I was talking to a friend last week when he began to grieve over his recent losses in the stock market.
“Is there anywhere safe to put my money?” he asked me.
“Bonds,” I replied, definitively and succinctly.
He rolled his eyes and told me bonds were boring.
“Are you having fun with the excitement of the stock market right now?” I pushed back.
I understood his hesitation. After all, he bought Tesla (Nasdaq: TSLA) stock years ago when the company’s cars were still a novelty. (He sold way too early and also invested in a lot of duds.) A bond will never generate the return of a great stock that was bought early. But that’s not what bonds are designed to do.
You buy them to protect your wealth and earn income.
Like stock prices, bond prices fluctuate (though typically not nearly as much as stock prices). However, unlike with stocks, you know exactly how much a bond will be worth in the future.
At a bond’s maturity date, it will pay investors $1,000 per bond – whether they paid $800, $1,000 or $1,100 for it. That payout is contractually obligated. The company’s stock could go to zero, but unless the company goes bankrupt, it will pay bondholders their $1,000 at maturity.
To top it off, investors will get paid interest while they wait for their bonds to mature.
And now that rates have come up from rock-bottom levels, there are many safe investment-grade bonds with yields to maturity (YTMs) above 6% or even 7%.
YTM is essentially the average annual total return until maturity. For example, a BBB rated bond from Air Lease Corp. (NYSE: AL) that matures in July 2026 has a YTM of 6.5%.
In other words, if Air Lease keeps the lights on and its business running, bondholders will earn an average yield of 6.5% until maturity. The chances of that happening are extremely high. A rating of BBB or better is considered investment grade. Investment-grade bonds have a default rate of just 0.1%.
While I suggest that bond investors plan on holding a bond until maturity, you don’t have to. You can sell anytime you want. And if the bond’s price goes higher, you can take profits. If it doesn’t rise – or if it even goes lower – that means nothing to you because you know that your bond will be worth $1,000 at maturity.
The Air Lease bond is currently trading around $850. Let’s say it drops to $750 in six months. Does that matter if you know with near certainty that you’ll get paid $1,000 at maturity?
For those willing to take on slightly more risk, high-yield bonds offer higher YTMs. I’m currently seeing some BB rated bonds with YTMs of 7.5% to over 10%. The average default rate on high-yield bonds is around 3% since 1998, with the vast majority of those defaults occurring in bonds rated CCC or lower. The current default rate of high-yield bonds in 2022 is around 1%.
I could tell my friend was going to ignore my advice. He prefers to buy high-flying stocks and complain when they don’t work out.
For the rest of us who want to know that a portion of our portfolio is very safe and earning 6.5% to more than 10% per year for the next few years, bonds are the way to protect your wealth, earn income and generate a strong total return.
I own bonds in my portfolio and will be adding more in the coming weeks and months. Most investors should do the same.