Why Bonds Could Be the Right Fit for Short-Term Financial Goals
The girlfriend case
This post was inspired by my girlfriend. Now, let’s be clear—she hasn’t suddenly developed an interest in stocks or investing (she usually checks out when I even mention the word "stock"). But after a recent financial windfall, she’s found herself with more cash than she expected. Since buying a house isn’t on the horizon just yet, but something we’re planning in the coming years, she’s hesitant about taking risks with stocks or ETFs in the short term. That’s what got me thinking—what about bonds?
When I first started investing in 2021, bonds were often dismissed as boring compared to the excitement of stocks. I put them aside, even when interest rates started rising rapidly. But given today’s financial environment, bonds deserve a second look—especially for someone like my girlfriend, who needs a low-risk solution for her short-term goals. In this post, we’ll explore which types of bonds might suit her needs and look at which bonds currently offer the best return-to-risk balance.
Why Consider Bonds for Short-Term Investing?
There’s an old belief that bonds are the safest bet for short-term investments. To test this idea, we dug into some research. Studies suggest that, for investors with a one-year plan, Treasury bills (T-bills) and short-term bonds offer an ideal mix of low risk and reasonable return. Mukherji (2003) highlights the key role T-bills play in short-term portfolios thanks to their minimal downside risk. For those aiming for slightly higher returns without excessive risks, medium-term government bonds offer a good alternative.
On the other hand, stocks—while historically known for their long-term gains—aren’t recommended for short-term investors due to their volatility and potential for significant short-term losses. Shen (2005) emphasized this point, showing that stocks can expose short-term investors to much greater risks compared to bonds. Based on this, a combination of T-bills and short-term bonds often provides a good balance of liquidity and safety for a one-year timeframe.
Exploring Different Types of Bonds
Bonds come in many forms, each offering different levels of risk and reward. Government bonds are among the safest, as they are backed by a country’s government. The risk of default is low, which makes them particularly attractive for risk-averse investors. However, the trade-off for this safety is typically lower interest rates, especially in economically stable countries. For investors who are more focused on capital preservation than on seeking higher returns, government bonds could be a good fit.
Corporate bonds are another option, usually offering higher interest rates compared to government bonds. These bonds are issued by companies, which makes them somewhat riskier. If a company experiences financial difficulties, there’s a chance it might default on the bond. That said, bonds from companies with high credit ratings (known as investment-grade bonds) offer a middle ground: higher returns than government bonds, but with relatively lower risk compared to high-yield, or “junk,” bonds.
Another interesting option is inflation-adjusted bonds. These bonds protect investors against inflation by adjusting their payouts based on the rise in prices. They are particularly useful during periods of high inflation, ensuring that your investment maintains its purchasing power. However, the downside is that their initial interest rates tend to be lower than those of non-inflation-adjusted bonds, making them less attractive during periods of low inflation.
Zero-coupon bonds work a bit differently. Rather than paying periodic interest, they are sold at a discount and pay out the full face value at maturity. This can offer a good return over time, but since there’s no interest income during the bond’s term, they are more sensitive to interest rate changes. If interest rates rise, the market value of zero-coupon bonds can drop significantly, making them less appealing for investors who may need liquidity before the bond matures.
Lastly, we have asset-backed securities (ABS). These bonds are backed by pools of loans, such as mortgages, making them more complex. If you’ve seen The Big Short, you’ll know that these types of bonds played a role in the 2008 financial crisis. Despite this complexity, they are generally considered safe in today’s market. However, for someone like my girlfriend, who is looking for simplicity and short-term gains, ABS may not be the best choice.
Which Bonds Are Best for Short-Term Investments?
In my girlfriend’s case, simplicity and liquidity are key. This means we can immediately rule out convertible bonds, which allow investors to convert the bonds into shares. Since we need to turn these investments into cash in the short term, the stock conversion option doesn’t make sense. Likewise, asset-backed securities can be too complicated and unpredictable for a straightforward short-term investment strategy.
So, what are the most suitable bonds? Government bonds, while not offering the highest returns, remain a safe and reliable choice. They’re ideal for preserving capital, especially in politically stable countries with strong economies. Investing in these bonds would provide security without exposing her to unnecessary risks.
Corporate bonds, on the other hand, offer a balance of higher returns with some increased risk. For this type of bond, it’s best to focus on investment-grade bonds—those issued by companies with strong credit ratings. This ensures a good return potential without excessive risk. For an investor comfortable with slightly more risk and looking for higher returns than government bonds can offer, corporate bonds could be a good option.
Inflation-adjusted bonds also make sense, especially if inflation remains a concern. These bonds ensure that your investment isn’t eroded by rising prices, although the returns may not be as high as those from traditional bonds in a low-inflation environment. However, if preserving purchasing power is important, they are an excellent choice.
Alternatives to Traditional Bonds: ETFs and iBonds
Another way to invest in bonds is through bond ETFs. These exchange-traded funds offer diversification by spreading your investment across many different bonds, which helps reduce risk. However, ETFs often follow indices that invest in countries or companies with high levels of debt. This can be problematic, as you might find yourself heavily invested in bonds from countries like Japan, where government bonds often provide poor yields. Additionally, when bonds in an ETF mature, the fund automatically reinvests the money into new bonds, which may not align with your timeline if you need cash in the short term.
A more structured alternative is iBonds from iShares. These work similarly to bond ETFs but with one key difference: they have a fixed maturity date. This gives you a clear timeline for your investment, along with regular income from coupon payments. For investors like my girlfriend, who are focused on both diversification and liquidity, iBonds could offer the predictability needed without tying up funds for too long.
WATCH OUT!!!!
Investing in bonds is generally considered less risky than investing in stocks, but it still carries significant risks. One key risk is interest rate risk: when interest rates rise, the market prices of existing bonds fall, as newly issued bonds become more attractive with higher yields. This can lead to capital losses for bondholders who wish to sell before maturity. Additionally, there is currency risk for bonds issued in foreign currencies. Fluctuations in exchange rates can negatively affect both the interest income and the principal value for investors not holding bonds in their home currency. Inflation risk is another concern: if inflation increases, the real value of the fixed interest payments from bonds declines, reducing the investor’s purchasing power. Lastly, there is credit risk, which is the possibility that the bond issuer may default on its payment obligations, leading to partial or total loss of the investment.
Conclusion: Making the Right Choice
Given my girlfriend’s goal of converting these investments back into cash in the short term, government bonds or highly-rated corporate bonds seem to be the most suitable options. They provide a good balance of safety and moderate returns. Inflation-adjusted bonds could also be considered, particularly if inflation becomes a concern again.
For those looking to diversify without locking away cash indefinitely, IBonds are a flexible option that provides both a predictable timeline and steady income. Even for the girlfriend these IBonds are a good option that I will consider.
I hope this post has captured your interest, as it certainly did mine while writing it. There's so much to explore when it comes to bonds, and perhaps in the future, there will be more posts—such as how to determine the value of a bond. Stay tuned for more insights into this fascinating topic!
Please note: This article includes a disclaimer regarding investment advice.