With stocks trading at record levels, bonds have become something of an investment orphan, especially among young people. They don’t hold the potential for double-digit capital appreciation the way stocks do. But that’s what’s happening in the current market. At some point, market conditions will change, and you will need some bonds in your portfolio before that day comes. That will leave you in a more favorable position to deal with uncertainty, and that’s the main purpose for investing in bonds in the first place.
Let’s take a close look at bonds, and how they should fit into your investment allocation.
How does a bond work?
A bond is a debt obligation, typically issued by a corporation or a government agency. They are unlike stocks, which represents ownership in an organization, notwithstanding the fact that “stocks and bonds” are often mentioned in concert with one another, like “peanut butter and jelly.”
Bonds are interest-bearing IOUs that can be issued for a specific purpose. That may include refinancing existing debt, making capital improvements, purchasing equipment or real estate, acquiring other businesses, or even to cover general expenses.
Bonds are typically issued for terms of up to 30 years, and pay a fixed amount of interest throughout the term. And once the term has expired, the issuing company or government agency pays off the bondholders and retires the debt. They usually sell at a face value of $1,000 each, but are purchased in blocks of five or ten at a time.
Institutions will issue bonds rather than obtaining bank loans, because they can usually get better terms for doing so.
There is one confusion surrounding use of the word “bonds.” In the strict definition, a bond is a long-term obligation, generally exceeding 10 years. But it’s not unusual for the word to be used in a way that also includes shorter-term maturities—sometimes as short as six months.
The relationship between bonds and interest rates
One of the most fundamental issues with bonds is that they have an inverse relationship with interest rates. When interest rates rise, bond values fall. And when interest rates fall, bond values generally rise.
Since bonds are interest-bearing securities, the value of a bond will be closely affected by changes in interest rates.
For example, if you purchase a $1,000 bond with an interest rate of 5 percent (known as the coupon rate), but rates rise to 6 percent, the value of your bond (i.e. what you could trade it for) will fall until it reaches a point where the bond can be purchased at a price that will result in an interest rate that approaches 6 percent.
Original bond value: $1,000 x 5 percent (coupon rate) = $50
Reduced bond value: $833 x 6 percent (market rate) = $49.98
By contrast, if you purchase a $1,000 bond with an interest rate of 5 percent, and rates fall to 4 percent, your bond will increase in value until they can be purchased at a price that will result in an interest rate that approaches 4 percent. This can provide the bond investor with capital appreciation.
Original bond value: $1,000 x 5 percent = $50
Increased bond value: $1,250 x 4 percent=$50
How much the bond will change in value due to changes in interest rates will depend upon the remaining term of the loan. As a rule, bonds with a remaining maturity of more than 20 years will be more subject to interest rate swings. Shorter terms, closer to 10 years, will be less affected because they are closer to being paid off.
Why you need bonds in your investment portfolio
There are five reasons why you would hold bonds in your investment portfolio:
- Though bond values can rise and fall, they are generally more predictable than stock prices
- A bond is a debt obligation that will eventually be paid in full by the issuer upon maturity; stocks have no guarantee of future value.
- Bonds offer an opportunity to add fixed-interest income to your portfolio, making you less dependent on capital gains alone.
- The greater predictability of bonds makes them very suitable to generating retirement income.
- Bonds sometimes (but not always) move in the opposite direction of stocks, reducing the volatility of your portfolio.
The different varieties of bonds
The word “bonds” actually covers a wide range of securities, including:
US Treasury securities
These are debt securities issued by the US government. They are issued in denominations as low as $100, and for terms ranging from a few days to one year (referred to as “bills” or “T-bills”), and up to 30 years (referred to as “bonds” or “T-bonds). Since they are issued by the US government, they are considered to be the safest investment securities available. They can be purchased through the US Treasury using Treasury Direct.
E*Trade is an example of a broker that deals with these securities, and they offer them commission-free. (E*Trade also offers many of the bonds we’ll discuss below).
These are debt securities issued by large corporations.
These are debt securities issued by states, counties, municipalities, and related agencies. The interest paid on the bonds is tax-free for federal income tax purposes. They are also free of state income taxes if you are a resident of the issuing state, but will be taxable if you live elsewhere.
These are corporate bonds that can be converted into stock of the issuing company at various times during the term of the bonds. Because of the connection with company stock, they can perform in a way that is very similar to stocks.
Bond issues are rated by bond rating agencies, such as Standard & Poor’s and Fitch. They are assigned letter grade ratings. AAA is the highest rating, but bonds are generally considered to be investment grade if they carry a rating of BBB or higher. Bonds with lower ratings are considered “junk bonds” or “high yield bonds” because they must pay a higher rate of interest due to the fact that there is a higher risk of bond default.
These can include bonds issued by either foreign governments, or by corporations based in foreign countries. They are similar to their US counterparts, but carry the added risk of currency fluctuations. They are generally considered to be more of a speculation than a safe investment.
One of the problems of investing in individual bonds is that it can be difficult to properly diversify your bond holdings if you don’t have a ton of money to invest. You can get around this by investing in bond funds.
A bond fund is a ready-made portfolio of bonds. You can choose specific categories, such as US Treasury securities, corporate bonds, or junk bonds. You can also select bond funds based on specific maturity ranges. This enables you to diversify across many different bonds, without having to manage the portfolio, and with a small amount of money.
If you do invest in a bond fund, be sure that you are completely familiar with everything that the fund holds. For example, if you are interested in US corporate bonds, be sure that the fund is not also invested in foreign corporate bonds.
The risks of investing in bonds
Despite the widespread perception of safety, bonds do have certain specific risks:
Interest rate risk
As discussed above, the price of a bond can fall if interest rates rise to a level that is higher than the effective rate at the time you purchased the bond. If you sell prior to maturity, you could lose money on the sale. This includes US Treasury Notes and Bonds.
With the exception of US Treasuries, virtually all bonds hold the potential for default by the issuer. If they do, you may receive only a small amount of your investment, or even none at all.
Even if a bond issuer does not default, and even if interest rates remain level, a bond can still fall in value. This can happen if the market believes that the issuer may be in danger of default. It can also happen if one of the bond rating agencies lowers the issuer’s credit grade.
There is no FDIC for bonds
Unlike bank investments, like savings accounts and certificates of deposit, there is no FDIC equivalent to insure bondholders in the event of a default by bond issuers.
Though they are typically small, transaction costs involved in purchasing and selling bonds can reduce the net interest yield that they pay. This is more pronounced during times like now, when interest rates are historically low.
Corporate bonds sometimes include this provision. It enables the issuer to redeem the bonds at certain times, or under certain circumstances. A common circumstance is when interest rates drop, and it will be in issuers favor to refinance the bonds at lower rates. This can take away the advantage of having a higher rate of return than what the market is currently paying.
Bonds don’t always move in the opposite direction of stocks
This is one of the primary reasons why investors hold bonds, but it doesn’t always work out. There are many times when stocks and bonds will move in lockstep. When that happens, the diversification aspect of bonds can be minimized.
Should you include bonds in your investment portfolio?
Considering all the risks involved in bond investing, should you include them in your portfolio?
As a 20-something or 30-something investor, you generally won’t be holding a large bond position anyway. This is because your investment focus needs to be on growth, and that means stocks. But that doesn’t mean that you should ignore bonds altogether.
A relatively small position in bonds can reduce the volatility of your portfolio, if only because the downside risk of bonds is lower than stocks. But it will reduce volatility considerably if bonds move in opposite directions during a market downturn.
You should also seriously consider investing in long-term bonds if you believe that interest rates will be lower in the future. This is not an idle consideration either. Economists are discussing the prospect of negative interest rates, which mean that investors will actually pay issuers each year that they hold their bonds.
There’s no way to know if this will happen in the US, but it is already happening in Europe. Should interest rates go negative in the US, bonds that you own that pay a positive interest rate will likely increase in value. That will give you capital appreciation on your bonds, in addition to interest income.
Investment diversification is all about allocating your portfolio for changing circumstances. Keeping that in mind, a small position in bonds is very well advised.
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