Although bonds may not be as popular as stocks and commodities, they are an important component of many investment portfolios. Although bonds are traded in large volumes each day, their true value is often overlooked and underappreciated.
Why should you invest in bonds?
You can diversify your portfolio by using bonds. Bond interest payments can be used to hedge against relative volatility in stocks, real estate, and precious metals. These interest payments can also provide a steady income stream.
How do bonds work?
You are basically lending money to a bond seller when you purchase a bond. They require cash to finance a venture or fund a program. These issuers can be a corporation, government agencies, or private individuals. You will receive interest payments at regular intervals in return for your investment. These payments are usually based on a fixed annual percentage (coupon rate). The bond’s face is also paid at the maturity date.
Bonds can be purchased in denominations as low as $100, though individual brokers may require a lower minimum purchase. Some bonds are backed with tangible assets like buildings, mortgage contracts, or equipment. In other cases, however, you can rely on the issuer’s ability to pay. Bonds can be bought and sold on the open market, just like stocks or other securities. Bond prices fluctuate and can be sold at a premium or a discount to the face value (par price). The more volatile a bond’s price swings, the longer it is until maturity. Bonds are exposed to certain inherent risks due to these factors.
Bond risk factors
While many bonds can be considered conservative investments with lower risk, others may not. All bonds come with some risk. There is always a chance that bonds will lose popularity and fall in price because they are traded on the securities markets. Interest rate fluctuations are a major factor in volatility in prices. If interest rates rise, the $1,000 you spend on a 10 percent bond might be enough to buy an 11 percent bond in the next month. Current investors may find your 10 percent bond worth less than $900.
Bonds are vulnerable to inflation because they typically have a fixed interest rate. Fixed investments are less attractive as consumer prices rise. There is also a possibility that the issuer may not be able to pay its interest payments or repay its bonds’ face values at maturity. This is called credit or financial risk.
This risk can be minimized by comparing the relative strengths of bonds and companies through a rating agency such as Moody’s or Standard & Poor’s or A. M. Best. Bonds also come with reinvestment risks: you might not get the same return if the bond matures.
Private corporations issue bonds that are highly volatile and high-interest, with varying degrees of risk. Many corporate bonds can also be called, which means that the debt can either be paid off or redeemed at a specific date. The company will pay back the principal and accrued interest. An additional amount is also paid to call the bond before it matures.
Some corporate bonds can be converted and exchanged for shares of company stock at a specific date. Zero-coupon bonds can also be purchased at a discount below the face value. You do not pay interest, but you will receive the face amount of the bond at maturity. A $1,000 zero-coupon 5-year bond costs $600. You will receive $1,000 at the end of five years. Corporate bonds can mature in one to 40 years. They typically pay fixed interest every six months.
U.S. government securities
Securities backed by full faith and credit from the U.S. government are safe. The terms of United States Treasury bills (T-bills) range from a few days up to 52 weeks. They can be purchased at a discount or redeemed at their full face value at maturity. Treasury bonds have a term of 30 years, and Treasury notes have terms ranging from 2 to 10 to 10. The interest earned on these securities is subjected to federal taxation but is not subject to any state or local taxes.
Numerous federal agencies also issue bonds. These bonds are risky, as with all investments. However, they are considered safe because they guarantee timely payment of principal, interest, and other payments by the U.S. government. These bonds may use mortgages as collateral. Most mortgage-backed securities pay monthly interest to bondholders.
Municipal bonds (munis) are issued by states, counties, or municipalities. They are generally exempt from federal taxation, with some exceptions. If you live in the state, county, or municipality where they were issued, some may be exempt from tax. Although municipal bonds typically pay lower interest than taxable bonds, the overall return of these bonds may be higher due to their tax-reduced status (or non-tax-free).
There are two types of Munis: revenue bonds and general obligation (GO) bonds. GO bonds are backed up by the taxing authority in the issuing state or local government. They are, therefore, less risky and have a lower coupon. Revenue bonds can be supported by money raised from bridges, toll roads, or other facilities that they were issued to finance. These bonds are riskier because they pay a higher rate of interest and have a greater chance of default. To ensure that you are able to pay the required income, do your research on the project before investing.
How to start investing in bonds
There are thousands of books, newsletters, websites, and other information available that will help you to evaluate and select bonds. This information will allow you to get started investing. In addition, major bond-rating agencies provide concise letter grades that indicate the relative strength of bonds or corporations.
If you don’t feel confident, a financial advisor or brokerage firm can help you make informed decisions. This service may be offered at a charge by advisors or brokers.
Bonds can be purchased from a broker or a commercial bank over the Internet. You can also buy Treasury securities directly from the U.S. Treasury. In addition, you can purchase shares in bond funds through a bond trust or mutual fund.
Monitor your bond portfolio
As with all investments, you will want to monitor your bond portfolio. While other factors can affect bond prices, they are often directly tied to interest rates. Rates rise, and the market price for your bonds goes down. However, if interest rates drop, your bonds will generally appreciate in value.
The current yield of a bond is also affected by interest rates. This measures the coupon rate for your bond relative to its current price. With a drop in bond price, the current yield will rise and vice versa. Bond prices can also be affected by inflation, corporate finances, or government fiscal policy.
The role of bonds in a portfolio
Governments have been issuing bonds with greater frequency since the early 20th century, leading to the development of the modern bond market. Investors are drawn to bonds for a variety of reasons, including capital preservation, income, diversification, and protection against economic weakness or deflation. As the bond market has grown in size and diversity, bond prices have become more volatile, leading many investors to trade bonds for the potential of capital appreciation. Today, investors have a range of motivations for investing in bonds.
One significant benefit of bonds is capital preservation. Unlike stocks, bonds have a predetermined maturity date when the principal should be repaid. This characteristic is attractive to investors who don’t want to risk losing their capital or who have liabilities due at a specific future date. In addition, bonds typically offer a fixed interest rate that is often higher than short-term savings rates, providing investors with regular income.
Income: The majority of bonds offer a fixed income to investors, with interest payments sent to the bondholder on a regular schedule, whether quarterly, bi-annually, or annually. These payments can be reinvested in other bonds or used as desired. While stocks can also provide income through dividends, these payments are usually smaller than bond coupon payments, and the timing of dividend payments is at the discretion of the company. In contrast, bond issuers are legally required to make coupon payments.
Capital appreciation: Bond prices can increase for various reasons, such as a decrease in interest rates or an improvement in the issuer’s creditworthiness. Suppose an investor holds a bond until maturity. In that case, any price gains that occur over the life of the bond are not realized, as the bond’s price typically returns to its par value of 100 as it nears maturity and the principal is repaid. However, investors who sell bonds after they have risen in price – but before maturity – can achieve capital appreciation, also known as price appreciation, on their bonds. By capturing the capital appreciation of bonds, investors can increase their total return, which is the combination of income and capital appreciation. Investing for total return has become one of the most commonly used bond investment strategies in the last four decades.
Investors have found several reasons to include bonds in their portfolios, including diversification and as a potential hedge against an economic slowdown or deflation. Diversification is the practice of investing in a variety of assets, such as equities, bonds, commodities, and alternative investments, to lower the risk of low or negative returns on investments.
Bonds can provide a potential hedge against an economic slowdown because bond prices depend on how much investors value the bond’s income. Inflation, a condition where prices of goods and services rise, reduces the attractiveness of fixed bond income because it buys fewer goods and services. Conversely, slower economic growth usually leads to lower inflation, which makes bond income more attractive. Furthermore, if the economy falls into deflation, bond income becomes even more attractive because bondholders can buy more goods and services with the same bond income. As demand for bonds increases, bond prices increase, providing bondholders with higher returns.
Therefore, investors may choose to invest in bonds for capital preservation, income, diversification, and as a hedge against economic weakness or deflation. Additionally, investing for total return, which combines income and capital appreciation, has become a popular bond strategy over the past four decades.
In conclusion, while bonds may not be as exciting as stocks or commodities, they are a critical part of most investment portfolios. Bonds can diversify your portfolio and provide a hedge against volatility while also generating a steady stream of income. However, bonds also carry inherent risks, such as credit risk, inflation risk, and reinvestment risk. It is essential to consider these factors and thoroughly research bond issuers before investing. Despite these risks, bonds backed by the full faith and credit of the U.S. government are generally considered safe investments. Municipal bonds may offer tax advantages, but they require careful consideration of the project being funded. Overall, bonds can be an essential part of a well-diversified investment portfolio, providing stability and income, and should not be overlooked by investors.