If you are interested in investing in bonds but don’t know where to start, things can seem overwhelming. In this brief guide we will not be able to cover all of the ins and outs of investing in bonds. However, we can provide you with enough information to feel confident, to understand the language, to understand the benefits, and to understand the risks associated with bonds.
What Are Bonds?
Bonds are a style of investment where an investor lends money to the person who issues the bond. In exchange, the individual who issues the bonds offers interest payments. Bonds are at the heart of investing. People who want to live for a long time off of money earned in their portfolio turn to bonds.
There are a variety of bond options available. These include municipal bonds, treasury bonds, savings bonds, and commercial bonds. It is widely accepted that trading government bonds offer numerous advantages over traditional financial instruments.
Other types of bonds include:
Corporate Bonds are where you lend money to a business that issues bonds in exchange for payment. The company can use the bonds to generate higher returns on equity, change its capitalization structure, acquire competitors, refinance old debt, or whatever the Board of Directors feels is a good idea.
Municipal Bonds are tax free under the right circumstances. They are favored by fixed income investors who want a consistent stream of passive income. These bonds are designed to finance infrastructure in the community. They have a positive impact on things like sewers, school construction, building bridges, hospitals, and other important parts of the infrastructure.
Junk Bonds have a higher risk of default than the majority of bonds issued by the government or by corporations. These bonds are issued by companies that are having a hard time financially and have a higher risk of defaulting or not paying the interest payments. Junk bonds are attractive to some because although they offer a high risk, they also have a higher yield.
What Are the Benefits of Investing in Bonds?
The biggest benefit of investing in bonds is that they create income. Bonds offer the highest and most reliable cash streams. Even when other investment vehicles in the market are producing relatively low returns, there are usually a number of high-yield bonds that investors can use to construct a portfolio.
Bonds provide diversification. Most investors have heard that it is not wise to put all of their eggs in one basket. The more diversified an investor’s portfolio is, the better risk adjusted their returns are. Bonds can reduce volatility and help an investor preserve capital even when the stock market is not doing great.
Bonds preserve principle. This is a key point, especially if you are getting close to the point where you are going to need to be able to use the cash that you have invested. Let’s say you are parent and your child is going to start college in five years. A bond portfolio that is diversified is unlikely to suffer major short-term losses. This means that you are going to be able to increase your allocation to fixed income and decrease your allocation to equities the closer you get to your end goal.
Another reason why bonds may be attractive is because they possess some tax advantages. The interest on municipal bonds may be tax-free on the federal level. If you own a municipal bond issued by the state where you live, the interest could be tax-free on the state level as well as.
While it’s true that bonds are not the most exciting form of investment, they are valuable. They should be included in the portfolio of investors regardless of their investing style.
Things to Consider before Investing in Bonds
1. Do not reach for yield. This is a huge mistake that new bond investors make. It happens when interest rates are low, so investors feel that they are not earning a return rate that is as high as they want. They get tempted by higher yields offered from junk bonds. It’s true that yield is one factor you should consider as an investor when you buy a bond. However, you should never forget that the higher the yield, the higher the risk.
2. Know what your objectives are. If you are looking to put away money for your child’s education, know how much money your child is going to need. If you are looking to have a comfortable retirement, you should know how much money will be required for that. If you don’t know where you are going when you start to invest in bonds, you will be disappointed because you will never arrive at your goal.
3. Understand your risk. Bonds and bond funds have different risk profiles. Before you invest, know the risk. We recommend you writing them down so that you can see them right in front of you and make an informed decision.
4. Research, research, research. We cannot stress this enough. It’s good that you are reading guides like these. But you also need to read books and articles that delve deep into bond investing. Familiarize yourself with the mathematics behind bonds. Become familiar with a bonds offering statement. This is where you are going to find important information about your bond, including its yield and its call schedule.
5. Create an investment strategy and stick to it. Do not try to speculate or time interest rates. Remember, the information that you are basing your decision on is outdated. When you make a decision based on speculating, you are often making decisions based on where rates were as opposed to where they are going.
Bonds, especially short and medium dated bonds, have a lower volatility rate than stocks. This is why bonds are viewed as a relatively safe investment. Bondholders enjoy protection under the law of most countries. Even if a company goes bankrupt, bondholders are entitled to receive money back. There are a number of bond options available to fit the needs of different investors.
We would love to hear about your experiences investing in bonds. Tell us about them in the comments section below.