Because bonds come in so many varieties, investors can build a fixed-income portfolio that behaves differently than equities in any market cycle. That makes bonds the ideal asset class to diversify any equity portfolio.
A significant concern for investors is how to manage risk, without completely sacrificing return.
It's a dilemma that drives many to consider investing in bonds.
Bonds offer regular income for investors (at higher yields than many cash equivalent investments). Bond investments are also expected to preserve capital and protect against market volatility.
Learn how bonds investments can help you diversify your portfolio and achieve an acceptable level of risk as you work toward your investment goals.
What is a Bond?
A bond is essentially an IOU. Bonds are issued by borrowers to lenders (or bondholders).
The borrower, or bond issuer, can be the U.S. government, a state, a federal agency, a corporation, a municipality, or even a foreign nation.
Types of Bonds
Bond professionals agree that there are seven types of bonds:
- U.S. Treasury bonds
- Other U.S. government bonds issued by federal agencies (such as Freddie Mac, Fannie Mae, Ginnie Mae, Federal Home Loan Bank Corporation)
- High-quality, investment-grade corporate bonds
- High-yield corporate bonds (which are low-quality bonds also known as junk bonds)
- Foreign sovereign bonds
- Mortgage-backed bonds
- Municipal bonds
How Do Bonds Work?
Bonds come in many forms and qualities and are issued for different time frames. U.S. Treasury bonds, for example, are commonly issued from one to 30 years.
Each bond category has its own price history, risk profile, market characteristics, and tax profile.
The price of a bond is determined by its interest rate, yield, maturity, redemption features, default history, credit ratings and tax status, as well as market factors.
Each of these key features has its own specifics that allow bond investors to conduct detailed research in order to make more informed decisions about which bonds, or bond funds and ETFs, are most appropriate for their portfolio.
Of these variables, interest rates are considered the most important. These rates can be either fixed, floating, or payable at maturity. A bond's return, or yield, is determined by its interest rate and price.
Note: Since bond issuers agree to pay purchasers a rate of interest throughout the loan in addition to repaying the principal (the face value of the bond) at the bond's maturity date, it is critical to know the financial stability of the bond issuer.
There are two main types of yields:
- Current yield
The current yield is how much the bond will return in a year based on its price and interest rate. This calculation is made by dividing its interest payment by the price.
- Yield to maturity
The yield to maturity is the sum of all the interest payments you receive until the time the bond matures.
In some instances, bonds are quoted as a yield to call. This is almost the same calculation as yield to maturity; but since the bond is called by the issuer before the maturity date, the amount of interest received is reduced.
Bonds are very mathematical and each variable can be calculated exactly.
But market factors affecting bond prices - such as changes in inflation, supply and demand, strong job reports, and increases in housing starts - are difficult to predict. These factors often push bond prices lower since they may foreshadow interest rate increases.
Are Bonds a Good Investment?
Wary of the high volatility in equities and low returns from CDs and money market funds, investors have been moving into bonds in search of stable returns accompanied by more price stability.
Two things make bonds attractive:
- Capital preservation (since bond defaults are rare)
- Interest is paid on a regular schedule (often semi-annually)
Investing in bonds during a period of high equity volatility is an understandable investment strategy. In addition to portfolio diversification, bonds have their own risk and return characteristics that develop during market cycles or in response to changing interest rates and economic uncertainty.
For these reasons, knowing the basics of bond investing (especially how to select the right mix of corporate, municipal, and international bonds) can complement any diversified portfolio and be a great help for anyone planning for retirement.
In addition, some bonds provide significant tax benefits, which should benefit investors in higher tax brackets.
Key factors to know which bonds to invest in
It is important to know the key factors affecting bond selection: These include important variables such as credit ratings and bond time frames (maturities), the inflation and interest rate environment, the quality of issuers, and what type of bond is most appropriate for your portfolio and investment goals.
Then, there is the question about whether it is best to buy a bond fund, ETF, or individual bonds. All these are key factors in creating an optimum bond portfolio.
The good news is that bonds come in so many varieties that investors can build a fixed-income portfolio that behaves differently than equities in any market cycle. This makes bonds the ideal asset class to diversify any equity portfolio. In addition to tax benefits, bonds also offer predictable payment streams over time that often are not available from equities.
Strategy: How to Invest in Bonds
Investors who want an income stream to cover college tuition or supplement retirement income can buy Treasury bonds with different maturities. The most common types of bond strategies rely on buying bonds with different maturity dates.
In a laddering strategy, investors often buy bonds with two-, four-, six- and 10-year maturities. As the shorter bonds mature, the principal is re-invested in the 10-year bond.
This strategy reduces interest rate risk since the maturities are staggered. As shorter maturity bonds mature, investors can select other bonds as rates rise or fall in order to maintain the strategy.
Another strategy is the barbell strategy. This involves buying short- and long-term bonds only. If long-term interest rates rise, the investor will benefit from their long position.
If rates fall in the short term, the investor can use the proceeds to buy more bonds as rates increase - or the investor can move into other investments if rates decline. At the same time, the bonds with longer terms are providing interest payments to the investor.
Buying Bond Funds and ETFs
Most investors that delve into the bond market buy bond funds or ETFs as opposed to individual bonds. This makes it easier to gain broad exposures and, in some cases, professional management, to the fixed-income segment that meets investor needs.
The largest of these categories include corporate and U.S. Treasury bond funds.
Partly as a result of the aging population, bond mutual funds (comprised of Treasuries, corporates and municipals) saw net inflows through most of the past decade, according to the Investment Company Institute. Investors also bought funds with exposure to investment-grade corporate bonds, government, and multi-sector bond mutual funds, the ICI said.
Bond ETFs have also proven to be very popular, especially as the 30-year Treasury bond yield fell to an all-time low of 1.9% in August 2019.
This decline pushed prices higher, accompanied by investors seeking the safety of U.S. Treasuries. As a result, bond ETFs had their best year ever in 2019, according to FactSet. This also included international bond ETFs that invest in the national debt of countries outside the U.S. In some international bond ETFs, the price moves are hedged against currency fluctuations to protect price declines that can impact U.S. investors.
Multi-sector bond portfolios
For investors who want the broadest bond exposure in a single fund, the industry has developed multi-sector bond portfolios. These portfolios generate income by diversifying assets among several fixed-income sectors, often U.S. government obligations, U.S. corporate bonds, non-U.S. bonds, and high-yield U.S. debt securities.
Some bond funds have a wider mandate and can delve into more esoteric fixed-income investments, such as corporate debt securities of U.S. and non-U.S. issuers, including convertible securities, corporate commercial paper, inflation-indexed bonds issued by corporations, structured notes, including hybrid or "indexed" securities and event-linked bonds.
Managing Interest Rate Risk and Inflation Risk
While bonds are negatively affected by rising interest rates, Treasury Inflation-Protected Securities (TIPS), offer some protection.
These bonds are guaranteed by the U.S. Government. TIPS prices can increase in value as inflation increases or decreases. Their principal value changes in response to inflation, while their yield is calculated by subtracting the rate of inflation from the Treasury bond yield.
Since TIPS have a 10-year time horizon, investors buy them when they think inflation will increase. However, if you have a view that inflation will not rise, you should buy nominal T-Bonds, not TIPS. These bonds can be important to retirees who have a fixed income whose buying power can be eroded by inflation.
While there have been record sums invested in bond funds, this large shift into fixed income is not risk-free.
What fixed-income investors should consider
In the current environment, fixed-income investors should recognize that bond fund total returns over the past decade were attributable to capital appreciation and yield. But today, yields are at historic lows for the 10-Year Treasury bonds and corporates. This has made capital appreciation the main engine for propelling bond funds higher in price.
To generate income, individual investors have been hunting for under-valued, or higher-risk assets, such as high-yield bond funds.
The problem is that some bond funds sell bonds as they get close to maturity and replace them with similar bonds with longer maturity dates. The better choice, according to some financial experts, is for investors to buy individual bonds, not bond funds, and hold them to maturity when they will return their face dollar amount.
Do Bonds Belong in Every Portfolio?
Bonds come in many maturities, qualities, risk levels, prices, and from a wide variety of issuers.
Government bonds can provide capital preservation, regular income, stability, and tax benefits.
Bond funds and ETFs offer a wide exposure to bond exposures in a single investment that can provide portfolio diversification and a higher level of professional investment management than if you managed a portfolio of individual bonds yourself.
However, when added to any portfolio, bonds provide essential diversification into investments with very different characteristics than equities. As a result, investors should take the time to learn how bonds can supplement any portfolio to reach their short- and long-term financial goals.