Investing In Bonds
What are Bonds
Bonds are basically loans. A company, state or government issues bonds to raise money to fund expansion programs or build schools and hospitals. The bond issuer agrees to pay its investors periodic “fixed” interest payments (hence, the name “fixed income”), while the loan is outstanding, and to pay back the full loan at the end of the bond’s life (called maturity).
Governments have been using bonds to raise funds for centuries. While it’s not entirely clear when the first bond was issued and by whom, historians believe Venice was an early innovator. To defend itself against war in the 1100s, Venice “taxed” its citizens to build a fleet of ships, but unlike a regular tax, the government promised to pay it back with interest.
Bonds can play a vital role in any investment portfolio. Bonds yield income, are often considered less risky than stocks and can help diversify your portfolio.
Bonds offer a host of advantages:
- Capital preservation: Capital preservation means protecting the absolute value of your investment via assets that promise return of principal. Because bonds typically carry less risk than stocks, these assets can be a good choice for investors with less time to recoup losses.
- Income generation: Bonds provide a fixed amount of income at regular intervals in the form of coupon payments.
- Diversification: Investing in a balance of stocks, bonds and other asset classes can help you build a portfolio that seeks returns but is resilient through all market environments. Stocks and bonds typically have an inverse relationship, meaning that when the stock market is down, bonds become more appealing.
- Risk management: Fixed income is broadly understood to carry lower risk than stocks. This is because fixed income assets are generally less sensitive to macroeconomic risks, such as economic downturns and geopolitical events.
- Invest in a community: Municipal bonds allow you to give back to a community. While these bonds may not provide the higher yield of a corporate bond, they often are used to help build a hospital or school or that can improve the standard of living for many people.
Types of Bonds
The three major types of bonds are corporate, municipal, and Treasury bonds:
Corporate bonds are debt instruments issued by a company to raise capital for initiatives like expansion, research and development. The interest you earn from corporate bonds is taxable. But corporate bonds usually offer higher yields than government or municipal bonds to offset this disadvantage.
Municipal bonds are issued by a city, town or state to raise money for public projects such as schools, roads and hospitals. Unlike corporate bonds, the interest you earn from municipal bonds is tax-free. There are two types of municipal bonds: general obligation and revenue.
Treasury bonds (also known as T-bonds) are issued by the U.S. government. Since they’re backed by the full faith and credit of the U.S. government, treasury bonds are considered risk-free. But treasury bonds don’t yield interest rates as high as corporate bonds. While treasury bonds are subject to federal tax, they’re exempt from state and local taxes.
Other Bonds
Bond funds are mutual funds that typically invest in a variety of bonds, such as corporate, municipal, Treasury, or junk bonds. Bond funds usually pay higher interest rates than bank accounts, money market accounts or certificates of deposit.
Junk bonds are a type of high-yield corporate bond that are rated below investment grade. While these bonds offer higher yields, junk bonds are named because of their higher default risk compared to investment grade bonds. Investors with a lower tolerance for risk may want to avoid investing in junk bonds.
Diversifying your portfolio across stocks and bonds can help lower your overall risk and reduce volatility. When you may be tempted to abandon your investment plan in favor of market-timing moves, it’s important to remember that sticking to your asset allocation is often the best strategy for keeping your long-term goals on track.
Bonds are providing healthier yields than we’ve seen since before the 2008 global financial crisis. Higher current yields support a much-improved outlook for bond returns going forward. Higher yields can help reduce risk by acting as a buffer to additional rate increases while also providing a stronger base for future returns if the Federal Reserve begins cutting rates in the future. As a result, bonds may provide you with attractive yields at a lower risk profile than we’ve seen in recent years.