I’ve never been the biggest fan of bonds, but I can see their value for the right person. A long time ago, my friend Jeremy Siegel wrote the book, “Stocks for the Long Run”, and it really confirmed my views on bonds.
Like I said, bonds and fixed income in general can be a great fit for the right person, but I would always say make sure it fits your income / growth needs as an investor.
Below I will provide a “bonds 101” for those interested.
What Are Bonds?
A bond is essentially a loan that you give to an issuer, which could be the government, a municipality, or a corporation. In exchange for your loan, the issuer promises to pay back the principal amount on a specified maturity date and to make regular interest payments at a predetermined rate (known as the coupon rate). This regular payout is why bonds are generally considered income-generating investments.
Types of Bonds
Bonds come in various forms, each with unique characteristics and risks:
- Government Bonds: These are issued by national governments and are considered very safe investments because they are backed by the taxing power of the government. Examples include U.S. Treasury bonds, notes, and bills.
- Municipal Bonds: Issued by states, cities, or other local government entities, these bonds often provide tax-free interest income, making them especially attractive to investors in higher tax brackets.
- Corporate Bonds: These are issued by companies. They usually offer higher interest rates than government and municipal bonds but carry a higher risk because they depend on the company’s financial stability.
- International Bonds: Issued by foreign governments or corporations, these bonds can offer diversification and potentially higher returns but also carry additional risks, including currency fluctuations and geopolitical instability.
How Do Bonds Work?
The key terms to understand when investing in bonds include:
- Principal: The face value of the bond, which is paid back to the investor at maturity.
- Coupon Rate: The interest rate that the issuer agrees to pay the bondholder annually until maturity, expressed as a percentage of the principal.
- Maturity Date: The set date on which the principal (or face value) of the bond is paid back to the bondholder and the issuer’s obligation ends.
- Yield to Maturity (YTM): The total return anticipated on a bond if held until it matures, which includes all remaining coupon payments and any gain or loss if the purchase price was above or below par.
Investing in Bonds
Investing in bonds can be done directly by purchasing individual bonds or indirectly through bond funds, which pool money from many investors to buy a diversified portfolio of bonds. Here are some reasons why investors choose bonds:
- Income Generation: Bonds provide a predictable income stream through regular interest payments.
- Diversification: Including bonds in a portfolio can reduce volatility and provide a safety net during economic downturns.
- Safety: Bonds are generally safer than stocks, particularly those issued by stable governments and financially sound corporations.
Risks Involved
Despite their reputation for safety, bonds do come with risks, such as:
- Interest Rate Risk: If interest rates rise, the prices of existing bonds will typically fall.
- Credit Risk: The risk that the issuer will be unable to make timely payments of interest or principal.
- Inflation Risk: Inflation can erode the purchasing power of the fixed payments received from bonds.
Conclusion
Bonds can be a valuable component of a well-rounded investment portfolio, offering benefits like steady income and reduced portfolio volatility. However, like all investments, they carry risks that should be understood thoroughly before investing. By balancing the types of bonds and understanding their dynamics, investors can effectively harness the benefits of bonds to meet their financial goals. Whether you’re a new investor looking to understand the basics or an experienced player diversifying your portfolio, bonds offer opportunities and challenges worthy of consideration.
Feel free to contact me or anyone on my team at Chapwood Investments about this. We’d be happy to share more and/or walk you through how we invest in bonds.
Ed Butowsky, Chapwood Investments
Disclosure:
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. Chapwood Investments, LLC is a SEC Registered Investment Advisory Firm. No mention of a particular security, index, derivative or other instruments in this material constitutes an opinion on suitability of any security. The information and data in this material were obtained from sources deemed reliable. Their accuracy and completeness are not guaranteed. At any given time, principals at Chapwood Investments, LLC may or may not have a financial interest in any or all of the securities or instruments discussed in this material. The guests appearing in material do not receive compensation or provide endorsements or testimonials. Past performance is not indicative of any future results.