Bonds are sometimes seen as less glamorous in the world of investments; however, bonds can provide stability and a reduction in volatility when used to complete an investor’s diversification picture.
Bonds can benefit nearly everyone’s portfolio because they come with various risks and rates of return. Unlike a stock that may or may not appreciate, one of the most attractive features of bonds is that you know what you are getting .
This higher level of security makes bonds a very attractive investment. Fundamental things you need to know about bonds include the following:
- Bonds are loans. Corporations, governments, and municipalities (cities) which want to fund capital projects often turn to loans, giving investors the opportunity to lend money to the organizations to meet their capital needs. A bond buyer loans the company money, with the promise of repayment.
- Bonds pay a set rate of interest. When you purchase a bond there is a set interest rate called a coupon paid over a set period of time called the bond maturity. The most common payment schedule is semiannual or annual interest payments. Investors can take the cash payment or reinvest the interest to increase the rate of return. A bond is essentially an interest only loan with the principal (or capital investment) paid back to the investor, on the date of maturity.
- Bonds are either secured or unsecured investments. Just like personal loans, the rates you pay are higher for unsecured loans and lower for secured loans. Bonds operate under the same principles. Secured loans can include real estate, inventory, or other collateral that can be used to repay investors in the event of a default. They pay a lower interest rate than unsecured bonds, which are riskier because they rely only on the faith and credit of the company or government, rather than tangible collateral.
- Bond ratings measure the bond risk. Companies, like individuals, have a credit score that helps you determine the strength of the company and the risk of default. Independent companies like Moody’s, Fitch, or Standard and Poor’s rate bonds from AAA (being the strongest) to a D rating (which represents loans currently in default). A BBB rating and up are considered investment grade bonds with a low risk of default. That is equivalent to an individual with a 700 or higher credit score. A BB rating or below are considered junk or high yield bonds. They pay a much higher rate of interest, which correlates with their higher rate of default.
- Bonds have market value. The initial bond offering by the government or organization provides capital directly to the bond issuer to pay for the intended project. After the purchase of the initial bond, the investor may trade the investment on the market, much like a stock. The coupon or interest rate, current interest rates, time to maturity, and the strength of the issuer, determine the resale value of the bond on the secondary market. Most bonds do not offer market appreciation but focus on returns based on the interest rate.
- Mutual funds and ETFs hold bonds in their portfolios. Most consumers do not have large enough resources to purchase bonds in the initial offering, which could require a minimum investment of $100,000 or more. It is also a challenge to achieve diversification buying one bond at a time. Mutual funds and ETFs allow the average person to invest in bonds, take advantage of regular interest payments, and lower portfolio volatility with small investment amounts. 100% bonds funds, real estate-backed bonds, and balanced funds, which carry both stocks and bonds in the portfolio, are options for your bond investment.
- Taxes matter when you purchase a bond. Government and municipal bonds offer preferred tax treatment at state, local, and federal levels. The rates are often lower than corporate bonds, but investors can enjoy the tax benefits in a traditional brokerage account. Investments in accounts with other preferred tax treatment, such as a retirement account, may benefit more from corporate bonds that typically pay higher interest rates.
- Bonds are not without risk. All investments carry some form of risk. Bonds face three principal types of risk. Credit risk, which is the risk the company will not be able to pay back the bond on schedule. Prepayment risk is in place on callable bonds, which give the bond issuer the right to pay off the loan early. Companies typically call bonds when interest rates fall, and the company can issue new bonds at a lower rate, and pay off higher rate bonds. Interest rate risk is present because interest rates fluctuate over time. The longer the bond maturity date, the higher the risk of interest rate movement.
- Bonds improve diversification and reduce volatility. Many investors begin with an investment strategy with very little bond holdings. As you get older and more conservative bond holdings, increase because of the reliability of payments. You can purchase a bond, or a bond mutual fund and receive regular payments throughout retirement, while preserving your capital.
- The yield Determines the rate of return. The two most common yields are the yield to maturity (which considers reinvested interest) and current yield (which is the coupon or interest rate on the bond). Other yields calculate returns based on call dates, tax treatment, and other elements that are active in specific bond offerings.
Governments issue bonds such as US Treasury bonds. Municipalities issue bonds to pay for local projects like road improvements or building schools. Corporations like Apple or Ford issue corporate bonds. Bonds are called fixed income investments because the payoff amount never grows, and interest payments are steady. Investors can receive consistent, regular interest payments throughout the life of the bond to help pay retirement expenses without reducing the principal.
Adding a higher percentage of bond investments in your portfolio, as you near retirement, may help you establish investments that are less volatile and will preserve your capital investment dollars.