Intro to bonds investing
No, not like James Bond or covalent bonds like you learned in school!
If you’ve spent time researching personal finance, you’ve probably run into the term “bonds” here and there.
But do you know what bonds are?
Don’t worry, most people don’t!
Bonds typically don’t get as much hype because they’re kind of a “get rich slow” investment...
In fact, you’re likely not going to get “rich” from bonds. But they can still be a great asset to your portfolio.
By the end of this article, you will understand what a bond is, how to invest in a bond, and whether or not it’s the right strategy for you.
So buckle up, and let’s get started with today’s lesson!
Why is it important to understand bonds investing?
Bonds offer a reliable source of fixed income in the form of interest payments to you - the investor.
They are a great way to diversify your portfolio because they are often considered less risky in comparison to stocks.
They can even outperform stocks in some cases despite their slow and steady reputation. An article from Market Watch in 2020 claimed that long-term bond had outperformed tech stocks “in one of the weirdest years ever in the market.”
What are they and how do they work?
A bond is another word for a loan agreement between an investor and a borrower.
You can look at a bond like an I.O.U situation where an investor lends money to a borrower (which is usually a company or the government) and the borrower pays back the loan with additional payments.
Bond agreements include a time period and an end date when the original amount (the principal) of the loan is expected to be paid back to the bond owner.
This is also known as maturity and duration.
Maturity and duration:
The maturity of a bond refers to the amount of time it takes for you, the investor to get your original payment (face value) back. And during the maturity period, you’ll be receiving interest payments.
For example, if you purchase a bond in Feb. 2021 and the duration lasts for ten years, then you’ll be receiving interest payments until Feb. of 2031.
But just like a mortgage, you can experience changes in interest rates. So, a bond with a longer duration is more likely to experience ups and downs. But this is why long term bonds generally offer higher yields to remain attractive to potential buyers.
If you’re confused about what it means to have higher yields, don’t worry we’ll get there in a second.
There are a handful of terms you should understand when learning about bonds and they all fit together like a puzzle. Here are a few:
Coupon: The annual or bi-annual interest payment that the bondholder receives until the date of maturity.
Yield: This is the expected earnings generated from a bond during it’s duration until maturity. Don’t mistake this for the interest payments. The yield refers to the bigger overall amount to picture of what is being paid back to the bond holder (you, the investor).
Rating: Bonds are rated by organizations so you have an idea of how likely yoo’ll get your expected payments. Kinda like a credit card company evaluating someone’s creditworthiness.
Face value: The amount that the bond is originally worth. In other words, this is the amount that the bond holder purchased the bond for and the amount that the bond holder will get back on the at maturity.
How can bonds investing help your portfolio?
Investors decide to invest for several reasons:
Investors look at bonds as “fixed income.” Bonds can pay investors in the form of interest quarterly, or bi-annually. You may compare this to dividend payments from Stocks. But remember, not every company is committed to paying dividends. And dividends fluctuate depending on the performance of the company whereas bond issuers are obligated to make a set payment.
Capital preservation (a conservative way to make sure you don’t lose your money):
Bonds should repay the principal at a specified date or maturity. This means you will get your initial payment back. Unlike a stock investment where you are risking the price of your investment to go down. Your gains from bonds will only go up. Bonds have the added benefit of offering interest at a set rate that is often higher than short-term savings rates from a bank.
To combat market deflation:
This can help against market deflation for several reasons...
Many investors know that diversifying your portfolio is best practice. Most investors invest in a variety of asset classes including stocks, commodities (like gold), real estate, and bonds.
Diversifying your portfolio allows you to manage your risk level. So, if one class of your portfolio is negative, your other classes will keep your portfolio afloat.
The different types of bonds you might want to buy
This is also referred to as treasury bonds. Treasury bonds can be broken up into three categories - notes, bills, and bonds. The U.S. Treasury sells them at an auction to fund the operations of the federal government.
Government bonds are considered the safest since they’re guaranteed by the U.S. government. But just like any type of safe investing, this means they offer a lower return…
These are bonds that are issued by companies. Corporate bonds are considered to have a higher risk than government bonds so they have a higher rate of return.
These are bonds issued by cities, states, and counties. These are typically used to build roads, buildings, and other community projects.
Municipal bonds are tax-free and have lower interest rates than corporate bonds. They generally have higher returns which makes them more attractive to investors. But be careful because wealth managers say municipal bonds may indeed be tax-free and have high returns, but they often have more risk as well. Sometimes the advantage isn’t worth the level of risk.
These are bonds that are also issued by the Treasury Department. So you like government bonds we talked about earlier, you are also lending money to the government with savings bonds.
Savings bonds are considered a low-hanging fruit compared to other bonds options because they’re more affordable and designed for individual investors.
A mortgage bond is a bond where the holder has a claim on real estate assets as collateral.
Active vs. Passive Investing
Which bond strategy is right for you? This will depend on your goals.
If you’re seeking diversification or capital preservation with bands, then you can simply buy and hold them until they mature.
Active portfolio managers can seek to maximize their income from bonds. This may be a good idea for institutional investors. This strategy will most likely not be common if you’re an average investor. But if you choose the active investing route, then you may want to consider hiring a bond fund manager.
Pros and Cons of Bonds
Bonds typically rise and fall at a small rate. This means bonds provide a low-risk investment opportunity.
The right bonds provide you “fixed income.”
Generally, bonds provide a lower long-term return compared to stocks.
Bond prices fall when interest rates go up. This can take a toll on long-term bonds because it can negatively affect their prices. But usually, long-term bonds anticipate this risk, so they provide a higher yield.
Are bonds the right investment for you?
Our goal isn’t to persuade you to make specific investment decisions. Our goal is to provide you with valuable knowledge that you can use for your own long-term strategy.
You may want to consider investing in bonds if you want to diversify your portfolio and receive an extra fixed income.
Bonds are as opposite of a “get rich quick” scheme as it gets. They are paying you at a slow and steady rate and are a great option for conservative investing.
Bonds investing has it’s own pros and cons that you can weigh out yourself and decide what’s right for you.
If you’d like to learn more about investing strategies, you can check out more of our articles.
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