The Basics of Building a Bond Portfolio

Mar 24, 2021

Are you looking for a way to bolster your portfolio’s risk-return profile?

If so, bond investing might be right for you. You can reduce the volatility of your portfolio by diversifying with bonds.

Even if you’ve been investing in the stock market for a long time, the bond market may seem like unfamiliar territory. In reality, bonds are simply debt instruments—assets that provide fixed income, plus some interest.

Read on to learn the basics of bond investing. 

What are bonds?

Simply put, bonds are a way for an organization to raise money. Corporations, municipalities, and the federal government issue bonds to borrow money. In return, you’ll receive interest payments.

Bonds can help guard against market swings. Historically, bond prices have moved in the opposite direction to stocks during times of stock market duress. 

Additionally, bond coupons can provide you with fixed income. Bonds are one of the most important investments available for those who follow an income investing philosophy, hoping to live off the money generated by their portfolio.

Furthermore, bonds serve the roles of capital preservation, capital appreciation, and as a potential hedge against deflation.

If you’re a young investor, your portfolio will be weighted more heavily toward stocks, which have greater growth potential over the long term. But if you’re nearing retirement, adding income-generating investments like bonds can help minimize the impact of market volatility.

With the variety of different options available to you, including municipal bonds, commercial bonds, savings bonds, and treasury bonds, you need to know which is right for your unique situation as well as the risks inherent to bond investing.

Don’t know where to start?

Your Prosperity Financial Advisor can help you build a balanced portfolio that generates returns but is resilient through all market conditions.

How do bonds work?

Bonds are one way that entities raise funds for specific projects. Instead of going to a bank, entities get the money by borrowing from investors. 

For example, you might buy a 10-year, $10,000 bond paying an interest coupon of 3 percent. (That’s the annual interest rate paid on a bond expressed as a percentage of the face value.) In exchange, your city promises to pay you interest on that $10,000 every six months, and then return your $10,000 after 10 years, on the maturity date, ending the loan.

Bonds can vary based on the terms of its indenture, or its key terms.

1

Maturity

Maturity refers to the lifetime of a given bond. This is the date when you receive the principal or par amount of the bond, and the entity’s bond obligation ends. 

Maturity is often classified in three ways:

  1. Short-term: Bonds that fall into this category tend to mature within one to three years
  2. Medium-term: Maturity dates for these types of bonds are normally over ten years
  3. Long-term: These bonds generally mature over longer periods of time

In general, the longer a bond’s duration to maturity, the more volatile its price swings. If you buy a bond that matures in 30 years, it could fluctuate far more violently than a bond that matures in two years. In some cases, bonds with high durations can actually fluctuate as much as stocks!

Maturity refers to the lifetime of a given bond. This is the date when you receive the principal or par amount of the bond, and the entity’s bond obligation ends. 

Maturity is often classified in three ways:

  1. Short-term: Bonds that fall into this category tend to mature within one to three years
  2. Medium-term: Maturity dates for these types of bonds are normally over ten years
  3. Long-term: These bonds generally mature over longer periods of time

In general, the longer a bond’s duration to maturity, the more volatile its price swings. If you buy a bond that matures in 30 years, it could fluctuate far more violently than a bond that matures in two years. In some cases, bonds with high durations can actually fluctuate as much as stocks!

2

Secured or unsecured

A bond can be secured or unsecured. 

A secured bond provides a specific asset as collateral for the bond if the entity cannot repay the obligation. If the bond issuer defaults, the asset is transferred to the investor.

An unsecured bond is much riskier, as it is not backed by any collateral. If the bond issuer defaults, you’ll receive little of your investment back.

3

Liquidation preference

When a corporation goes bankrupt, the liquidation preference dictates the order of payouts. After a firm liquidates, or sells off assets (such as mortgage contracts, buildings, and equipment), it pays out its investors. 

4

Coupon (aka coupon rate or nominal yield)

The coupon amount represents interest paid to bondholders. Bondholders are generally paid semiannually or annually. To calculate the coupon rate, divide the annual payments by the face value of the bond.

5

Callability (aka call provision)

Some bonds can be paid off by an issuer before maturity. With a callable bond, the issuing entity reserves the right to return the investor’s principal and stop interest payments early.

An entity may choose to call its bonds if interest rates allow them to borrow at a better rate. Callable bonds are appealing because they offer better coupon rates.

6

Tax status

The majority of corporate bonds are taxable investments. However, some government and municipal bonds are tax-exempt, so you won’t have to pay taxes on income and capital gains. Of course, tax-exempt bonds generally have lower interest than equivalent taxable bonds. 

Before investing in corporate and government bonds, check their ratings to assess the likelihood that you’ll be repaid. Investment-grade bonds are higher rated and high-yield bonds are lower rated.

Because each bond issue is different, it is important to understand the precise terms before investing. 

Need help building a bond portfolio?

We can help you calculate the tax-equivalent yield to compare the return with that of taxable instruments.

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What to know before investing in bonds

Like all investments, bonds have their own potential rewards and risks.

Advantages of Bond Investing

  • Low-risk. In the world of investing, bonds are considered to be relatively safe. Bond values don’t tend to fluctuate as much as stock prices, because fixed-income assets are generally less sensitive to macroeconomic risks, such as economic downturns and geopolitical events.
  • Diversification. Investors may eschew bonds because of their limited return potential relative to stocks. But while many investors claim that their goal is to maximize returns, their more accurate goal is to maximize returns without taking too much risk. As such, it’s crucial to invest in a bond portfolio.
  • Fixed income. Bonds offer a predictable income stream, paying you a fixed amount of interest (in the form of coupon payments) at regular intervals.
  • Capital preservation. Assets that promise the return of your principal (like bonds) are good for pre-retirees and retirees who have less time to recoup losses.
  • Community investment. When you invest in a municipal bond, you’re also giving back to a community. Your money might go toward improving a local school system, building a hospital, or developing a public garden. Municipal bond investors help enhance a community’s quality of life.

Considerations of bond investing

  • Lower flexibility. Bonds freeze your investment for a fixed period of time. For example, if you buy a 30-year Treasury bond, you can’t redeem it for 30 years. Your initial investment can potentially lose value. 
  • Lower returns. Historically, the return on investment you’ll get from bonds is substantially lower than what you’ll get with stocks.
  • Liquidity risk. You might wish to sell a bond but are unable to find a buyer.
  • Interest rate risk. When interest rates rise, bond prices tend to fall. Conversely, as interest rates fall, bonds typically rise. Interest rate movements are the major cause of price volatility in bond markets. (So, during times of rising rates, it’s often better to hold shorter duration bonds; as each bond matures, the proceeds can then be reinvested into a new bond paying a higher interest rate.)
  • Inflation risk. Bonds provide a fixed amount of income semiannually or annually. But if the rate of inflation outpaces this fixed amount of income, you may lose purchasing power.
  • Prepayment risk. Prepayment risk is the risk that a callable bond issue will be paid off earlier than expected, normally through a call provision. Firms have the incentive to repay the obligation early when interest rates have declined substantially, so instead of continuing to hold a high-interest investment, you may be left to reinvest in a lower interest rate environment.
  • Credit/default risk. This is uncommon. However, if you’ve invested in unsecured bonds and the issuing entity goes belly-up, you risk losing out on interest payments, getting your principal back, or both. In general, safety usually means the firm has higher operating income and cash flow compared to its debt.

Your Prosperity Financial Advisor can help you manage these risks by diversifying investments within your fixed income portfolio.

How to make money from bonds

Bonds are an integral component of any investor’s portfolio as a source of fixed income, diversification, and stability.

Benjamin Graham, the father of value investing, suggested having 25 to 75 percent of your investments in bonds and varying this based on market conditions. This strategy had the added advantage of keeping investors from boredom, which leads to the temptation to participate in unprofitable trading (i.e. speculating).

There are two ways you can make money from bond investing:

  1. Hold those bonds until their maturity date and collect interest payments on them. Bond interest is usually paid once or twice a year.
  2. When their market value increases, sell them at a higher price than what you paid initially. Bond prices usually increase if the borrower’s credit risk profile improves, or if the prevailing interest rates on newly issued bonds go down.

Of course, you’ll want to monitor your bond portfolio, as with any of your other investments.

How to buy bonds

Unlike stocks, most bonds aren’t traded publicly, but rather trade over the counter, which means you must use a broker. However, you can buy Treasury bonds directly from the U.S. government.

The bond market is regulated by the Financial Industry Regulatory Authority (FINRA). FINRA posts transaction prices as that data becomes available.

Different types of bonds

There are several types of bonds in which you can invest.

Corporate Bonds

Corporate bonds are usually issued to raise capital for initiatives like expansion and R&D. 

Municipal Bonds

Also called muni bonds, these are issued by states, cities, and towns to invest in local schools, hospitals, and community improvements. For example, a city might issue municipal bonds to build a new bridge, sports stadium, or toll road.

There are two types of municipal bonds: general obligation and revenue.

General Obligation Bonds vs. Revenue Bonds

General Obligation (GO) Bonds

General obligation (GO) bonds are used to fund non-income producing projects, such as playgrounds and parks.

These are backed by the full faith and credit of the issuing municipality, so the issuer can take whatever measures necessary to guarantee payments on the bonds, such as raising property taxes.

Revenue Bonds

Revenue bonds pay back investors with the income they’re expected to create.

For example, if California issues revenue bonds to finance a new highway, it would use the funds generated by tolls to pay bondholders. Revenue bonds are a good way to invest in a community while generating interest.

U.S. Savings Bonds

The government sells 2 types of U.S. savings bonds on its website: the Series EE and the Series I.

Series EE Savings Bonds
  • Offer tax advantages for education funding
  • Are guaranteed by the United States Treasury
  • Have a fixed rate of return for up to thirty years
  • Series I Savings Bonds
  • Feature both a fixed rate and a variable rate to keep up with inflation
  • Are backed by the taxing power of the U.S. government
  • Are guaranteed to never lose money
  • Bond Funds

    Bond funds are a special type of mutual fund. A bond fund takes money from many investors and pools it together for a bond fund manager to handle. The fund manager will then invest in a variety of individual fonds.

    Investing in bond funds can be safer than owning individual bonds.

    Junk Bonds

    Junk bonds are a hot button topic. Junk bonds are a type of high-yield corporate bond that are rated below investment grade.

    Foreign Bonds

    Foreign bonds are a way for foreign entities to raise capital in the domestic market’s currency.

    We Can Help

    A well-managed bond portfolio will deliver three crucial benefits to your portfolio: steady income, portfolio diversification, and capital preservation.

    If you’d like to learn more about fixed income investments, please fill out the form below. We look forward to hearing from you.

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