In this series of articles, we have already explored different investment options like small businesses, stocks, and mutual funds. In this article, we look at bonds as another popular, tried, and tested investment vehicle.
What is a Bond?
A bond is a financial instrument that companies, municipals, and the federal government use to raise capital for different purposes. With bond investment, an investor lends money to the bond issuer in exchange for interest. When an investor purchases a bond from a bond issue, the later pays interest to the investor and at the maturity date, the face value of the investment.
For example, Company A can issue a 5-year bond at a 5% interest rate. Investor A can purchase $20,000 worth of this bond. In that case, the company pays an annual interest (often paid twice a year) of $1,000. In the fifth year, Company A will also pay $1000 interest and make repayment of the principal amount – $20,000.
How to make money from Bonds
There are two ways to make money from a bond: interest payment and growth in bond value.
When a bond investor decides to hold the bond until maturity, he earns a consistent interest (as long as the issue does not default). Alternatively, the bond investor can decide to sell the bond before maturity. You can make money from this if there has been an increase in the bond value from the time of purchase to the time of sale.
However, a bond is majorly an income investing strategy. It is an investment option suitable for people who want to earn a consistent stream of income for a particular period. Therefore, most bond investors tend to hold it until maturity.
Different Types of Bonds
There are various ways to classify bonds. However, for our purpose, we will classify bonds based on the issuer. There are four types of bonds:
- Corporate Bonds: These are bonds issued by companies to raise funds for various R&D and capital investment projects. The interests earned on corporate bonds are subject to taxation.
- Municipal Bonds: These are bonds issued by states, local governments, cities, or local communities for public infrastructures and services. Interests on municipal bonds are exempt from tax at the federal level. If the investor purchases the municipal bond from his home state, it will also be exempt from state and local taxes.
- Treasury Bonds: These are bonds issued by the federal government. Treasury bonds come with the lowest risk since they are backed by the financial power of the federal government. Interests from treasury bonds are exempt from state and local taxes.
- Savings Bonds: Savings bonds offer a fixed rate of interest over a fixed period. Savings Bonds are non-marketable (you cannot sell them), and the interests accrue (only payable at maturity or redemption). The federal government issues them, and interests earned on them are exempt from state and local taxes.
There are other types of bonds popular in any discussion about bond investing:
- Zero-coupon bonds: These bonds do not pay interest. Instead, they are issued at below the par value. They function more like a treasury bill where the investor receives the par value at maturity.
- Junk Bonds: They are bonds issued by high-risk companies with ratings below BBB- (on standard and poor or Fitch) or Baa3 (on Moody). These bonds offer a high yield on investment to compensate for the high risk.
Pros of Investing in Bonds
Investing in Bonds is desirable for many good reasons:
Predictable and consistent income stream
A bond is a good investment vehicle for income investors. A bond allows you to earn a predictable and steady income stream through the bi-annual payment of interest.
By purchasing bonds from municipals, especially in your home state, you contribute to the development of your community and state. While this is non-financial, it gives a sense of social fulfillment.
Bonds are typically less risky compared to shares. Corporate bonds are the riskiest of bonds. However, rating agencies provide ratings of corporate bonds to help you identify companies that are financially sound with a lower risk of default.
When you purchase municipal bonds, you are exempt from federal tax on the interest. Similarly, when you purchase treasury and savings bonds, you are exempt from state and local taxes on the interest.
Cons of Investing in Bonds
However, there are some downsides to investing in bonds:
Interest Rate fluctuation
Interest rates do fluctuate. When they do, it may be a disadvantage to bond investing. If you purchase a bond today at 5% interest and interest rate rises to 6%, you will feel a sense of loss when companies issue new bonds at 6%.
While selling your bond and purchasing the new one is an option, it depends on the market value of the bond you want to sell. Since bond value sustains an inverse relationship to interest rate, you would probably lose if you sell the bond.
Long maturity period
Holding your money in bonds for 10, 15, 20 years is a long-term commitment. Tying down your money for that long period. Unlike stocks where you can buy and sell after a short time, selling a bond before maturity is mostly a bad idea.
The returns on bonds are generally smaller than the returns on stocks. Corporate bonds have the highest returns and the highest risk (compared to other bonds). However, the lesser risk (compared to stocks) compensates for the lower returns (compared to shares).
Possibility of default
While bonds are low risk compared to stocks, they are not zero risk investments (treasury bonds are the closest to no-risk investment). There is always the possibility that a company or municipal will default on interest payments.
Factors to consider before investing in Bonds?
There are certain factors that an investor must consider before deciding to invest in bonds:
- How close are you to retirement? When you are far away from retirement, you should have a higher percentage of your investment in stocks and a lower percentage in bonds. However, when you are closer to retirement, it is a great idea to be more invested in bonds than when you are farther away.
- What is your risk appetite? Bonds offer predictable and consistent income, which is attractive to the risk-averse investor and income investors. If you are an income investor or a risk-averse investor, you will want to invest in bonds.
- Diversification: Bonds are an excellent way to diversify your portfolio. This is especially important if your portfolio is stacked with so many stocks. It is a good way to reduce overall portfolio risk.
Recommendations for Investing in Bonds
Below are some recommendations for investors who decide to invest in bonds
- Have a plan: Like every other investment vehicle, have a plan for your investment in bonds. What do you want to achieve with bond investment? How does this goal(s) fit into your overall financial goals?
- Conduct Research: Use the rating agencies to know companies with a low-risk profile. Also, research the company issuing the bond to assure yourself of their viability.
- Avoid speculation about interest rates: Devise a strategy and stick to it. Timing the bond market is often futile.
- Create a bond ladder: To deal with the problem of the long maturity period, you can create what is known as a bond ladder. It involves purchasing bonds with different maturity period – 5 years, 10 years, 15 years, etc. rather than just buying a single type.
A sound investment portfolio will include a certain portion of bonds. The size of the portfolio that constitutes bond investment will differ from person to person and from time to time. However, whatever the size, bonds are tried and tested investment vehicle that surely belongs in your investment strategy. Make good use of them.