Bonds, especially U.S. treasury bonds, are one of the safest investments in the world. As we know, safe investments will have lower returns. Bonds are essentially debts or IOUs we are granting to an entity. The entity has a responsibility to pay us interest and the original amount (principal) of the loan we have given them.¹
There are various types of bonds, ranging from corporate to government to zero-coupon to convertible. The main difference between these types of bonds is the risk associated with them and how they are paid back to us.
An example of a bond would be if we purchased a 30-year U.S. Treasury bond worth $1,000 with 3% coupon rate, then for every year for 30 years we will receive $30 of interest ($1000 * 3%) and finally on the 30th year we will receive our $1,000 principal back.
From this investment, in 30-years we will have $1,900. Not great returns especially when we factor in inflation. With an inflation rate of 2.5%, our $1,900 will have the purchasing power of $906 in today’s dollars.²
For many of you in the wealth accumulation phase, we strongly believe you should have 0% of your investments in bonds and at least 95% in total market index funds.³
The chart below compares the returns of SWRSX (Treasury bond fund) and SWTSX (total market index fund) between 2007 to 2018.
SWRSX is a mutual fund composed of various Treasury inflation-protected securities (bonds).⁴ According to the chart from 2007 to 2018, SWRSX increased 10.30% versus SWTSX’s 115.43%. For context, an investment of $10,000 into SWRSX will turn into $11,030 and and the same $10,000 in SWTSX will turn into $21,543. That is a huge difference in returns.
Young professionals who intend to invest for 30+ years do not need bonds because the returns will be much lower and nearly stagnant if we account for inflation. Instead, we should invest at least 95% of our retirement funds into total market index funds similar to SWTSX.
If this is the case then why are bonds important or exist at all?
We may not need bonds now, but we will in the future. Let’s further examine the graph between 2007 and 2013. SWTSX began to tank in 2007 due to the financial recession and did not recover to previous levels for 2 years.⁵ While SWRSX barely changed and remained the same throughout the financial recession. 2 years is a long time, especially if you planned to retire during that period.
For many people, the financial recession would delay their retirement. Once we have accumulated enough wealth to retire comfortably, we should move a portion of our retirement funds to bonds to protect ourselves against economic disaster.
If a recession occurs, we can retire and withdraw from our bonds. This would allow time for our total market index funds to recover in value. In additional to the financial benefit, there is the psychological benefit of knowing bonds are safe and you can safely stop working.
Bonds are safe and we will need them the closer we are to retirement. During the wealth accumulation phase, we should not invest in bonds because we do not intend to withdraw money during a recession. What happens if we need to withdraw money before retiring? We won’t because we will be prepared with an emergency fund.⁶
Got more questions about bonds? More than happy to answer them in the comments or over email. If you would like to request a specific topic you want to learn more about, please let me know in the comments section below or email me at firstname.lastname@example.org!
¹ Description of bonds from Investopedia
² Inflation Calculator to calculate the effects of inflation
³ Description of total market index funds
⁴ Description of SWRSX
⁵ History of United States Bear Market from 2007–2009
⁶ The Importance of an Emergency Fund
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