4 trillion loss for the month, according to Wilshire Associates Inc. This loss occurred exactly one decade after the October 2008 stock plunge that was part of the financial crisis, and could signal the beginning of the next plunge — so it may be a good time to consider the role of bonds.
In 2008, while U.S. stocks lost 37 percent of their value, a high-quality bond fund like a Vanguard Total Bond Market ETF (BND) gained 7.66 percent and acted as a shock absorber. My own portfolio is roughly 55 percent in bonds and CDs. Here’s what you need to know now about bonds.
What are bonds? What risks do they have?
A bond is simply a loan to a corporation or government for which they promise to pay you interest, and your principal back upon maturity.
Bonds have two types of risk. The first is that they default and don’t pay back the principal. For example, in 2009, General Motors defaulted on its bonds and investors lost the vast majority of their principal. Owners of General Motors stock, however, lost everything — so bonds have less default risk than stocks.
A second risk involves interest rates. If interest rates rise, the value of your bond will likely decline. That’s because your loan will be at an interest rate lower than the current market rate.
Conversely, if interest rates fall, your bond becomes more valuable as it’s earning a higher-than-market rate. It’s a myth that holding a bond until maturity eliminates interest-rate risk, because the bondholder earns a below-market rate until the bond matures.
Are bond funds better than individual bonds?
Generally, yes. The funds can own hundreds or thousands of bonds that diversify the risks noted above. That diversification comes at a cost, known as the fund expense ratio, so work to minimize fees.
Two-low expense bond funds are the Vanguard fund noted above or the Fidelity U.S. Bond Index Fund. They have annual expense ratios of 0.05 percent and 0.025 percent, respectively. I tell people these bond funds have less risk in a year than stock funds have in a day.