Bonds have an essential role to play in any investor’s portfolio. While they have not historically provided the same level of returns as equities, bonds still possess characteristics that add considerable value to your asset allocation. However, if you’re not familiar with how to invest, bonds may seem a bit mysterious to beginners.
Introduction to Bonds
Bonds are IOU investments in which a contract is formed between the issuer and the bondholder. The bondholder, or investor, agrees to lend money to the issuer – typically a government body or corporation. The money on loan goes toward operating and funding various projects. In return, the issuer agrees to pay back the bondholder on a specified date (with interest).
Due to the underlying guarantees, bonds are generally less risky than equities (stocks). Another crucial difference is that stocks do not agree to any financial reimbursement. As a result, bonds tend to provide lower rates of return.
However, this does not mean that bonds are free from risk.
Before we dive into the pros and cons, let’s look at the significant characteristics of a bond.
Before we continue, Financial Professional wants to remind you that this article serves educational purposes only. Any securities or firms named are for illustrative purposes only and do not constitute financial advice. Always do your due diligence and consider your situation – and the help of a licensed financial professional – when making investment decisions.
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Are You My Type?
Warren Buffet suggests that bonds should constitute no less than 25% of any portfolio for the best diversity. However, this all depends on what type(s) of bond you prefer to buy.
Some bonds offer the promise of high yields and fail to deliver, while others are always consistent in upholding their guarantee. It’s important for everyone, beginners and seasoned veterans all, to know what kind of bonds you’re looking to invest in before you enter a contract with the issuer.
A few of the more common bonds on the market include:
- Corporate bonds usually enjoy higher yields than other bonds. Frequently, these are favored as a tax shelter holding by middle to high tax bracket investors.
- Municipal bonds have more stable interest rates and smaller yields than corporate bonds. The money from these investments go toward city infrastructure, such as schools and hospitals.
- U.S. Savings bonds offer fixed interest and are not subject to local or state income taxes. The capital raised goes toward economic management and infrastructure projects.
- Series EE bonds sell at face value and offer a fixed rate of interest
- Series I bonds sell at face value and offer inflation interest adjustment
Term-inology of Bonds
A bond’s term refers to how long it takes before a bondholder sees a return on their capital. When the issuer pays back the investor, this is referred to as a bond’s “maturity,” which is divided into three categories:
- Short-term bonds have mature at or less than one year
- Intermediate-term bonds mature between 2 and 10 years
- Long-term bonds mature at 10 or more years
When looking at a bond’s maturity, the main consideration is the interest rate risk. Bond prices and interest rates have an inverse relationship. In short, when interest rates go up, bond prices fall, and vice versa.
As a rule, long-term bonds are generally riskier than intermediate-term bonds, which are generally riskier than short-term bonds. Interest rates are more likely to change over a longer period of time, which poses more risk of financial loss to the investor. To compensate for the risk, long-term bonds tend to offer higher starting interest rates.
Most bonds offer a fixed interest payment, known as a coupon. The coupon rate is stated as a percentage of the par value, or the amount of money you receive when the bond matures. Note that not all bonds pay interest (zero-coupon bonds).
Most coupon bonds pay out interest on a semi-annual basis. For example, say you buy a bond with a par value of $1,000 that pays a 7% coupon semi-annually. $1,000 x 0.7 = $70, which would be paid out in two $35 installments per year until the bond matures. At the time of maturity, you would receive your $1,000 principal back from the issuer of the bond.
While bond prices can increase, the coupon rate tends to be the primary source of return for fixed-income investments. As with the par value, the bond issuer also guarantees the coupon payment.
The Qualities of…
Another vital element of bond investing is understanding the quality of the bond. Quality is determined by, and directly proportional to, the creditworthiness of the bond issuer.
Typically, investors who hold riskier bonds demand higher rates of return compared to investors who own higher-quality bonds. This is why a U.S. Government Treasure bond yields a lower rate of return than a bond from a distressed government – they are more likely to pay up.
There are multiple rating agencies that attempt to describe the quality of bonds, and therefore the likelihood of the issuer defaulting on the loan. Moody’s and Standard & Poor’s are among the most well-known of these agencies. They each have their own system, though the processes by which they arrive at their conclusions are similar. For instance:
- Investment-grade bonds are high-quality and less prone to default risk.
- Junk bonds are much riskier and susceptible to default. Investors who hold junk bonds should be cautious about the risks to which they expose themselves, lest they lose their money in an unwise bid.
To Whom the Benefit?
While fixed income does not yield the highest returns compared to its sexier, more volatile counterpart (equities), the asset class still has potential to add considerable value to a portfolio.
For instance, the interest payments on a bond are a quick, easy way to generate returns on your investments. Income-oriented investors have an affinity for bonds, as they are a guaranteed way to see profits sooner rather than later. Beginners may be drawn to invest in bonds because of the promise of near-instant gratification. Furthermore, the reliability and consistency of fixed income coupons makes income planning easier compared to a portfolio of stocks, each with different – or no – dividends.
Furthermore, bonds are a diversifier in a portfolio. It’s wise to consider diversification not only across sectors, but across asset classes as well. A drastic – and apt – example of this stems from the nosedive the market took in 2008. While the S&P 500 dropped nearly 37%, 10-year U.S. Treasury Bonds returned over 20%!
Bonds act as a safe haven asset during volatile times. This can assist investors in avoiding steep maximum drawdowns (the killer of any financial plan).
My Name is Bond. Risk Bond.
Just because bonds are generally considered safer investments compared to stocks doesn’t mean they’re risk-free.
As mentioned earlier, bond prices are susceptible to fluctuations in interest rates. Bondholders should therefore be way of rising interest rates, as they can be detrimental to the value of their bonds. This is especially true for beginners in the world of bonds, as you don’t want to invest in a portfolio of losses from the outset.
Inflation risk also preys on your financial future. Bonds have a fixed coupon rate, which means that they do not account for inflation when their yearly payments are made. As such, in a high inflation year, the same interest payment will purchase fewer goods than during times of low inflation.
Note: while some bonds do account for inflation, such as Treasury Inflation Protected Securities, this is not a common practice.
Bonds play different roles in a portfolio based on the investors themselves. Generally, the younger an investor is, the less exposure they have with fixed income coupons. Statistically, early on in your investing career is when you can afford to take the most risk.
Your early investment years are also an important time for experiencing growth in your investable assets, during which you can establish a solid principal to build off throughout the coming decades.
On the flip side, the older an investor is, the more exposure they should have to bonds. Once an individual reaches their 50s and 60s, they are nearing the stage of life where they will rely on their portfolio for income. Because of this, preservation of capital and income generation takes precedence over higher returns.
Bond it All Together Now…
Bonds are a staple of the investing world for a reason. In fact, the bond market as a whole tends to be much, much larger than equity markets.
As with any investment, it’s essential to educate oneself on the basics of the asset class, the benefits, and the potential disadvantages. When it comes to bonds, it’s prudent to know what you invest in and why – especially for beginners with smaller portfolios.
Consider where you are in your investment timeline, your income needs, and your issuer – but most importantly, consider your goals. Whether you’re a young investor cutting their teeth or a seasoned veteran in the financial market, there will come a time where you are comfortable in your fixed income portfolio.