Bonds are an asset class almost every young person has heard of but very few truly understand what they are and whether they should make up a part of their investing strategy.
Most young people do not need to invest in bonds as part of their investment portfolio due to young people generally having a longer investment horizon and a higher tolerance for risk. However, bonds can be a good way to diversify, particularly for those who are more risk-averse.
If you’re interested in finally understanding what bond investing actually is and whether it would be a good idea to include this asset class in your investment portfolio, read on (estimated reading time: 7 minutes).
Should I invest in bonds in my 20’s
It is a personal choice whether to invest in bonds in your 20s or not. This choice will come down to your own risk tolerance and investing horizon and specifically how diversified you want your investment portfolio to be in terms of asset classes. People tend to invest in bonds more as they get older.
There are clear advantages and disadvantages to investing in bonds in your 20s. On the upside, bonds allow investors to better diversify their risk by being exposed to more asset classes.
Traditionally, bonds are negatively correlated with stocks in terms of returns, so if your stock portfolio decline, this risk would be at least somewhat mitigated by your exposure to bonds.
On the other hand, bonds have, on average, provided smaller percentage investment returns than stocks historically. So if an investor is solely focused on capital appreciation, i.e. increasing the total value of their investment pool as opposed to earning a predictable periodic income, bonds are less useful.
Due to this, the net effect of bonds is to essentially smooth out investment returns over time – the returns won’t be as great as they otherwise would be in times of rising stock prices but the returns won’t be as bad as they otherwise may be in a falling stock price environment.
As someone who is not particularly risk-averse, my own strategy is to not really include bonds in my investment portfolio as I am happy to ride through the fluctuations of the stock market at my age. However, I would advise everyone to consult a risk-tolerance calculator (click on the link to visit the calculator) to work out how averse to risk they are.
What are bonds?
Bonds are simply a promise between someone lending money and someone borrowing money that the money will be repaid according to an agreed timetable with an agreed level of interest. Bonds can be thought of as an ‘I owe you’ contract, typically with either corporations or governmental bodies.
Let’s say a Company needs to raise money to finance its expansion into new territory, one way it could do this is via a bond.
The Company may offer potential lenders of money the opportunity to lend them a set amount of money, let’s say £10,000 which will be paid back in full after five years. To incentive the lender to do this, the Company offers an interest rate of let’s say 2% per year.
Therefore, the lender gives the Company £10,000 and receives interest of £200 (2% * £10,000 a year) for the five-year bond term. At the end of the term, the Company returns the £10,000 principal that is borrowed.
As you can see, the lender has received its £10,000 back plus interest of £1,000 (£200 * 5 years).
The interest given is to compensate the lender for the risk they are taking by giving the Company money and the opportunity cost of not having that money available for other projects.
The principal risks of a bond like this are a) where the company can’t afford to pay back the principal and b) where the company is unable to make its scheduled interest payments.
For this reason, debt securities such as bonds are rated for their creditworthiness. I.e. government institutions issuing bonds are seen as very secure and likely to pay the lenders back and therefore have a low level of interest whereas some corporate bonds may be less secure and therefore have a higher rate of interest to reflect this.
Risk tolerance, investment horizon and bonds
Common advice is to increase your personal exposure to bonds more as you age. To understand this advice, we have to understand the interrelations between risk, returns, fluctuations and investing horizons.
If we consider a 55-year-old who is planning on retiring at 60, their investment horizon is only five years so they are naturally far more conscious of fluctuations (i.e. their investments going up and down in value) than a 20-year-old who has an investment horizon of 40 plus years as they don’t want to retire and see that their nest egg has dramatically decreased in size due to the fluctuations of the stock market.
For this reason, younger people are generally less risk averse as they are more willing or able to withstand big swings in their investment values.
Stocks, whilst an excellent tool for building wealth, are subject to big swings in valuations. A stock may return 25% one year and give negative returns the next year, depending on the wider market and the underlying company.
Bonds, on the other hand, are far easier to telegraph as the interest payments and principal payments are all laid out in the bond documentation.
Is it risky to invest in bonds?
Investing in any asset class has some inherent risk and bonds are no exception. Whilst generally considered less risky than stocks, bonds still involve risk, particularly with institutions that are not deemed credit-worthy and have a significant possibility of defaulting on the bond i.e. not repaying the money.
As a rule of thumb, investors are compensated for taking on additional risk via the possibility (not guarantee) of higher investment returns.
We’ve already discussed how bonds provide lower levels of return than stocks, which reflects how they are generally less risky. However, not all bonds are created equal. A bond from a government department is far less risky than a bond from a start-up enterprise.
The key forms of risk associated with a bond are:
Default risk – the bond issuer is unable to repay the borrowed money meaning the investor loses their principal money and any possible interest earnings.
Inflation risk – if the rate of inflation exceeds the returns of the bonds, the value falls as the purchasing power of the returns has decreased.
Interest rate risk – if the wider market’s interest rate changes, the value of an investor’s bond may fall relative to other similar bonds on the market, making it more difficult to sell the contract to other investors.
What should I invest in – stocks or bonds?
Stocks and bonds can both make up a part of an effective investment portfolio. For risk-averse people or those with a shorter investing horizon, the percentage of bonds should increase. For young people with a high tolerance for risk and a long investing horizon, stocks should make up the majority of their portfolio.
For young people with a long investment horizon, it would seem overly cautious to invest purely in bonds as the likelihood of significant appreciation is much lower than in a stock-only or combined stock and bond portfolio.
For more on this topic, check out my below article on whether 10% is a good return on investment.
What percentage should bonds make up of a young person’s investment portfolio?
Bonds should make up less than 50% of a young person’s investment portfolio. The younger and more risk-tolerant the investor is, the lower this percentage should be. It’s perfectly reasonable to have no exposure or very low exposure to bonds until closer to retirement age.
If you are someone who is willing to accept the fluctuations of the stock market and can handle their investments going up and down over time, it’s not necessary to invest in bonds or to only have a small exposure to them (<10%).
Vanguard’s LifeStrategy range of index funds gives the option for the investor to tailor their stock: bond ratios i.e. the Vanguard LifeStrategy 80 fund is 80% stocks and 20% bonds which may be appropriate for some younger investors.
How should I be investing in my 20’s?
Every young person should be investing in assets, whether that be stocks, bonds, property or other asset classes to the extent they can afford it. It’s very difficult to build and accumulate wealth by holding your money purely in cash, which is gradually eroded by inflation.
For y a full guide on how to get started with investing, read my post on how to start investing in an ISA in the UK with Vanguard by clicking on the link.
At what age should bonds become a part of my investment portfolio?
It is prudent to gradually increase exposure to bonds and decrease exposure to stocks as you approach retirement age but this is highly dependent on each individual’s personal circumstances. For those planning on retiring in their 60s, it may make sense to start investing in more bonds from their 50s onwards.
As always, please remember I am an Accountant, but not your Accountant. In this post (and all of my others) I share information and often give anecdotes about what has worked well for me. However, I do not know your financial situation and do not offer individual financial advice. If you are unsure of a particular financial subject, please hire a qualified financial advisor to guide you.
This article has been written by Luke Girling, ACA – a qualified Accountant and personal finance enthusiast in the UK. Please visit my ‘About‘ page for more information. To verify my ACA credentials – please search for my name at the ICAEW member finder. To get in touch with questions or ideas for future posts, please comment below or contact me here.