Bonds are one of the easiest and most common ways to save money for the long term. There’s a good chance you already own one. If you have a certificate of deposit at your bank or your credit union, you own a kind of a bond. CD’s are quite a bit different than other kinds of bonds, but they have many things in common.
Rather than going over different kinds of bonds, I’d like to explain why they are a good investment for those of us saving for future needs. In a previous article, I described two ways of looking at our investments. Bonds are very useful for the part of our savings that we intend to preserve.
Bonds Eliminate Timing Risk
I mentioned back in my introduction to TIPS that bonds are actually a type of loan. CD’s are loans that you make to the bank. If you ever wondered how to turn the tables on a bank and get them to pay you interest, that’s how. If you have had a CD before, you know that it has an end date. That’s how bonds work. They “mature.” When they do, you get your money back.
Because bonds have a due date, they are great for eliminating timing risk. Bonds come with a promise to return your money on a specific day. If you intend to go on a big vacation in two years, you can get a two year CD at the bank and earn higher interest than you would in a regular savings or checking account. When the CD matures, you get your money back and all the interest right when you need it.
You can imagine what might happen if you put that money in a mutual fund for two years. If you happen to have planned your vacation during the next stock market crash, you probably would have to change your plans. It might be ok to miss your vacation, but putting off your retirement because you took that risk would probably be a bigger deal.
Certificates of Deposit and Inflation
Taking out a two year CD might not be that bad. At the time I write this, CD rates are still quite a bit lower than the rate of inflation. When that is true, you end up paying the bank to hold and protect your money. That’s not always a bad idea. Putting all that money in your house might be worse, but it sure would be nice to be able to keep up with inflation don’t you think?
I Bonds vs. CD’s
You might consider I Bonds for a two year holding time or more. You can’t take your money out for the first year, so if you need the money sooner than that, it wouldn’t be a good idea. If you need the money in less than five years, it would still be a pretty good idea to put your money in an I Bond because it protects your purchasing power at the cost of losing three months of interest. It’s still better than most bank CDs at the time that I write this. After five years of waiting, you can take the money out any time. If you have more than 30 years to wait, you will have to sell your bond in thirty years and get a new one. You can find out more about I Bonds in another article.
The advantage of using an I Bond over a CD is that you are more certain to keep up with inflation. There are CD’s that allow you to “step up” your interest rate if the interest rates go up at some point. The problem with that is that interest rates and inflation are not really linked. The will of the government is in between. Governments occasionally force interest rates lower as a way to “fix” the economy. As a result, CD’s have proven to not be a very precise way to protect your money’s purchasing power.
Using a Bond Ladder
You may have seen an article or heard someone at your bank talk about putting some money in a CD ladder. This arrangement helps you take advantage of changes in interest rates over time. It’s another way to attempt to deal with inflation issues as well.
The idea is that you split up your money, and buy CD’s or bonds with different maturity dates. For instance you might buy one for six months, another for one year and another for two years. The idea being that every six months you would have a CD coming due. When it does, it allows you choose whether you need to use some of the money or put it back into another CD. It also allows you to take advantage of changes in the interest rates as they go up.
When you are trying to save your money for later, bond ladders have much different purpose. When you are using inflation protected bonds like I Bonds or TIPS you don’t really have to worry about the interest rates. Remember that taking advantage of rising interest rates is the kind of thing we do with the part of our money set aside for opportunity investing. When we are dealing with the preservation side, what we concern ourselves with is timing. We just need to ask ourselves: When do I need this money? In this case, we would use a ladder to put the right amount of money in the right place in the future to meet our needs.
Here’s an example. Suppose you need your money in 15 years. It may require that you take out a ten year TIPS, and after 10 years you need to remember to buy another 5 year TIPS when it matures. You can think of your needs like buckets of money. Let’s say that you have one bucket for each year during your retirement. You need a ladder of bonds that reach to each bucket in order to fill them with the right amount of money so that you meet all of your needs.
Beware of Bond Mutual Funds
Bond mutual funds don’t have a maturity date. Shorter duration funds may be safer than stock funds, but they are definitely more risky than just owning the bonds. That’s because the fund share prices change every day based on market forces, not inflation. I plan to explain that more in an article about mutual funds.
A Smart Way to Plan
Bonds are a great way to plan because they are based on time commitments. Not everything in life can be planned, but for things that need to be, it really makes sense to use investments that have commitments built into them so that you can be sure to have money when you need it.