First of all, I must confess that I’m not a big fan of bonds in general. I have always been an aggressive stock investor and I didn’t understand why I needed bonds. Historically, the stock market has a higher return on investment (ROI) than bonds over the long term. So I thought, if I’m not concerned about volatility, then why not just invest 100% in the stock market?
100% invested in the stock market
I think going all in on the stock market is fine if all these apply to you:
- You are young – You have 20+ years of time to add to your stock market investment, and you can afford to ignore the short term volatility. You will have time to recover from big market crashes.
- You have a high saving rate – When those bear markets come along, you have plenty of extra savings to take advantage of the bargains. You will be able to dollar cost average your stock positions and reap the benefit later.
- Your portfolio is small – If your portfolio is small, it’s really not a huge deal to go through a big correction. If you have $50,000 in your portfolio, a 50% drop is just $25,000. That may sound like a lot of money to young folks, but believe me, it’s not. You can recover from that pretty quickly if you have extra income to invest. On the other hand, if you have a $2 million portfolio, it would be much more difficult to recover from a 50% drop.
- You have high risk tolerance and don’t mind the volatility – The stock market can be very volatile and many people can’t deal with sudden drops in the value of their portfolio.
In my 20’s, I fit the bill perfectly, but that’s no longer the case. I don’t make a lot of money anymore so I won’t be able to add much money during a down market. At this point, I’m not willing to lose 50% of my investment portfolio.
Everyone need some bonds
Over the last few years, I have been reading more financial books and all of them recommend holding some bonds. The Millionaire Teacher by Andrew Hallam in particular showed me how holding bonds can be helpful during a down market. Bond prices usually rise during a bear market and you can sell some bonds to buy stocks at bargain prices. After I rolled over my 401(k), only 10% of my portfolio was in bonds and I have been working to correct that. Currently, I have 20% in bonds and 20% in cash. My target is to increase my bond holdings to around 30% in the next few years. Hallam recommends the same % of bonds as your age, but I’m going to take my age minus 10 because I still want to be a bit more aggressive.
What Bonds to buy?
The interest rate is very low now and it will go up at some point. When the interest rate rises, bond yields will rise and bond prices will drop. From what I read, this is not a good time to buy bonds. One way to avoid price fluctuation is to buy bonds directly from the issuers and hold them until maturity. That way, you won’t be affected by the price fluctuation.
Series I Saving Bonds (I Bonds)
I Bonds are issued by the US Treasury and are backed by the US government. This is one of the safest ways to invest your money. A US resident with a social security number can buy up to $10,000 worth of I Bonds each calendar year. You can also use your tax refund to buy additional I Bonds, up to $5,000.
Interest rate – I Bonds are indexed to inflation so the money you invest today will maintain its purchase power. Interest on a I Bond rate is a combination of two rates.
- A fixed rate at the time of purchase which remains the same though the life of the I Bond. I Bonds pay interest for 30 years so there is no advantage to hold them longer than that. The fixed rate has been zero since November 2010.
- A variable inflation rate which is calculated twice a year.
The good thing about I Bonds is the variable rate will never be negative. Even if we enter a long period of deflation, the rate can drop to 0% at the most. In contrast, the other inflation-protected bonds from the US government (TIPS) already have negative interest rate.
Tax advantages Tax Deferral – I Bond interest accrues in your account over the time you hold it. You only pay tax when you redeem your bond.
Tax Exemption – You don’t have to pay State and local income tax on the interest earned. One good way to take advantage of the tax deferral is to build a bond ladder. You can buy $10,000 of I Bonds per year and redeem them after you retire. You’ll most likely be in a lower tax bracket then and pay less tax. This $10,000 can be a nice supplement to your social security income. I Bonds interest is also tax exempted if you use it to pay for education. Your MAGI (modified adjusted gross income) needs to below a certain threshold though.
Limitations You have to hold I Bonds for at least one year. If you redeem before 5 years, then you give up the last 3 months of interest. After 5 years, you can redeem the bonds without penalty. Geez, that’s a lot of info. I tried to go over the most interesting points. You can read more about I Bonds and purchase them at Treasury Direct.
Why I’m buying
I’m going to assume most young folks don’t have a lot of bonds for the same reasons I didn’t. It’s a good idea to have a portion of your portfolio in a safe and stable investment though. The next time we have a bear market, I will be able to use these reserve funds to pick up some bargains. Let’s summarize why I’m buying I Bonds.
- It’s a safe investment that is backed by the US government.
- I Bonds are inflation protected because their interest rate is adjusted to inflation every 6 months.
- I need to increase the bond allocation in my portfolio.
- The interest rate is better than saving accounts and CDs.
- Tax deferral and exemptions.
- I have too much cash and want to shift some portions to I Bonds.
I purchased $5,000 of I Bonds each for myself and Mrs. RB40 in March. I’ll probably buy another $5,000 for us soon. I have been retired for almost a year and I found that we haven’t needed our $50,000 cash stash. I’ll shift these over to I Bonds over time. Maybe I’ll buy some I Bonds for Baby RB40, too. What about you? Do you have I Bonds in your investment portfolio? Why not open an account at Treasury Direct and buy some? You only need $25 to get started.