The bond market has become synonymous with many of today’s most prolific investors. The addition of bonds to any portfolio may simultaneously yield income, mitigate risk and diversify holdings. That said, not everyone knows how to invest in bonds, and many novice investors are missing out on a unique opportunity to bolster their portfolios. Now, perhaps more than ever, the safety of bonds can help investors navigate today’s uncertain marketplace.
Bonds have already proven they belong in most investment portfolios; now it is time for you to determine whether or not they belong in yours.
What Are Bonds & How Do They Work?
Bonds are an attempt on behalf of governments, municipalities, and corporations to raise capital for a wide range of projects and ongoing expenses. In other words, when one of these entities needs money, they will issue a bond. It is worth pointing out, however, that these governments and companies are not going to banks and traditional lending institutions for the funds they need.
Instead, issuing a bond on the market allows them to tap into investor capital. When a bond is issued, it will be “purchased” by an investor. The money used to buy the bond will then serve as a loan for the respective company/government. That way, each entity gets the money they need, and investors can collect interest on the bond that they now hold. In their simplest form, bonds are ultimately glorified IOUs.
Governments, municipalities, and corporations will issue bonds for a specific amount, otherwise known as the face value. When an investor buys a bond on the market at face value, the entity agrees to pay back the same amount over a predetermined amount of time (the maturity date). In that time, the investor can expect to receive their initial investment, plus interest (also known as the coupon rate).
Let’s say, for example, San Diego wants to develop a park for $50,000 in a local neighborhood. To fund the project, San Diego will issue bonds on the open market. For the sake of this example, each bond will represent a request for $1,000. In addition to the face value, each bond will have a maturity date of ten years and a coupon rate of 5.0% (all things investors will know before buying a bond).
To fund the project, San Diego will need to issue 50 bonds, each with a face value of $1,000. When purchased on the market, the city will receive the money it needs to build the park, and the investor is promised their money back in 10 years, with interest. Instead of repaying each bond with one lump sum at the end of 10 years, the bond issuer will pay 5.0% (the coupon rate) in interest each year. In this example, the person holding the bond will receive $50.00 a year for ten years. In the tenth and final year, the bondholder will exchange their bond with the issuer for their final payment of $1,000. When all is said and done, the investor will have made $500 over ten years.
What Kinds Of Bonds Can You Invest In?
Bonds are a tool used by governments, municipalities, and corporations to raise money. That said, not all bonds are created equal. There are several types of bonds, each of which are based on the legal entity issuing them. Here’s a list of the bonds investors are most likely to come across, and how they contribute to diversified portfolios in their own unique ways:
Corporate Bonds: As their names suggest, corporate bonds are debt instruments issued by corporations. Large corporations will issue corporate bonds to pay for a wide variety of initiatives, like scaling their business or funding research and development. Corporate bonds typically coincide with higher yields than their counterparts, but the interest is taxable.
Municipal Bonds: Issued by cities, towns, and states, municipal bonds are usually used to raise money for public projects. Schools, roads, and hospitals, for example, can all be paid for using municipal bonds. Unlike corporate bonds, the interest made from holding a municipal bond isn’t taxed, but the yield is slightly lower.
General Obligation (Municipal Bonds): Municipalities across the country issue general obligation bonds to fund projects which aren’t expected to generate any income. As a result, the city, town, or state needs to come up with an alternative way to pay the bondholder. More often than not, general obligation bonds will witness municipalities increase taxes to keep paying back their bonds.
Revenue (Municipal bonds): Municipalities across the country issue general obligation bonds to fund projects which generate income. To build a toll road, for example, a town would issue a revenue bond to generate capital. As a result, the revenue generated from the toll road will be used to pay the bondholders.
Treasury Bonds: Otherwise known as T-bonds, treasury bonds are always issued by the U.S. government. Since they are backed by the government, treasury bonds coincide with the least amount of risk. However, the lack of risk also means the coupon rate on treasury bonds is much lower.
Savings Bonds: As fixed-income instruments issued by the U.S. Department of the Treasury, savings bonds help pay for the government’s borrowing needs. Again, bonds backed by the U.S. government are generally the safest, but the yields are slightly lower than those associated with other bonds.
Junk Bonds: Corporate bonds which don’t meet investment-grade requirements are called junk bonds. However, the higher risk associated with junk bonds comes with a higher yield. While there is a much higher risk of default associated junk bonds, corporate entities offer higher yields to entice investors.
Bond Funds: Not unlike mutual funds, bond funds pool capital from a number investors to invest in bonds. Bond fund managers will collect money from investors to invest in a variety of bonds: municipal, corporate, and treasury. Doing so grants investors access to professional money management and a diversified portfolio.
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Important Tips Before Investing In Bonds
Whether rehabbing real estate or trading stocks, investors need to familiarize themselves with the ins-and-outs of their particular industry, and bond investors are no exception. At the very least, gleaning a handful of tips can make learning how to invest in bonds a lot easier and safer.
Here’s a few of the most important tips new bond investors need to heed before they invest themselves:
Make sure the borrower can comply with their debt obligations
Understand the best time to invest in bonds
Invest in the bods that meet investment criteria
Check If The Borrower Can Pay Its Bonds
Bonds are essentially loans by which individual investors act as the bank to fund corporate or government projects. That said, there’s always a risk of default. While bonds like T-bonds or savings bonds are backed by the U.S. government, corporate and municipal bonds are not guaranteed to result in a yield for investors. Therefore, it’s imperative to mind due diligence and research on how likely the borrower is to comply with their debt obligations.
Fortunately, investors aren’t alone in their efforts to identify risk-averse opportunities. To help investors determine which bonds are most likely to repay their debts, Moody’s, Standard & Poor’s, and Fitch (three of today’s most trusted ratings agencies) have all come up with a system to determine the safest bonds to invest in. These ratings agencies look at bond issuers and evaluate their creditworthiness, not unlike how a bank would evaluate someone borrowing money for a home. The higher the grade, the more likely the company/government is to honor its debt. The grading works a lot like traditional school grades, with AAA representing the best possible score. The higher the grade, the safer the investment will be.
A slightly lower grade may represent a higher risk, but the risk is often justified by a higher interest rate. As a result, investors will also need to account for the coupon rate yield, along with their risk tolerance.
Know If It Is The Right Time To Buy
Investors need to account for the state of the economy when considering investing in bonds. There are good times and bad times to buy bonds. Investors will find bond yields more attractive when interest rates are higher, which begs the question: When is the right time to buy bonds?
The interest rates associated with bonds tend to move inversely from the broader U.S. economy. When the economy is firing on all cylinders and healthy enough to support high benchmark rates, companies and governments aren’t usually desperate for capital. The economy is usually strong enough to support any needs they may have. As a result, the interest rates on bonds in a booming economy are usually lower; they aren’t willing to overpay for money in an economy of abundance.
Conversely, companies and governments are usually more desperate for funds when the economy is in a recession. It is more likely issuers will entice investors with higher interest rates when the economy isn’t able to provide the money they need. In the end, issuers are willing to pay higher borrowing costs in a poor economy.
Choose Which Bonds Are Right For You
As previously discussed, there are several types of bonds. Treasury bonds tend to have the most secure profits, but offer some of the lowest return potential. Corporate and municipal bonds may allow investors to realize higher rates of return, but there’s no guarantee the borrowers won’t default on the loan. Junk bonds, on the other hand, award investors with incredibly high yields, but the corporate entities behind them aren’t “investment grade,” meaning their risk is exponentially higher.
Knowing full well that profits and risk are at a crossroads, investors must choose the bonds that meet their investment criteria. Investors with long-term aspirations, for example, are awarded the luxury of being able to choose the “riskier” bonds with higher yields. Investors near retirement, however, can’t risk losing any income, which makes the more risk-averse options appealing. To be clear, there’s no objectively correct way to invest in bonds, but investors would be wise to choose the fixed-income assets which meet their needs the best.
How To Start Investing In Bonds For Beginners
A lot of parallels can be drawn between buying stocks and bonds, but there is no correlation between where each may be purchased. The starting point for each asset is slightly different. While stocks are publicly traded on a centralized market, bonds are not publicly traded. Instead of trading on major indices, bonds must be purchased “over the counter,” which is another way of saying investors must go through a broker to buy most types of bonds; the exception is T-bonds, which are purchased directly from the government. Outside of brokers and government websites, investors may seek out exchange-traded funds that deal in bonds.
Unlike stocks, bonds require an initial amount of money to start investing. Most bonds have a face value of $1000, but there are options you can take to work around this. Here is a brief overview of how you can start investing in bonds:
Buying Bonds From A Broker: The first way you can start investing in bonds is by buying through an online broker. When you purchase from a broker, you are actually buying from other investors looking to sell. To receive a discount on the bond’s face value, you can purchase a bond directly from the underwriting investment bank in an initial bond offering.
Buying Through An Exchange-Traded Fund: ETFs most commonly buy bonds from several different companies and some funds vary in focus such as short-term, medium-term, and long-term bonds. Purchasing bonds through funds is ideal for individual investors as you do not have to purchase in $1000 increments and they provide immediate diversification.
Purchasing From The Government: You can buy government bonds from the Treasury Direct website. This can be beneficial as you do not have to pay a fee to a broker.
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Are Bonds A Good Investment?
Bonds may serve as a great addition to any investment portfolio. However, expectations for returns should be tempered. According to Maurie Backman at The Motley Fool, “stocks averaged an 11.3% return, while bonds averaged just 5.28%” between 1928 and 2010. While it’s not fair to expect bonds to realize as high of returns as stocks, the security they award investors is invaluable. It’s their relative safety which makes learning how to invest in bonds a great idea for new investors.
While bonds alone can provide their holders with predictable income over decades, their true brilliance shines when they are added to a diversified portfolio. Their inverse correlation with the stocks market means bonds tend to increase in value when stocks drop, and vice-versa. As a result, bonds are the perfect hedge against volatility.
The Pros Of Investing In Bonds
Learning how to invest in bonds will grant investors access to yet another powerful wealth-building vehicle. There’s more than one reason to consider these fixed-income instruments. For what it’s worth, bonds offer many other advantages:
Diversification: Today’s greatest investment portfolios are the result of proper diversification. A broad assortment of stocks, bonds, exchange-traded funds, and other assets can simultaneously protect investors from the volatility of the marketplace while giving them exposure to several industries. A well-diversified portfolio is capable of generating attractive returns and mitigating risk. According to David Cusick, Chief Strategy Officer at House Method, “the closer to retirement, the more you should invest in bonds. Younger investors in their late-20s and early-30s can aim for 70% stocks and 30% bonds. Every decade or so, move 10% more into bonds and draw down on stocks until the ratio is reversed.”
Value Preservation: The highest-rated bonds, like those backed by the U.S. government, promise to return the principal investment by the maturation date. Investors can expect at least some level of capital preservation. The likelihood of losing everything is relatively low when investing in AAA-rated bonds. That said, junk bonds do not award the same level of capital preservation as their safer counterparts, so the risk is entirely dependent on the bonds themselves.
Risk Mitigation: Bonds have developed a reputation for being less risky than traditional stocks. The fixed income generated from bonds is usually less sensitive to the macroeconomics of the U.S. economy, whereas stocks have proven volatile over short periods.
Income Yield: When an investor purchases a bond, they are agreeing to lend money upfront in return for fixed income throughout the designated maturity date. Therefore, investors can expect a predictable return the moment they buy the bond.
The Cons Of Investing In Bonds
Bonds have already proven they belong in a well-diversified portfolio. However, not unlike every other investment, they aren’t without caveats. Buying bonds also coincides with risks, not the least of which include:
Volatile Interest Rates: Investors in possession of bonds are always at risk of volatile interest rates. In the event interest rates rise instead of a healthy economy, bond prices tend to fall. Therefore, the value of bonds may drop when the economy starts making improvements. While the principal payment will remain the same when the bond is redeemed, investors may receive lower interest payments over the course of holding the bond.
Inflation: Inflation represents the rate at which the price of goods and services rises over time. Therefore, any bond that can’t at least keep up with the rate of inflation can lower investor returns and buying power.
Default: Treasury bonds are backed by the U.S. government, which means returns are almost guaranteed. That said, municipal and corporate bonds coincide with more risk. There is always the chance—low as it may be—the issuers default on the bond.
Lower ROI: Bonds have proven to be one of the most risk-averse investments in any portfolio. Their relative safety has proven invaluable to investors who have less time to make up for losses. However, bond investors tend to trade profits for safety. If frothing else, stocks tend to realize more returns than bonds but are slightly riskier.
The last year has proven just how volatile the stock market can be. In as little as a few months, stocks went from realizing one of the largest single-day drops in recorded history to breaking new record highs. At the very least, this year has been a roller coaster, and bonds may be just the thing to level the playing field for risk-averse investors. Consequently, learning how to invest in bonds can hedge against a volatile market, which may not be a bad idea until the uncertainty surrounding the Coronavirus blows over.
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FortuneBuilders is not registered as a securities broker-dealer or an investment adviser with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority (“FINRA”), or any state securities regulatory authority. The information presented is not intended to be used as the sole basis of any investment decisions, nor should it be construed as advice designed to meet the investment needs of any particular investor. Nothing provided shall constitute financial, tax, legal, or accounting advice or individually tailored investment advice. This information is for educational purposes only is not meant to be a solicitation or recommendation to buy, sell, or hold any securities mentioned.