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Investment Bonds For Retirement Planning

Bonds are often perceived as being a boring investment that gets a low return and it's better to put your money elsewhere like stocks or mutual funds. For the most part this is true in that bonds over the last 75 to 100 years have had a lower overall return then equities. As any investment adviser will tell you, bonds should still be part of a diversified investment portfolio and can lead to significant tax advantages and returns if invested in wisely.

Our first exposure to bonds may be as children when grandparents for Christmas would have given you a United States EE Savings Bond. It doesn't seem like much of a gift then but as adults we understand that purchasing something for $25.00 which will then be $50.00 at maturity is kind of magical. To be guaranteed by the full faith and backing of the United States government that something purchased today will be worth twice as much in the future is unheard of in most circumstances.

Of course there are many different types of investment grade bonds available for purchase by individual investors. However, not all of these bonds are suitable for retirement planning and may actually result in a reduction of principle if not all facets of those bonds are not clearly understood. Junk Bonds for example in a low interest rate environment would not be recommended for a retirement portfolio. Not only are they risky but if interest rates rise the bond issuer could wind up going into default and the bonds made worthless.

However there are lots of bonds which are perfectly suitable for retirement portfolios and should be included in the retirement planning process for asset allocation and diversification. There is one fundamental understanding as it relates to bonds which is when interest rates go up the value of the bond goes down; that is they work in opposite directions. This fundamental principle is important because it could lead to a devastating reduction in principle if purchased in a low interest rate high inflation economic environment.

This principle becomes even more important if investors purchase bond based mutual funds. This is because money put into a mutual fund is not purchasing bond shares directly but investing in shares of the mutual fund itself. Therefore if interest rates go up the bond mutual fund shares will more than likely go down reducing the initial capital invested. Why does this happen and how does it affect my retirement planning?

If a bond is issued at a value of $100 and an interest rate of 5% in a stable economic environment then there are not any problems and a 5% dividend will be paid to the bondholder. However, if inflation picks up then that same bond will have a value of less than $100 on the open market because interest rates will more than likely go up to compensate for inflation. So now that $100 bond will have an interest rate of 6% but it's only worth $90.00. For a single bond this isn't a big deal but if hundreds of thousands of dollars have been invested in a bond mutual fund and interest rates sharply spike over a few years than the initial capital could drop by double digit percentages.

This of course would have a devastating effect on a retirement portfolio and as such, bonds should be part of an overall diversification strategy with investments purchased and sold according to current macroeconomic environment variables. Portfolio re-balancing, especially as it pertains to retirement planning, becomes very important if the preservation of capital is necessary.

That's not to say bonds should not be held in retirement portfolios there are many types of bonds which can be highly beneficial such as zero coupon bonds and municipal bonds. If interest rates are high but decreasing and zero coupon bonds are purchased in an individual retirement account then the value of those bonds could increase significantly in a tax deferred environment. Municipal bonds are also often free from Federal taxes because they are issued by local and state municipalities for infrastructure projects.

It is never wise to make any investment blindly and buying bonds can wind up being as risky as any other investment is not fully researched and understood. A well balanced retirement portfolio may include some moderate percentage of bonds as part of an overall investment strategy to generate income or receive significant tax benefits. If you're unsure or uncomfortable purchasing bonds or bond mutual funds speak with a licensed and certified investment professional to help guide you in what could be a great part of a well balanced retirement portfolio.