When governments and corporations need money to pay for projects, they raise capital by issuing bonds, which are debt securities that they must pay back to lenders in a specific time period at an agreed rate of interest.
Bonds are generally considered a more conservative asset class than stocks, which historically have been more volatile.
Government bonds are widely believed to be a safer bet than corporate bonds, but they also pay lower rates of interest to bond investors.
As with any investment, risk does accompany any bond purchase – even government debt. For example, Argentina defaulted twice on its debt obligations in the first few decades of this century and many times last century.
Still, government debt is generally a more conservative investment than corporate debt, and accordingly pays lower interest rates on borrowings to debt investors.
The Basics Of Investing In Bonds
A bond is simply an IOU that a borrower must pay back over time. The same way you might take out a mortgage to buy a home, a company may take out a loan to finance a new project. Or a government may issue bonds to finance infrastructure spending.
BONDS ARE FIXED-INCOME SECURITIES
Bonds are known as fixed-income securities because borrowers pay a specific amount on a regular basis. Unlike stocks, which can rise or fall on any given day causing variable returns, bonds are more predictable so investors earn a predictable yield.
If you were to buy a $10,000 bond with a 6% yield and a 10 year maturity, then you would receive $600 annually for 10 years plus your original $10,000 principal at the end of the 10 year term.
Generally, bond payments are made semi-annually, so you would receive $300 twice a year over the duration of the bond term.
At the time of bond issuance the payment frequency is specified and it could be monthly, quarterly, semi-annually or yearly. In all cases, the original investment is paid back at the end of the bond term.
BONDS HAVE FIXED MATURITY TERMS
Bonds have fixed maturities, meaning that they are issued for a fixed term.
Generally, bond maturities range from short-term bonds to long-term bonds.
Short-term bonds may only have maturities of a year while intermediate-term bonds have fixed terms that last from two to ten years.
Long-term bonds over 10 years and up to 30 years are common, but some governments have been known to issue bonds for terms as long as 100 years.
GOVERNMENT BONDS ARE CONSIDERED SAFEST
Government bonds are known as Treasurys and are backed by the full faith and credit of the U.S. government.
When you buy a government bond, you become a lender to the Federal government, so the likelihood that you will not get paid is low.
For this reason, Wall Street analysts who build financial models to value companies use the 3-month U.S. Treasury bill rate as a proxy for the risk-free rate used in valuation calculations.
States and municipalities issue debt also to finance spending on infrastructure, such as construction of bridges and roads, as well as to pay salaries of government employees, including teachers, firefighters, and police.
These bonds are considered to be the next safest tier of bond but they are not without risk. Mismanagement of state or city finances such as Illinois experienced with its pension crisis can increase risk of default.
INTEREST RATES ARE TIED TO RISK OF DEFAULT
The interest rate on a bond paid to investors reflects the likelihood of the borrower defaulting on its obligations to pay. The higher the creditworthiness, the lower the interest rate paid.
Governments pay lower interest rates than corporations because the risk of sovereign default is lower than corporate default.
There are exceptions to the rule. For example, Apple has so much cash that it historically paid a lower interest rate than some nations do – but equally it has more cash on hand than many nations do.
BOND PRICES MOVE OPPOSITE TO BOND YIELDS
Bonds are not just purchased on the day they are issued but can also be bought on a secondary market afterward issuance.
Bond prices may fluctuate in value on a secondary market so when bond prices decline, bond yields increase.
And vice versa, when the price of a bond rises above its original or par value, the yield to maturity decreases relative to the original rate when it was issued.
INTEREST RATES AFFECT BOND PRICES
When interest rates rise, new bonds issued on the market have higher yields which are more attractive to investors.
Older bonds paying lower yields are less attractive to investors than newer bonds paying higher yields, and so bond prices generally decline when interest rates rise.
Retirement Investing In Bonds
As you approach retirement, it is important to become more conservative with your portfolio.
To smooth out portfolio volatility, a larger weighting of bonds versus stocks is a good idea.
Historically, the stock market has enjoyed annual returns that average north of 7%. But behind the veil of this average return figure are a lot of ups and downs, including stock market crashes that typically happen on average at least once each decade.
So, the last thing you want when you are ready to retire is to have your entire nest-egg in a retirement portfolio of stocks just when the market is at a peak.
It is better to be safe than sorry, and create a balanced portfolio that includes its fair share of bonds.
If you want to avoid the homework of figuring out which bonds to invest in, a robo advisor might be a good option.
>> Related: How To Diversify Your Portfolio Intelligently
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Taxes And Bond Investing
Municipal bond investors enjoy tax breaks that are not available to bond investors generally.
When state and local governments issue muni bonds to pay for road constructions, schools, dams, and other public projects, they incentivize investors to loan them money by offering attractive tax breaks.
When you buy a muni bond, the interest payments you earn are not subject to federal taxation.
Plus, if you buy muni bonds issued by the state you live in, interest earned is often exempt from state and municipal taxes too.
>> Related: How To Lower Your Tax Bill
What Are The Risks Of Investing In Bonds?
The major risk when investing in bonds is default risk, which occurs when the borrower does not follow through on its obligation to repay the debt principal and interest.
Whereas shareholders in a company who have bought stock claim a share of future profits, bondholders receive a fixed interest rate that is independent of the profitability of a company.
Even if a company goes bankrupt, a bondholder may end up recouping some money because bondholders are more senior to shareholders and must be paid in full from any liquidation of assets before shareholders receive a penny.
The seniority bondholders enjoy comes at a cost, which is a limited upside. Whereas shareholders can earn ever higher returns as share prices rise, bondholders are limited only to what they can earn from the interest paid.
Have you invested in bonds that produced a good return with low risk? Share your bond investing experiences with us in the comments below – we would love to hear from you.
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