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.
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:
- Short-term: Bonds that fall into this category tend to mature within one to three years
- Medium-term: Maturity dates for these types of bonds are normally over ten years
- 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!
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.
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.
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.
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.
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?
Your Prosperity Financial Advisor can help you calculate the tax-equivalent yield to compare the return with that of taxable instruments.
What to know before investing in bonds
Like all investments, bonds have their own potential rewards and risks.
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:
- Hold those bonds until their maturity date and collect interest payments on them. Bond interest is usually paid once or twice a year.
- 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 are usually issued to raise capital for initiatives like expansion and R&D.
Corporate bonds tend to offer higher yields than other types of bonds. The trade-off is that corporate bonds have a higher default risk than municipal or federal bonds.
You will need to pay taxes on any interest earned from corporate 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 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.
In general, tax-exempt municipal bonds (munis) are more attractive to those in higher tax brackets. And if you live in a state with relatively high income tax rates, investing in municipal bonds will likely be a better option than taxable bonds.
You’re usually exempt from paying federal and state taxes on any interest earned from municipal bonds.
Pay attention to the credit rating when buying the bonds—they aren't as safe as U.S. Treasury securities.
U.S. Savings Bonds
The government sells savings bonds and other securities on its website.
There are two types of U.S. savings bonds: the Series EE and the Series I.
Series EE Savings Bonds vs. Series I Savings Bonds
Series EE Savings Bonds
Series I Savings Bonds
A U.S. savings bond is guaranteed to double in value over 20 years. It can keep earning interest if you hold it up to 30 years.
Interest is not subject to state and local taxes. And though interest is subject to federal tax, it is deferred until you cash in the bonds.
Series EE and I savings bonds are issued with maturities of 30 years, but can be cashed in after one year, with a penalty of 3 months’ interest. If you hold a savings bond for five years, you can cash it in, penalty-free.
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.
In general, bonds offer a predictable income stream and return of principal at maturity.
Your tax bill depends on the type of bonds held by the fund. Since fund managers regularly buy and sell bonds, there may also be capital gains and losses incurred. Bond funds pass along the interest income and capital gains on their investments to shareholders, who are then taxed on the taxable portion of those distributions.
Invest in multiple bond issuers for diversification, to create availability of funds at different times in the future, and to minimize exposure to lower creditworthiness of an issuer.
Junk bonds are a hot button topic. Junk bonds are a type of high-yield corporate bond that are rated below investment grade.
New investors are often attracted to junk bonds because they advertise double-digit yields during ordinary interest rate environments.
Junk bonds are generally taxed just like regular bonds.
Junk bonds lure inexperienced investors in with the promise of high yields, yet leave them high and dry when the companies that issue them miss payments or go bankrupt. Stick to investment-grade (read: Triple-A rated) bonds, especially if you have a lower tolerance for risk.
Foreign bonds are a way for foreign entities to raise capital in the domestic market’s currency.
Because investing in foreign bonds involves multiple risks, foreign bonds typically have higher yields than domestic bonds.
When Americans buy stocks or bonds from foreign-based companies, any investment income (interest, dividends) and capital gains are subject to U.S. income tax and taxes levied by the company's home country.
When you buy bonds of other countries or even companies located in other countries, you are subject to the operating rules of that country.
Here’s one example: In 2009, investors who owned bonds in oil companies headquartered in Venezuela, found their assets seized by dictator Hugo Chavez without any way to recover what they lost.
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.
DISCLAIMER: Advisory Services offered through Prosperity Financial Group, Inc., an Independent Registered Investment Advisor. Securities offered through Fortune Financial Services, Inc. Member FINRA/SIPC. Prosperity Financial Group, Inc. and Fortune Financial Services, Inc. are separate entities.