Stocks and bonds are often discussed interchangeably. That’s because most investors use both investments in their asset allocation.
Bonds are stocks’ more conservative cousins.
They’re added to a portfolio to provide a measure of the principal safety and a steady stream of interest income.
Since they’re part of any well-constructed portfolio, it’s important to learn how to invest in bonds.
What Are Bonds?
Bonds are debt securities issued by corporations and governments. They usually come between $100 and $1,000, which the issuer guarantees to pay when the bond matures. A fixed interest rate will be paid on the security between now and then.
A government or corporation can issue bonds for a variety of purposes. Governments typically issue them to finance capital improvements, such as building roads, bridges, seaports, and power plants. They can also issue them to finance general budget operations, which is much more typical.
Corporations may also borrow for short-term purposes, such as increasing cash or purchasing inventory. But the proceeds may also be used for capital projects, like purchasing plants and equipment, office buildings, land, or even other companies.
“bonds” refers to long-term debt securities, such as those with maturities greater than 10 years. However, in recent years it’s become a catchall phrase to describe all types of fixed income investments, including US Treasury bills and even certificates of deposit.
Loosely speaking, bonds describe the fixed income portion of your portfolio.
Depending on the bond issuer (government or corporation), the denominations and the frequency of interest payments will vary.
For example, corporate bonds are usually issued in minimum denominations of $1,000 and pay interest semiannually. The same may be true for municipal bonds issued by state and local governments. But US Treasury securities typically come in denominations of as little as $25 to $100 and have several methods for paying interest.
The Benefits of Investing in Bonds
As mentioned in the introduction, the basic purpose of bonds is to add stability to your portfolio by reducing risk. Since stocks can both rise and fall in price, the more stable value of bonds act as a counter.
When stock prices are falling, bond prices remain relatively constant and reduce the overall risk in your portfolio.
For example, let’s say your portfolio comprises 50% stocks and 50% bonds. Should stocks fall by 20%, your overall portfolio will drop by just 10%. That’s because only half your portfolio is in stocks.
Bonds also have the benefit of paying interest. This adds an element of stable income to your portfolio. And as a general rule, interest paid on bonds is higher than what you can get in savings accounts and bank certificates of deposit.
Unlike dividends, the interest rate on bonds can’t be reduced or eliminated. Since the bond is a legal, contractual obligation of the issuer, they must pay interest according to the terms of the security. Even if the issuer loses money and can’t pay dividends, they’ll still pay interest on their bonds.
Potential for capital appreciation. Investors don’t normally buy bonds for this purpose, but they have this potential. If interest rates fall after you purchase the bond, the value of the bond is likely to rise.
For example, if you purchase a 20-year $1,000 corporate bond at an interest rate of 5%, the bond will pay an interest of $50 per year. If prevailing rates fall to 4%, the value of the bond may rise to $1,250. That’s because the annual interest of $50 will represent a 4% return at that value.
This describes the inverse relationship between bonds and interest rates that we’ll discuss in greater detail below.
The Risks of Investing in Bonds
The above benefits notwithstanding, bonds do involve a measure of risk.
The most obvious is the potential for issuer default. If the company that issues the bonds goes out of business, the bonds will become worthless. This is certainly a possibility with corporate bonds, and while it’s theoretically possible for states and local governments to default on municipal bonds, there’s not much history of it.
By contrast, US Treasury securities are considered impervious to default. That’s because the US government can tax, borrow, or print money to pay the interest and principal on their securities. US Treasury securities are also considered the safest investments in the world, are traded globally, and have a very liquid market.
Interest rate risk. This is the risk inherent to all bonds – including US Treasury bonds. In the previous section, we describe how bonds can experience capital appreciation if prevailing interest rates fall after you purchase the bond. But of the inverse relationship between interest rates and bonds, if interest rates rise, bond prices fall.
For example, let’s say a corporation issues a $1,000 20-year bond with an interest rate of 4%. The bond will pay $40 in annual interest. But if prevailing rates go up to 5%, the bond’s market value may fall to $800. The $40 in annual interest would represent a 5% return at that market price.
It’s important to understand that this is a temporary market situation, though it can last for many years in extreme circumstances. However, if you hold the bond until maturity, you’ll be paid the full-face amount.
The Different Varieties of Bonds
There are three major types of bonds available to investors – corporate bonds, municipal bonds, and US Treasury securities.
These are debt securities issued by public corporations and traded on national exchanges. They can be purchased through investment brokerage firms for a very small fee. A typical bond term is 20 years, and they’re purchased in denominations of $1,000. A broker, however, may have a required minimum 10 bond purchase, or $10,000.
They can be purchased as either newly issued bonds or as existing bonds. If you purchase existing bonds, the price may be higher or lower than $1,000, depending on current market rates compared to the coupon rate the bond is paying.
If you do purchase corporate bonds, you’ll need to understand the risk level of the securities you’re purchasing. You can obtain that information through major bond rating agencies, including:
There are two basic classes of bonds. The first is known as investment grade bonds. The agencies rated these issues as AAA, AA, A, or BBB. AAA is the highest-rated bond, while BBB is the lowest in class.
The second category is what is known as high-yield bonds because they pay higher interest than investment-grade bonds due to their lower ratings (BB and below).
A few years ago, they were commonly referred to as junk bonds because of their higher likelihood of default. But apparently, the investment community isn’t comfortable with that label and converted it to the more positive sounding “high yield bonds.” But don’t be fooled by the fancy repackaging. These bonds may pay higher yields than investment-grade bonds, but they also carry a much greater risk of default.
They’re still junk bonds, even if they aren’t called that anymore.
These are bonds issued by states, counties, municipalities, and agencies. Their major advantage is that interest on the bonds is tax exempt from federal income tax. They’re also exempt from state income tax if you live in the state where the bonds are issued (which is commonly referred to as “double tax-free”).
Because of their tax-exempt status, they’re best held in taxable investment accounts. They’re not necessary for tax-deferred accounts, like IRAs, because tax exemption benefits don’t apply.
Like corporate bonds, municipal bonds can be purchased through investment brokerage firms. You should also check the bond ratings from the three rating agencies listed above, as they vary even on municipal bonds. This is true even though the incidence of municipal bond default is extremely rare.
US Treasury Securities
If you’re familiar with the national debt, this is how the government funds that obligation. Because the US government issues the securities, they’re considered the safest of all bonds. They can be purchased through the US Treasury portal, Treasury Direct, or an investment broker.
Though Treasury securities make up a big segment of what is commonly referred to as bonds, they represent a large number of different security types.
- Treasury bills. These have maturities of between a few days and 52 weeks. They’re available in denominations of $100 but are sold at a discount. For example, you might purchase a bill for $98, and be repaid $100 at the end of the term. The $2 difference will be the interest paid.
- Treasury notes. These have maturities ranging from 2 to 10 years and are purchased in denominations of $100. They pay interest every six months, then face value at maturity.
- Treasury bonds. These securities have terms of 30 years and are also available in denominations of $100. Like notes, they pay interest every six months and the face amount at maturity.
- Treasury Inflation-Protected Securities (TIPS). These securities are issued with terms of five, 10, and 30 years and in denominations of $100. They also pay interest twice yearly, but they come with a twist. The principal value of the security is adjusted based on the Consumer Price Index (CPI). If the CPI increases, so do the principal value of the security. If it decreases, so does the principal value of the security. However, if you hold TIPS until maturity, you’ll be paid the greater of the face amount or the principle adjusted value.
- Savings bonds. These include EE and E bonds that can be purchased for as little as $25, and earn interest for 30 years. There are also I bonds, which work the same, except they pay additional principal based on the CPI, just like TIPS.
Technically speaking, only Treasury bonds are true bonds. But treasuries of all denominations are frequently described collectively as bonds. Also, be aware that interest from US Treasury securities is exempt from state income tax.
Interest in the securities fluctuates daily, and you can check them on the Treasury Resource Center page.
Using Treasury Bonds to Preserve Capital
TIPS and I-Bonds
US Treasury bonds are generally considered to be rather low risk. Even with the current fears of a huge federal deficit, many believe that the U.S. will not default with its very stable taxpayer base, will not default.
As a result, bonds are often considered low-risk additions to an investment portfolio that needs a little more safety. While the possibility of default is always present, many do not consider the U.S. government likely to do so.
Unfortunately, yields on bonds are rather low right now. In many cases, Treasury yields would be hard-pressed to keep up with inflation, much less beat it. Unless you get inflation-protected securities specifically designed to keep pace with inflation. This is what TIPS and I-Bonds are.
TIPS and I-Bonds both have ties to Consumer Price Index. For I-Bonds, there is a variable rate portion — in addition to the fixed rate that applies until bond maturity — that changes every six months, based on what is happening with the CPI. With TIPS, the adjustment is made to the principal every six months, according to the inflation measured by the Consumer Price Index. You won’t get your increase in principal, though, until the bond matures.
Taxes on Earnings from TIPS and I-Bonds
Understand that you still have to pay taxes on earnings from TIPS and I-Bonds. With I-Bonds, you can defer reporting the interest until the bonds are redeemed. However, if you want to report the accumulated interest, you risk paying when you are in a higher tax bracket.
TIPS, though, are different. You have to pay taxes on your earnings as you receive them. And, even though you don’t get the cash from principal adjustments made to keep pace with inflation, you still have to pay taxes on them. This means that you pay taxes on earnings — even though you do not have the cash in hand. You can offset this by holding TIPS in a tax-advantaged retirement account; then you do not have to pay taxes on your earnings until you withdraw from your retirement plan.
Purchasing TIPS and I-Bonds
It is fairly easy to purchase inflation-protected securities from Treasury Direct. You can set up an account and then purchase according to available options. Note that you cannot have TIPS issued in paper format; it’s all electronic. You can purchase I-Bonds for as little as $25 and TIPS for as little as $100.
If you are interested in preserving some of your capital, inflation-protected securities can help. However, realize that the low yields and the inflation adjustments won’t help you beat inflation — you’ll only keep pace. So, while your purchasing power is protected from great losses, you are unlikely to see it grow.
Should You Invest in a Bond Fund?
A bond fund is a portfolio of bonds and other debt instruments (like mortgage-backed securities) that are managed professionally. A fund allows you to spread risk across a broad range of individual securities. Some funds are actively managed according to a stated objective and others are designed to mimic an index of bonds and are passively managed.
A bond fund is likely to pay higher returns than certificates of deposit (CDs) and money market investments, but they aren’t completely safe from risk. Your return on a bond fund can vary dramatically depending on the underlying bonds. For instance, it could be made up of high-yield, risky, junk bonds or own low-yield, safe, government securities only. Additionally, all bond funds are subject to interest rate risk. Bonds have an inverse relationship to interest rates—when rates rise, the value of a bond fund can go down.
Differences Between a Bond and a Bond Fund
As I mentioned, a bond has a specified maturity date when the investment term ends. However, a bond fund does not have a maturity date because bonds are continually added to or removed from the portfolio in response to investor demand and overall market conditions. There are three common types of bond funds: open-end mutual funds, closed-end mutual funds, and exchange-traded funds.
What is an Open-End Bond Mutual Fund?
With an open-end bond mutual fund, you can buy or sell a share of the fund at any time. But the price of each share is only valued at the end of each trading day. The price is based on the net asset value (NAV) of all the underlying bonds in the portfolio. The fund’s value can be higher or lower than the price of any one bond owned inside the fund.
What is a Closed-End Bond Mutual Fund?
Bonds funds can also be closed-end mutual funds where a limited number of shares are listed and sold. The price of each share fluctuates according to the prices of the securities in the portfolio (and is valued once a day, just like with open-end funds), but there’s also a supply and demand issue that comes into play with the price.
What is an Exchange-Traded Bond Fund?
Unlike either type of mutual fund, exchange-traded funds (ETFs) trade on an exchange, just like stocks. So the price of a bond ETF changes throughout the day as it’s bought and sold. It doesn’t have a net asset value calculated just once a day like a mutual fund.
Whether you prefer bond mutual funds or exchange-traded funds, they make buying bonds much easier and less intimidating. So don’t miss out on the income and diversification bond funds can add to your portfolio.
This Risks of Investing in Bond Funds
With the stock market largely stalled since May – albeit in record territory – nervousness is developing by investors wondering which direction it will go in from here. That kind of doubt breeds a natural inclination to seek out investment alternatives. One such alternative, traditionally, has been bonds. But since so few people fully understand investing in bonds directly, bond funds are often the vehicle of choice. But bond funds may not be as risk-free as you think.
The Inherent Risks of Holding Bonds
While we often think of bonds as “safe,” they have two inherent risks: default and interest rate risk.
The default is easy enough to understand. Suppose a corporation or local government agency issues the bond. In that case, there’s always the possibility that the issuer may hit on financial difficulties and default on either the interest, the principal, or both.
But you can generally get around this by staying in funds that invest only in the US government securities, which are immune to default since the US government can literally create the money to pay them off.
Interest rate risk is a more complicated one and the virtual Achilles’ heel of bonds. Simply put, bond prices move in the opposite direction of interest rates. When interest rates fall, bond prices rise – much like stock prices. But when interest rates rise, bond prices fall to keep their rates competitive with current levels. This is also true of US government securities, particularly those with 10 years or more to maturity.
Of course, the way to minimize this risk is by investing in shorter-term securities. For example, 30-year bonds with 25 years remaining are highly sensitive to changes in interest rates. But a 10-year bond – with three years remaining – will be only minimally sensitive to rate changes since the ultimate payoff is so close.
If you want to invest in bond funds to offset the risk of stocks, you want to stay with funds primarily invested in US government securities with maturities less than 10 years. This will eliminate the risk of default and minimize interest rate risk.
Bond Fund Portfolio Composition
There is another X-factor when investing in bond funds: the actual fund portfolio composition. To improve fund yield, the bond funds will invest in a mix of bonds. That can include US government securities, state and local government bonds, corporate bonds, “junk bonds,” and even foreign bonds.
While this may achieve the fund’s desired goal of increasing yield, it will increase the risk of loss of principal. Other than US government securities, any of the bonds held in the fund could default.
One other area to pay particular attention to concerns government bond funds. While a fund can be comprised entirely of government bonds, they may include foreign government bonds. After all – they are government bonds, technically speaking. Among their holdings of US government securities, they may also include higher-yielding instruments from non-US sources that will introduce the risk of fluctuating currency values.
I think it’s safe to say that when investing in bond funds, most people are looking for capital preservation. As you can see, however, not all bond funds necessarily deliver on this expectation.
Your best protection is to get a copy of the fund’s prospectus before investing any money. Find out their investment holdings specifically and make sure they match your investment goals. Also, pay close attention to their historic performance. Significant declines in investment value over the past 10 years can indicate that it’s not the fund for you, especially since interest rates have behaved so reliably over that period.
Stocks and Bonds Aren’t so Mutually Exclusive
The key to solid portfolio management is maintaining a mix of mutually exclusive investments. But if you are looking for diversification away from stocks, bonds – especially long-term bonds – may not be so mutually exclusive.
Historically, stocks and bonds have risen in price on lower interest rates. They’ve also tended to decline in tandem with rising interest rates. While bonds react to changes in interest rates on a mechanical basis – because it intimately affects yield – stocks react because changes in interest rates affect corporate borrowing and the general direction of the economy. A similar reaction to interest rate changes puts stocks and bonds too close to achieving true diversification.
Should You Add a Bond Fund to Your Investment Portfolio?
Bonds are a natural diversification away from stocks, but are bonds a good investment choice right now? And after decades of strong bond performance, could we even be on the edge of a bond bubble?
It all hinges on interest rates. Since bonds move in an inverse direction to interest rates – when rates rise, bond prices fall, and when interest rates fall, bond prices rise – the fate of bonds rests entirely upon the direction of rates.
The Case for Using Bond Funds In Your Investment Portfolio
Bonds can prove to be a solid investment under at least four different scenarios.
1. Interest rates could stay low for several more years.
Though the economy is growing, it is doing so relatively slowly. There is little incentive for the Federal Reserve to advocate for higher interest rates, which can mean several more years of low rates. That being the case, 30-year US Treasury bonds paying over 3% per year are much better than short-term savings instruments paying well below 1%.
2. Interest rates could go even lower, raising bond prices.
Though interest rates are at historic lows, that doesn’t mean they can’t go even lower. The economy is growing slowly enough that it could drop into negative territory, and if it does, there will be tremendous pressure to lower interest rates even further. Should rates drop, not only will a 3% 30-year bond rate be highly desirable, but the price of those bonds can also increase. As a result, leaving the bondholder with a substantial capital gain – in addition to the higher than the market rate.
3. Bonds could be safer than stocks in a market fall.
It’s possible that the stock market could decline even though the overall economy stays in a modest growth phase and interest rates remain level. From a standpoint of the safety of principal, bonds could become the preferred investment as a place to earn relatively high interest rates without any risk of principal.
4. International instability.
Still another development that could prove to be an advantage for bonds could be international instability causing a flight to the safety of US investments in general and of bonds in particular. Such a development could cause interest rates in the US to decline (and bond prices to rise) due to a flood of foreign money looking for safe haven investments. Bonds would be a natural destination for that capital, turning this into one of the best-performing years ever for the asset class.
How and Where to Buy Bonds
Bonds can be purchased either individually or through bond funds.
As discussed above, corporate and municipal bonds can be purchased through investment brokers, while US Treasury securities can be purchased through Treasury Direct. For most, individual bonds are best used by those with large portfolios. That will provide an opportunity to diversify among many different bond issues.
Bond funds are a way to diversify over many different bond issues, but with a lot less money. But another major advantage is that you can choose specific types of bonds or bond terms.
For example, you can choose a fund that invests strictly in the US and/or foreign bonds. You can also go with a municipal bond fund, even one specializing in your state. You can also go with a fund that invests only in US treasuries. Some bond funds offer a mix of corporate and municipal bonds and US Treasury securities.
But that’s just the beginning. You can also choose an investment-grade bond fund or a high-yield bond fund. Some funds also specialize in bonds of certain maturities. For example, one might specialize in bonds with maturities of greater than 20 years. Another might focus on those maturing in five years or less.
The advantage with bond funds is that you can choose specifically how you want to invest in bonds, as well as the specific amount. They’re perfect for smaller portfolios.
How Much Should You Invest in Bonds?
Should you invest in bonds, and if so, house much? This is an ongoing debate. As a general rule, it depends on your risk tolerance. The lower your risk tolerance, the higher the percentage of your portfolio that should be invested in bonds. If you have a high risk tolerance, the bond allocation should be smaller. If you invest with a robo-advisor, they’ll make this determination for you and set a specific bond allocation in your portfolio.
But if you don’t invest through a robo-advisor, there is a rule of thumb you can use. It’s 120 minus your age. It calculates the amount of your portfolio in stocks based on your age.
For example, if you’re 30 years old, 90% of your portfolio (120 – 30) should be invested in stocks, leaving 10% for bonds. If you’re 50 years old, 70% of your portfolio (120 – 50) should be invested in stocks, with the remaining 30% in bonds.
But remember, that’s just the rule of thumb. You should adjust that based on your risk tolerance and how soon you expect the need the funds from your portfolio.
That’s the basic summary of how to invest in bonds. Everyone should have at least some in their portfolio.