What are bonds?

Bonds are fixed-income financial instruments that represent a loan made by an investor to a borrower. The bond issuer borrows capital from investors for a defined period of time at a variable or fixed interest rate.

When you buy a bond, you are lending money to the issuer in exchange for a promised interest payment over a specified term plus repayment of principal at maturity.

There are different types of bonds:

• Government bonds are issued by federal, state or local governments. These bonds are considered low risk because governments can raise taxes or create additional currency to meet their debt obligations.
• Corporate bonds are issued by companies to raise capital. The credit risk depends on the financial health of the issuing company. Corporate bonds generally pay higher interest than government bonds.
• Mortgage-backed securities (MBS) pool mortgage loans together into a bond. These bonds pay interest based on the payments made by underlying mortgage borrowers.
• Municipal bonds are issued by states, cities and local governments to fund public projects. Interest income from munis is often exempt from federal taxes.

When you invest in a bond, you become a creditor of the issuer. The issuer is contractually obligated to pay you periodic interest payments at a coupon rate for the life of the bond plus repay the principal upon maturity. Bonds provide fixed, regular income to investors.

Why Invest in Bonds?

Bonds can play an important role in a diversified investment portfolio for several reasons:

• Diversification: Bonds tend to behave differently than stocks and provide steady income. Adding bonds to an investment portfolio that contains mostly stocks can provide diversification and balance risk.
• Lower Risk: Bonds are considered a lower-risk investment than stocks. Though their potential returns are lower, bonds provide more predictable returns than stocks. The relative stability of bonds can offset some of the volatility of stocks in a portfolio.
• Fixed Income: Bonds provide regular interest payments, usually semiannually. These payments provide income that is fixed, meaning they do not fluctuate like stock dividends can. Having a portion of a portfolio in bonds can provide investors with a steady stream of income.
• Capital Preservation: When invested in high-quality bonds, investors are likely to get their principal back when the bond matures. This makes bonds a good option for investors who want to preserve capital while still earning returns.

In summary, incorporating bonds into an investment portfolio can provide diversification, reduce risk, generate fixed income, and preserve capital. This makes them an attractive option for many types of investors.

How do bonds work?

Bonds are fixed income investments that pay interest to investors at preset intervals until the bond matures.

Bonds are issued by corporations, governments, municipalities and other entities to raise capital. The entity that issues the bond is known as the issuer. When an investor purchases a bond, they are essentially loaning money to the issuer.

In return, the issuer makes regular interest payments to the bondholder. The interest payments are usually made every six months. The bond issuer also agrees to repay the principal (the amount that was originally invested) when the bond matures or reaches its maturation date.

For example, a company may issue a 5-year bond with a face value of $1,000 and a 5% interest rate. This means investors who buy the bond will receive $50 in interest every six months for 5 years, equaling 10 total interest payments. At the end of the 5-year period, the investor will also receive the $1,000 principal that was originally invested.

The maturation date, interest rate payments, and face value are all established when the bond is first issued. The terms of the bond are legally binding on the issuer.

What are the different types of bonds?

There are several main types of bonds that investors can purchase:

Government Bonds

Government bonds are debt securities issued by governments to finance projects, infrastructure and operations. The U.S. Treasury issues Treasury bonds to fund federal spending. State and local governments issue municipal bonds to raise capital for local projects. Government bonds are considered low-risk investments since governments can raise taxes to repay their debts.

Corporate Bonds

Corporate bonds are issued by companies to raise capital for business operations, expansions and acquisitions. Companies with higher credit ratings issue investment-grade corporate bonds while companies with lower ratings issue high-yield or “junk” bonds. Corporate bonds carry more risk than government bonds but offer higher interest rates.

Municipal Bonds

Municipal bonds are issued by local governments such as cities, towns and counties. The proceeds finance public infrastructure projects like roads, schools, airports and utilities. Municipal bonds are exempt from federal taxes which makes them attractive to investors in higher tax brackets.

Treasury Bonds

Treasury bonds are debt securities issued by the federal government to fund operations and pay down existing debt. Treasuries carry the full faith and credit backing of the U.S. government and are considered one of the safest investments available. Treasury bonds pay interest semi-annually and return the principal upon maturity.

Junk Bonds

Junk bonds are high-yield, high-risk bonds issued by companies without investment-grade credit ratings. Junk bonds compensate for their higher default risk by paying much higher interest rates than investment-grade bonds. They can potentially produce greater returns but investors may lose their entire principal if the issuer defaults.

What are the risks of bonds?

Bonds carry certain risks that investors should be aware of before investing. The main risks associated with bonds include:

Interest rate risk

Interest rate risk refers to the risk that bond prices will fall if interest rates rise. This is because when interest rates go up, newly issued bonds pay higher interest. Existing bonds with lower rates become less valuable. Longer-term bonds tend to be more sensitive to interest rate changes than shorter-term bonds.

Inflation risk

Inflation can reduce the purchasing power of interest payments from bonds. If inflation rises faster than the interest rate earned on the bond, the real return on the investment is reduced. This risk is higher for longer-term bonds.

Default risk

Default risk is the chance that a bond issuer will fail to repay interest and principal. This risk varies between issuers based on their creditworthiness. Government bonds typically have the lowest default risk while high yield corporate bonds have higher default risk. Ratings agencies assess the creditworthiness of bond issuers.

How to Buy Bonds

There are a few main ways to invest in bonds:

Newly Issued Bonds

• When companies, municipalities, or governments need to raise capital, they may issue new bonds. Typically this is handled through an investment bank that helps price and organize the bond issuance.
• As an individual investor, it can be difficult to directly buy into a newly issued bond offering unless you are an institutional or accredited investor. The minimum investment amounts tend to be high.
• Talk to your financial advisor if you are interested in newly issued municipal or corporate bonds, as they may have access to new offerings that are appropriate for your portfolio.

Secondary Bond Market

• Most trading of bonds happens on the secondary market, after a bond has already been issued. This is where individual investors can buy bonds.
• You can buy bonds on the secondary market through a brokerage account. Talk to your broker about available inventory and pricing.
• Another option is purchasing bonds directly through TreasuryDirect for government bonds or directly through a bond issuer for corporate bonds. This allows you to avoid broker commissions and markups.

Bond Mutual Funds and ETFs

• For diversification and simplicity, consider investing in bonds through a mutual fund or ETF that holds a portfolio of bonds.
• These funds trade on the stock market like a stock but provide exposure to many underlying bonds. Investors can achieve instant diversification.
• Make sure to research the fund’s holdings, strategies, risks, expenses and past performance before investing. Target funds that align with your risk tolerance and portfolio needs.

Bond Ratings and Research

When investing in bonds, it’s important to research the credit quality and potential risks. The two largest credit rating agencies, Standard & Poor’s (S&P) and Moody’s, analyze bond issuers and assign credit ratings. These ratings can give investors insights into the financial strength of the issuer and the likelihood of default.

Some key things to consider when researching bond investments:

• Credit Rating – The credit rating from S&P or Moody’s indicates the creditworthiness of the bond issuer. Ratings range from AAA/Aaa for the most creditworthy down to D for bonds in default. In general, the higher the rating, the lower the yield, as higher rated bonds are seen as safer investments.
• Yield to Maturity – The yield to maturity represents the total return an investor can expect if they hold the bond until it matures. This factors in both the coupon payments and any capital gains or losses. Yields tend to be higher on bonds with lower credit ratings to compensate for the additional risk.
• Duration – Duration measures a bond’s sensitivity to interest rate changes. Bonds with longer duration tend to be more sensitive and may decline more in price when rates rise. Shorter duration bonds are less risky in rising rate environments.
• Callability – Some bonds are “callable”, meaning the issuer can redeem them before maturity. This introduces reinvestment risk if rates decline. Investors may want to avoid callable bonds if rates are expected to fall.
• Liquidity – Secondary market liquidity is important, as it represents how easy it is to sell a bond before maturity. Larger issuances from well-known entities tend to have higher liquidity.

Performing thorough due diligence and analyzing the risk metrics can help drive informed investment decisions in the bond market. Monitoring credit developments and staying diversified are also key for managing portfolio risk.

Bond Investment Strategies

Bonds can be purchased individually or through funds and ETFs. Here are some strategies for investing in bonds:

Bond Laddering

A bond ladder spreads out maturities over several years so bonds are constantly maturing. This provides steady income and reinvestment opportunities without tying up money long-term. To create a ladder, buy bonds that mature in successive years (i.e. 1, 2, 3 years).

Bond Mutual Funds and ETFs

Bond funds provide diversification by holding many different bonds. Bond mutual funds have managers who actively trade bonds based on market views. Bond ETFs passively track bond indexes. Both offer easy diversification for small investors. Consider the fees, liquidity, credit quality and duration of any fund.

Individual Bonds

Buying individual bonds allows you to choose maturity, credit rating and yield. Individual bonds have fixed principal payments if held to maturity, unlike bond funds. Focus on investment-grade corporate and government bonds. Build a ladder with bonds of varying durations for balance. Use online brokerages and bond platforms to purchase individual bonds.

Bond Alternatives

While bonds can provide stable income and diversification, they are not the only options. Here are some alternatives to consider:

Cash

Keeping cash in savings accounts or money market accounts provides liquidity and preserves capital. Interest rates on cash tend to be low, but risk is also very low. Cash offers stability but little growth potential.

Certificates of Deposit (CDs)

CDs are time deposits with banks that pay higher interest rates than savings accounts. The catch is that you cannot access the money until the CD matures, usually in set periods like 3 months, 6 months or 1 year. Penalties apply for early withdrawal. CDs offer modest returns with low risk.

Money Market Funds

These mutual funds invest in short-term debt instruments like government securities and commercial paper. Returns are driven by prevailing interest rates. The upside is that these funds provide higher yields than cash while still maintaining liquidity and low volatility.

While not offering as much diversification or income potential as bonds, cash and cash equivalents do provide stability and principal preservation. They can play a role in a balanced portfolio, especially for near-term savings goals or as a place to park money awaiting other investments.

The Future of Bonds

With rising inflation and the potential for interest rate hikes on the horizon, the future of bonds faces some uncertainty. However, bonds are still likely to play an important role in diversified portfolios.

Rising Rates

As the economy continues to recover from the pandemic, the Federal Reserve is expected to raise interest rates to keep inflation in check. This will cause yields on newly issued bonds to rise. However, bonds already held in a portfolio will not change. Their prices may drop initially, but if held to maturity their face value will be repaid. Rising rates present an opportunity to reinvest matured bonds at higher yields.

Inflation

Inflation erodes the purchasing power of fixed bond payments. Shorter-term bonds can help manage this risk, as they can be reinvested at higher rates as inflation rises. Treasury Inflation-Protected Securities (TIPS) also provide protection, as their principal adjusts with inflation. Diversifying into assets like stocks, real estate, and commodities can further hedge inflation.

Demand

Bonds remain an essential part of asset allocation for income, diversification, and managing risk. With an aging population and pension funds needing fixed income, demand should continue. Bonds’ income and relative stability will still be attractive, even if their price movements may be more volatile during periods of rising rates. Overall, bonds will likely continue playing a key role in portfolios.

Note – This is not a financial advice to invest in Bonds. Make sure to do your proper research before investing in Bonds.