Anytime we experience high degrees of volatility with an investment class (such as stocks or real estate), it verifies the fact that investment portfolios need to be diversified. One very important area to diversify into is bonds and while the percentage of your portfolio invested in bonds can vary with your investment risk tolerance, they are a crucial aspect of a well-rounded investment strategy. But bonds do have their idiosyncrasies. Make sure you understand what bonds are and how they work before plunging into this investment class.
What are bonds?
Bonds are debt. Plain and simple. Technically, they’re a type of lending investment with investors loaning money to bond issuers, which are usually corporations, or federal, state, or local governments, or quasi-government agencies. Investors buy bonds for two primary reasons … reasons that other investments simply do not or can not provide:
Bonds pay investors fixed monthly, quarterly, semiannual, or annual interest payments.
2. Return of principal
Bonds return the entire principal (the original investment amount) back to the investor after a certain period of time.
In the short term, bonds are generally less volatile and risky than stocks — but not as risk-free as cash investments such as certificates of deposit (CDs) or money market accounts. As a result, bond returns tend to be higher than those of cash equivalents but not as high as stock returns (over the long term). Investors typically buy bonds as a hedge against stock losses since bonds tend to rise in value when stocks decline.
Before you invest in bonds, familiarize yourself with some basic bond terminology:
The face-value price of the bond that the investor will eventually receive back as principal. Most often this is $1,000 per bond.
The interest rate that the bond pays. For instance, a bond with a par value of $1,000 and an annual coupon rate of 7% will pay $70 a year.
The date on which the bond issuer will return the principal to the lender and cease making interest payments. The length of time until a bond’s maturity date — the bond’s term — can be anywhere from less than a year to 30 years. Usually, the longer the term, the higher the coupon rate.
Callable bonds give the issuer the right to recall the bond, pay back principal, and stop paying interest at a point in time before the maturity date. All corporate and state or local government bonds specify whether they can be called and how soon they can be called. Federal bonds are never callable, though like anything government related, that could change.
Classifying bonds by their term
Bonds are often grouped based on their terms:
- Short-term: Bonds with terms of 0–3 years
- Intermediate-term: Bonds with terms of 3–10 years
- Long-term: Bonds with terms of 10 years or more
Credit risk and interest rate risk
On the surface, bonds seem like a great deal. You get paid to lend money, and then you get back all the money you lent. But bonds do present two unique types of risk: credit risk and interest rate risk.
The riskiness of a bond depends in part on the bond issuer’s creditworthiness, the likelihood that the issuer will in fact make good on its promise to pay all interest owed and return the investor’s principal. When you buy an individual bond, there’s rarely a 100% guarantee that you’ll receive your interest payments and your principal. If a bond issuer suffers a major financial crisis, such as bankruptcy, it may default, or fail to meet its obligations.
Individual bonds have bond ratings that rank the creditworthiness of their issuers. The safest issuers have A ratings, such as A, AA, or AAA. For instance, a AAA rating — the highest rating — implies a default risk of less than 1%. Riskier bond issues have ratings with Bs, Cs, or Ds (D means the issuer is in default). In general, the higher the bond’s default risk, the higher the coupon rate.
Interest rate risk
Bond prices move in the opposite direction of prevailing interest rates: when interest rates rise, bond prices fall, and vice versa. Bonds react this way because higher interest rates make bonds with coupon rates below prevailing interest rates less attractive to buyers. When interest rates decline, bonds with a higher coupon rate than the prevailing interest rate are more desirable.
When in comes to bonds, investors will get the prevailing rate one way or another. If the prevailing rate is 6% and a bond has an 8% coupon, sellers of that bond will adjust its price higher and the buyer (the investor) will net 6% anyway. If works in the opposite way as well. With prevailing rates at 8% and a bond with a 6% coupon, investors don’t want to put their money into that bond. That bond will be offered at a lower price to make up for the fact that the coupon is lower than what investors are demanding.
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The most common types of bonds
Of the many types of bonds on the market, the five most common are government bonds, municipal bonds, corporate bonds, TIPS, and high-yield (“junk”) bonds.
Government bonds are bonds issued by local, state, or federal governments. Government bonds issued by the U.S. government are called Treasuries. The interest that Treasuries pay is subject to federal income tax but is state-tax–free. The three main types of Treasuries are:
- Treasury bills: Have terms of 1 month to 1 year; also called T-bills
- Treasury notes: Have terms of 2–10 years
- Treasury bonds: Have terms of 10–30 years
Treasuries are considered very safe bonds with virtually no default risk. The debt of stable foreign governments is similarly safe but carries currency risk, the prospect of a change in interest payments based on fluctuating currency rates. Government bonds of developing countries, however, are considered very risky due to the combination of currency risk and political instability that may lead to default.
Municipal bonds, also known as munis, are bonds issued by state and local governments or government agencies. The interest that munis pay is not subject to federal tax. Munis are also state- and local-tax–free to investors who reside in the states or locales that issue the munis they own, which makes some munis triple tax-free, or entirely free from tax. Due to these tax savings, munis tend to offer much lower interest rates than Treasuries.
Corporate bonds are bonds issued by corporations. Corporate bonds tend to have higher yields than government bonds and munis due to their higher risk of default: companies go bankrupt more often than governments. Even so, the bonds of many companies — especially AAA-rated companies such as Microsoft or Johnson & Johnson — have very low default risk. In general, the higher a company’s credit rating, the lower the coupon rate of its bonds. All corporate bonds are subject to federal, state, and local taxes.
Treasury inflation-protected securities, known as TIPS, are a special type of Treasury note or bond that offers protection from inflation. Every year, the government adjusts the par value of these bonds based on the consumer price index (CPI)—a measure of inflation. If the CPI rises 4% in one year, so too will the par value of these bonds for investors who hold them to maturity. At maturity, investors receive the original par value of the bond or the inflation-adjusted par value—whichever is higher. The interest that TIPS pay is based on the inflation-adjusted par value, which means you’re likely to receive higher interest payments if inflation rises. TIPS are generally subject to federal income tax but are free from state and local taxes.
High-yield (“junk”) bonds
High-yield bonds, or “junk” bonds, are corporate bonds that have a high risk of default and as a result pay high annual coupon rates, often in excess of 10%. Junk bonds are very risky and should be approached with great caution.
Should you buy individual bonds?
Probably not. Like stocks, bonds can be purchased either individually or as part of bond mutual funds or ETFs. Though bonds are an important part of virtually any investment portfolio, buying individual bonds takes a considerable time and effort and is usually best left to professionals. If you do want to try buying individual bonds, it’s best to stick to Treasuries only. For most investors, though, the safest, cheapest, and easiest way to buy bonds is through bond mutual funds or exchange traded funds (ETFs).