Even those new to the investment market have heard about bonds at least once in their research. You may have encountered the term several times but have not gotten around to learning what it means. Or maybe you have but, because the topic is so extensive and more than just a little complicated, you may only have a very basic understanding of what bonds are.
Bonds can help add diversity to your investment portfolio and control risk. Simply put, bonds are a type of fixed-income investment that investors lend money to a certain entity (could be the state or national government or a corporation) which takes these funds for a set period at a variable or decided interest rate. That’s why owners of bonds are known as debt holders or creditors: because by issuing a bond, the corporation or government owes them a debt.
However, it is no secret that bonds can be a little tricky to comprehend fully. Even though bonds are, in the simplest of terms, debt obligations, it still encompasses a broad range of types and categories that are not as simple to understand. So here is a simple tutorial on what you need to know about bonds and how you can make them work for you.
Bonds: A Brief History
You may not know this, but bonds have been around since as early as ancient history. River valley civilizations like Mesopotamia (modern day Iraq) had utilized bonds in their trading systems. Bonds were crucial in guaranteeing traders repayment of their borrowed grain or other goods. Monarchs and, later on, democratic government officials, borrowed from merchants and traders by issuing bond contracts.
With these bonds, governments were able to finance the expansion of their territory and fund their wars. Fast forward to the 1940s, at the height of World War II, war bonds were vital financial instruments that helped the Allies win the war. It is safe to say that bonds have a long and proud history.
It is interesting to note that way before there were large, multinational corporations that issued shares of their stocks for investments, bonds were already in place as a systematic use of debt to raise money (either for the business or for the government itself).
The bonds that were issued a millennia ago are not all that fundamentally different from the bonds that we know today. While we have come a long way from trading in grains or wheat and big businesses can issue bonds as well as the government, the concept is still the same in our modern era. To undertake large-scale government projects or expand successful undertakings, governments and corporations need to utilize bonds.
How Bonds Work
Bonds are essentially just a form of borrowing money. If a business or a government borrows money from investors, the funds they receive is a loan that needs to be repaid over a certain period. What’s more, these loans have interest so investors can not only get a return but also gain a profit, depending on the bond issued.
What you should understand is that although governments (at all levels) have a set budget taken from taxes, some projects (like building/expanding schools and public offices, constructing roads, etc.) require a large number of funds, more than what the government can provide. Corporations have a similar problem. To grow their business or take on new and potentially profitable projects, corporations need money that banks are not legally allowed to loan.
Therefore, bonds are a handy solution to the government and the company’s problems. Individual investors can lend their money to an entity. They will be financially assisting in government or corporate projects and can even sell their bonds to other interested investors.
Of course, investors get something extra when they buy bonds from entities. The organization that issues the bond must not only repay the investors the full amount that they lent, and the issuer must also pay an additional amount to compensate the investor for the privilege of using the investor’s money. These are known as interest payments, and they are one of the main draws to investing in bonds.
These interest payments are pre-planned at a certain rate so is the schedule for paying back the investor with interest. The amount the organization borrows is called face value and the date in which they are required to repay the investor is known as the maturity date. The interest rate of these bonds are known as yield or coupon (stemming from the days when bonds were primarily paper documents that had actual coupons investors could clip off to redeem their interest payments).
Bonds can either have a fixed interest rate (an interest rate that will remain the same for the entire course of the contract) or a variable interest rate (which fluctuates over time). Variable interest rates are more common in bonds.
Bonds are known as fixed-income investments because the investor knows the amount of cash they will be repaid if they hold on to a bond until the maturity date. In this regard, bonds are more secure than stocks.
Bonds vs. Stocks
Because a diversified investment portfolio ought to contain some allocation of both stocks and bonds, it will help to compare and contrast both financial instruments briefly.
The easiest way to determine between the two is remembering that bonds represent debt repayment and obligations while stocks represent ownership of a business or company. Bonds are priced according to factors such as the likelihood of getting repaid while stocks are priced based on the expectations of future profitability for the company.
Stockholders can enjoy future profits of a stock when its value keeps on growing. Bondholders are bound by the predetermined interest payment so don’t have the same opportunities in company profitability like in investing in stocks. However, if a stock plummets in the event of the company going bankrupt, investors in bonds are guaranteed repayment from a liquidation before investors in stocks are paid anything.
Put this way, bonds offer lower risks but lower potential rewards while stocks offer higher risks but higher potential rewards. Bonds, by their very nature, are the conservative choice between the two.
Perks of Investing in Bonds
For investors, one of the most important factors to consider before investing in a particular financial tool is getting a total return of your investment. Bonds, in particular, are secure so they are appealing to a lot of people. Typically, there are three main advantages to investing in bonds, and they are as follows:
Bonds can be used to reduce your portfolio’s overall risk. As mentioned earlier, a nice diversified portfolio requires the acquisition of both stocks and bonds. Stocks might offer more opportunities for increased profit, and they can be volatile and unpredictable. Fortunately, bonds have a low correlation to stocks. This means that when stocks are down, the value of bonds go up – and the same holds when the roles are reversed. Basically, with both stocks and bonds in your portfolio, no matter which way the market goes, you most likely will not suffer too much financially.
Bonds are a safe source of additional income. There is a reason why experts and financial analysts recommend investing in bonds to prepare for your retirement. Because a bond’s interest payments are guaranteed, investors can easily anticipate the amount they will receive when the maturity date arrives. In this way, bonds can be extremely useful in funding future liabilities. And a retirement plan is not all that you can fund with bonds too. You can easily plan your bond’s repayment to coincide with major expenses (like a college fund) or with hefty purchases (like your dream house or a car).
Bonds can protect your portfolio from an economic decline. There is no avoiding an economic downturn and an investment in bonds can seriously be useful when that happens. When the economy hits a few speed bumps, falling inflation blows up the purchasing power of future bond payments. Also, a declining economy reduces stock returns, so investors see no other choice than to flock to the bonds market, increasing the prices.
Types of Bonds
If all of that sounds appealing to you, the next step is for you to learn the many types of bonds That is right, and there are numerous distinctly characterized types of bonds, each offering their benefits and drawbacks. Getting to know each type of bonds will give you an idea which type will be ideal for you. Please take note that not all bonds are created equal, and it pays to be aware of their advantages and disadvantages.
These are also known as “US Treasury bonds” and are considered the secure gold standard when it comes to bonds. These are bonds issued by the United States government.
The reason why this type is known as the safest investments available is that it is backed by the full faith and credit of the United States of America government. Since it is highly unlikely that the government will default on its debt, Treasury bonds are secure. This type has more or less zero risk because you are essentially lending the government your money. Moreover, all types of government bonds are tax-free, both in state and local levels. However, they are still subject to federal tax.
There are several types of Treasurys, but all of them share certain characteristics. Mainly, no matter what type of Treasury, their payment rates are always going to be comparatively lower than corporate or municipal bonds.
Treasury Bonds (T-bonds)
Not to be confused with “Treasury bonds,” a term used to refer to Treasury securities as a whole, Treasury bonds are what is considered as long-term basic security. This type of Treasury usually carries maturity dates of upwards to ten years of its issuance. Treasury bonds can be issued up to thirty-year terms. Treasury bonds typically pay interest every six months.
Although Treasury bonds are long-term Treasury securities, you do not need to hold on to your T-bond for the full term. After the first 45 days of purchasing it, you can sell your Treasury bonds at any time.
That being said, Treasury bonds carry the same risk as most long-term bonds. There is a significant risk that the interest rates will increase during the years the investor holds on to their bonds, and this could reduce the value of your Treasury bond. That is why long-term issues usually pay a higher rate of interest to compensate for that risk.
Treasury Notes (T-Notes)
These are known as intermediate-term Treasurys because they are issued regarding more than two years but less than ten years. If you can’t handle the potential high risks of long-term T-bonds but do not like the low payout of short-term bonds like Treasury bills, T-notes have the ideal balance of both which make them a great Treasury security to start investing in.
T-notes have varying interest rates that depend on the bond term. Longer term notes often pay higher interest payments.
Treasury Bills (T-Bills)
These are the short-term Treasury securities and are issued in a matter of weeks. You can buy terms of four to fifty-two weeks. New T-bills are sold every week. Because they are the shortest term Treasury, this type usually pays the lowest relative rate.
What makes Treasury bills unique is that they do not make interest payments. However, T-bills are sold for a discount. They work like this: when T-bills are first issued, they are auctioned to the public on a discount basis. The investor then redeems the T-bill at maturity for the full face amount. For example, if you buy a discounted T-bill at the rate of 5%, you would be buying it at 5% off but would be collecting the full amount when the T-bill matures.
There also exists a special type of T-bill known as the cash-management bill that is issued regarding days.
Treasury Inflation-Protected Securities (TIPS)
This type of Treasury security is quite special as it gives investors an “inflation insurance.” The government started selling TIPS way back in 1997, and these are issued in five-, ten-, even thirty-year terms. The interest payments of TIPS are determined by the inflation rate, and the principal is adjusted semi-annually to reflect the change. This means that although TIPS have less current interest than Treasury notes, they do offer a bigger payoff at maturity.
This type of Treasury bond is known to be safe, convenient, and enjoys tax advantages. Savings bonds are designed as a tool for saving money rather than an investment option. And unlike other Treasury securities, a savings bond can only be bought directly through the US government.
These bonds are issued by large companies and come in a wide range of maturity dates. Unlike Treasuries, corporate bonds are not backed by the government, and they are not insured either. Investors are only assured getting repaid and receiving interest with the financial strength of the issuing corporation.
Investors looking for an investment that offers higher returns and willing to accept higher risks might find corporate bonds ideal.
Municipal bonds are the bonds issued by cities, counties, and states. These bonds are made to fund projects, usually related to infrastructure since those projects demand a high budget.
Majority of municipal bonds are insured by an outside agency which makes them significantly safer than other various forms of bond structures.
Zero Coupon Bonds
This type of bond best suits an investor not looking for immediate income but is instead interested in funding a long-term obligation or purchase. Zero coupon bonds, like Treasury bills, do not offer an interest payment but is bought at a discount. You buy the bond at a significant discount (50% to 70%) from its face value and collect the full amount years later.
Bond funds are not as complicated as some might make it out to be. Simply put, bond funds are pools of money deposited by stockholders and collectively invested in bonds. What makes bond funds so appealing to some investors is that they usually pay monthly interest. This can prove useful to people who need money frequently, rather than the semi-annual interest payment other types do.
What makes bond funds distinct from other bond types is that they do not have maturity dates. When individual bonds inside the fun do mature, the money is reinvested into new bonds. If ever you want to get your money back from the bond fund, you will need to sell your shares.
5 Best Fixed-Income Bond Funds to Buy
While individual bonds can turn a modest profit, choosing them can be difficult and confusing depending on the type you choose. Bond funds, on the other hand, are a much easier option that is why we have included a list of five best bond funds you can invest in today.
Vanguard Intermediate-Term Corporate Bond ETF (VCIT)
This bond fund has between five to ten-year maturity terms. It buys investment-grade debt from US companies, which means Vanguard Intermediate-Term Corporate Bond is not high at risk.
VCIT offers a decent income and comes with a risk profile that investors can stomach.
SPDR Bloomberg Barclays High Yield Bond ETF (JNK)
If you are an investor that is willing to take risks to enjoy higher rewards, the SPDR Bloomberg Barclays High Yield Bond ETF might be for you. This bond fund is a collection of around 960 bonds, all of which have a higher default risk than investment-grade bonds. These “junk” bonds have a high probability of not being paid back which means they tend to pay an outstanding yield. What this means is that if you hold this bond fund, you will be increasing your protection against one or two defaults.
iShares 1-3 Year Treasury Bond ETF (SHY)
As stated previously, US Treasury securities are among the most secure bonds worldwide, and they are highly sought after by domestic and international investors. iShares’ SHY invests in US debt with remaining maturities of only one to three years. SHY carries less risk since shorter-term bonds are not as sensitive to changes in interest rates. Moreover, their risk profile is so attractive that the US government tend to offer much lower coupon rates.
VanEck Vectors High Yield Municipal Index ETF (HYD)
Municipal bonds might be like Treasurys in that the government issues them, but they are not as secure as Treasury bonds, but they do tend to offer more yield in comparison. Moreover, they also provide more income because they are generally exempt from federal taxes. VanEck Vectors High Yield Municipal Index ETF is a collection of around 1500 bonds from different states including New York, California, and Illinois.
PowerShares Emerging Markets Sovereign Debt Portfolio (PCY)
This bond fund invests in international emerging markets so investors looking for high yield might like this. Although investing in sovereign debt means that there are risks to be considered and problems that are out of your control to take into account, you can enjoy a high yield near 5 percent with PCY. Also, investing in an ETF essentially reduces single-holding risk, so you are good.
The Bottom Line with Bonds
Bonds have quite the illustrious history and no doubt they will continue to be around for years to come. Investors worth their salt should by now realize the benefits of buying a bond. Regardless of what type of bonds you will acquire, you would be doing yourself and your investment portfolio a huge favor.
Bonds can be bought through the US Treasury Department, an online brokerage, or an exchange-traded fund. It is important to note that not all sellers are equal and you will need to do thorough research before you settle on which to utilize. Play your cards right, and you could one day reap the benefits of your investments in bonds. Whether it is having a nice and cozy retirement plan or seeing a loved one through college, bonds can offer you so much.