Bond Investments Provide Income For Your Portfolio

An old rule of thumb is the have 40% of your total portfolio in bond investments.

The problem?

No two investment portfolio's are the same, because no two people are in the same situation at the same time.

As part of a growth investing strategy, a 40% allocation into bonds is high.

On the other side of the coin, an income strategy might require more than 40% be invested in bonds.

In relation to stocks, bond investments are usually used to offset the volatility (NOT RISK) of investing in stocks, by protecting your principle (initial investment) and providing consistent dividend payment.

What are Bonds?

Bonds are financial assets that allow investors and traders to buy and sell claims against different types of debt. Corporations, municipalities, states, and governing bodies use bond investments to finance all sorts of activities.

An “issuer” issues a bond with a “coupon rate” (fixed interest rate) that will be paid when the “maturity date” (final payment date) is reached and the “bond principal” (borrowed funds) is returned. (maturity date).

The interest on bonds is usually paid every six months (semi-annually).

Since bonds are considered debt instruments, you are basically giving a company a loan for a defined period of time at a fixed interest rate. Bonds are called fixed-income securities for this reason.

The main categories of bond investments are corporate bonds, municipal bonds, and U.S. Treasury bonds.

While researching bonds, you've probably seen a lot about the "yield". Credit quality and duration are the key factors that determine a bond’s interest rate.

A company with low credit quality (i.e. less likely to pay off the debt or more likely to default), the higher the interest rate on the bond. A relative comparison of credit quality can be made using the bond's "rating" (e.g. AAA to D).

Duration refers to the bond's time period. Technically speaking, debt instruments can be grouped into three different categories, based on duration:

  • Bills - debt instruments maturing in less than one year
  • Notes - debt instruments maturing in 1 to 10 years
  • Bonds - debt instruments maturing in more than 10 years
Although they are not technically called "bonds", notes and bills can be considered bond investments. Bond durations range from 90 days (e.g. U.S. Treasury Bill) all the way to 30 years (e.g. U.S. Government Bond). Under "normal" conditions, longer duration bonds have higher interest rates.

Why Buy Bond Investments?

The main reason for investing in bonds is diversification. While bonds are considered a financial asset (just like stocks), they are based on debt. So investing in bonds will provide different advantages and disadvantages when compared to investing in stocks (based on equity), commodities, or real estate.

Advantages

  • The principle, interest payments, and timing are all set when the bond is issued, so you know what to expect before you make a purchase.
  • Bonds can provide a stream of "paper income".
  • The interest rates paid on bond investments are usually higher than those paid on savings accounts or trading accounts.
  • In the event of a bankruptcy, corporate bond holders are repaid before stockholders.


Disadvantages

  • Selling early (before the maturity date) may create substantial transaction costs or losses in principle
  • If a company defaults, your bond investments will lose value and may even become worthless (this happened to General Motors in 2009).


Factors Affecting Price

The following are general rules-of-thumb for investing in bonds:

  • As interest rates increase, prices for existing bonds fall. This is because existing bonds are not as attractive as newly issued bonds, which will have higher interest rates.
  • As interest rates decrease, prices for existing bonds increase. This is because existing bonds have higher interest rates, which are more attractive to investors.
Regardless of price changes, when you hold your bonds until maturity you will still get all your principle and interest as long as the issuer does not default.

Investment Choices

There are several ways to add bonds to your portfolio. The most common way is to purchase a bond-based mutual fund, although ETFs are gaining steam as a low cost alternative.

Directly purchasing bonds from the issuer is the lowest cost (in terms of fees and commissions), but is often overlooked due to the confusion caused by all the technical terms.

In terms of relative risk, government bonds are the least likely to encounter default, followed by municipal bonds, and then corporate bonds.

However, bonds are definitely not risk free. Default is always possible, especially in the case of corporate bonds.

Financial Assets

  • Treasury Bonds and Savings Bonds
    • Issued by the federal government
    • Lowest risk of default (government/central bank must default on debt, in which case there are bigger problems to worry about then the loss of your bond investment!)
    • Lowest Yield

  • Agency Bonds
    • Issued by federally sponsored agencies (Freddie Mac and Fannie Mae)
    • Low risk of default
    • Low yield

  • Corporate Bonds
    • Issued by corporations to fund their operations
    • Risk of default depends on corporate finances
    • Varying yield (Low/High) depending on risk of default

  • Municipal Bonds (Muni’s)
    • Debt issued by county or state governments and municipalities
    • Risk of default varies depending on financial stability of issuer
    • Low yield
    • Exempt from federal taxes – attractive to investors that are in high tax brackets

  • Bond-Based ETFs
    • Provide you with a way to capture the general price movement of bond markets
    • More liquid than mutual funds or bonds
    • May or may not provide dividends (substitute for interest payments)
    • Provides exposure to many different types of bond investments at one time

  • Bond-Based Mutual Funds
    • Provide you with a way to capture the general price movement of bond markets
    • More liquid than bonds
    • Provides exposure to many different types of bond investments at one time
    • May or may not provide dividends (substitute for interest payments)
    • Monthly payments vary depending on market conditions
    • Higher management fees than ETFs


Where to buy

You can buy most of the bond-based investments through your regular brokerage firm or open a trading account with a bond broker (specializes in bonds). It is also possible to purchase bonds from certain banks.

In the United States, you can purchase bonds directly from the government (bypassing a broker and their commissions) using Treasury Direct (www.treasureydirect.gov).

As with any other investment, research is key. Be sure to do your homework before purchasing a bond or bond investment.