When it comes to investment opportunities, most people immediately think of the stock market. That's understandable, really; trading in shares has a definite aura of excitement about it. It's hard not to be fascinated by the hustle and bustle of the stock exchange, where fortunes can be made and lost in the wink of an eye. But for the novice investor, the stock market can be a dangerous place, and most financial advisers recommend starting with more conservative investment products.
Bonds are an ideal alternative to the stock market, and their relative safety and stability have made them one of the most popular investment products on the market. Indeed, even experienced speculators understand the value of investing in bonds, and their rightful place in a diversified portfolio.
Of course, before you begin investing in bonds it's important to understand a bit more about them and how they work. After all, you can't be successful if you don't know how the game is played. So, for the beginning investor we've put together an introductory guide to bonds. We'll discuss the various types of bonds, their cost to yield potential, and their place in a structured portfolio.
At their most basic, bonds are really a type of loan. When organizations need to raise large amounts of capital, they will often borrow from the public at large. In modern terms, it might be compared to crowd-funding. For example, if a government or corporation needs to raise funds to expand services or operations they will issue bonds onto the public market. When you buy one or more of these bonds, you are essentially loaning the organization a portion of the capital they are trying to raise; in return for which, you (the bond holder) will be paid a set amount of annual interest over the term of that loan. Finally, when the bond reaches maturity, the organization repays you the original amount borrowed, or the face value of the bond.
Bonds are considered fixed income securities, because investors know exactly how much of a return they will receive on their investment. This makes them much more stable than stocks, which is why they are an ideal financial product for first time investors. Of course, the relative safety and stability of bonds also appeals to the experienced speculator, and they are an important part of any well structured portfolio. While it's true that bonds don't carry the higher earning potential of stocks, they do offer some distinct benefits of their own.
Now that you have a better idea of what bonds are, and the benefits they offer as a financial product, it's time to talk about purchasing them and making them a part of your investment portfolio. However, before we can do that, we need to review a few common terms. Having a working familiarity with these concepts will help you determine the value of a bond, and whether or not it belongs in your portfolio.
In addition to these basic terms, it will also be useful to have a working understanding of the bond rating system. This applies to bonds issued by corporations and other for profit organizations, and the ratings are based on the company's perceived credit risk. For example, a so-called Blue-Chip firm would be considered a safer investment, and would be given a higher rating. Companies seen as a higher risk, due to either past or projected performance, would be given a lower rating. In the United States, the bond rating system is controlled by three agencies – Moody's, Fitch, and Standard and Poor's. The table below should give you a better idea of how bonds, and the companies that issue them, are rated in the U.S.
|Moody's||Fitch/Standard & Poor||Grade||Quality (risk)|
|Aaa||AAA||Investment||Highest Quality (lowest risk)|
|Aa||AA||Investment||High Quality (lower risk)|
|A||A||Investment||Strong (low to moderate risk)|
|Baa||BBB||Investment||Medium Grade (moderate risk)|
|Ba, B||BB, B||Junk||Speculative (high risk)|
|Caa, Ca, C||CCC, CC, C||Junk||Highly Speculative (higher risk)|
|C||D||Junk||In Default (highest risk)|
As you can see, the higher the rating for the company and its bonds, the lower the risk. When a firm's rating slips below a certain point, their bonds are no longer considered investment quality, and become classified as junk bonds. In order to attract investors, these high risk firms must compensate by offering a significantly greater yield on their bonds. It's worth pointing out here, that while investing in bonds is generally safer than trading in stocks, it is not without its perils. Investing in high risk bonds can be just as risky as investing as stocks, if not more so.
Bonds may be issued by federal and local governments, as well as larger corporations. Fundamentally, they all follow the same investment model. That beings said, there are some subtle differences, and it's worth taking the time to review the various options to get a better idea of what's available to the ambitious investor.
Government issued bonds can be broken down into three basic categories – bills, notes, and bonds. Each is defined by the time it takes for them to mature. For example:
Strictly speaking, bills are not bonds. However, they are typically traded as bonds and are managed in much the same way. While their maturation period is shorter than a true bond, they can still offer significant returns on your investment, and can form a solid part of a well structured portfolio. It is worth recognizing the differences between the three basic categories of fixed income securities, as it will help to inform your choice of investment opportunities should you decide to take the plunge.
The U.S. government offers three different fixed income securities, each with a different price point and maturity profile. As a general rule, securities marketed by the federal government are considered extremely safe, though their yield may not match that of bonds offered by the private sector.
While treasury notes and bonds are initially sold at auction, once they are purchased they can be resold on the open market. This adds greatly to their liquidity, making them particularly attractive investment opportunities.
Municipal bonds are sold by state and local city governments to raise money for public works. Technically, they are considered a higher risk purchase than a federal security because, while cities rarely declare bankruptcy it can happen. The major attraction of municipal bonds is that the interest earned is often free of both state and federal taxes. However, the tax free nature of most municipal securities renders the yield substantially lower than what could be found on a taxable bond. Still, depending on your personal situation, and the amount of money you have to invest, municipal bonds can a be wise purchase.
Corporate issued bonds are considered a higher risk commodity than either of the popular government backed securities. That's because companies are more likely to default on their debts than the federal government or state and local municipalities. Consequently, the potential yield on corporate bonds is generally greater than what you would receive from a treasury note or T-bond. Interest rates on private sector securities are determined by the credit quality of the issuing organization. So, a bond issued by a company with a strong credit rating would carry a lower interest rate than one issued by a firm with a less impressive credit score. The higher yield associated with corporate bonds makes them particularly rewarding as fixed income investments, and the returns for the investor can be substantial. That being said, investing in corporate securities is not without it's risks, and they do not offer the stability of government bonds.
Like government bonds, corporate fixed income securities are categorized by their maturation dates, and the term of the bond will have a direct impact on its potential yield.
There are also two main variations to be aware of when investing in corporate backed securities, and they can have a direct impact on the term of the bond and the potential return on investment.
This is simply any type of bond, government or corporate, that makes no interest payments over its term. Instead, it is sold at a considerable discount to its par value. For example, a $1000 bond might be traded on the open market at a cost of $600, to be paid in full after 10 years. Quite often, standard issue bonds will be stripped of their coupons and sold on the public market as zero coupon bonds. The seller receives the interest payments, while the secondary buyer receives the final pay out.
One of the most confusing aspects of investing in bonds is the price vs yield equation, and this has been the undoing of many first time investors. Because bonds are basically loans, they are closely tied to the rise and fall of interest rates. When interest rates are high, bond prices drop, and when interest rates are low, bond prices rise; that can have a definite impact on the securities market. Let's look at a quick example:
Let's say you buy a 10 year $1000 bond with a 5% coupon. You hold that bond for the next few years collecting your $50 of annual interest. During that time, interest rates fall, and a comparable 10 year $1000 bond now carries a 4% coupon. Your original bond is now a much more valuable commodity, and it can be sold at a premium on the open market. Other investors will pay good money for a bond with a better coupon. This gives you the opportunity to make some quick cash, though you may ultimately incur a loss on the long term yield of your investment.
However, if interest rates have risen since your original investment, a comparable 10 year $1000 bond would now be paying a higher interest rate. That old 5% coupon is no longer as competitive, or as valuable, as it once was. Now, this does not necessarily mean you are facing a loss. Your original bond will continue to pay you $50 a year in interest, and when it matures you will be paid the full face value of the security. You aren't increasing your return, but there's no real diminishing of your investment either. But there is still a way to make money in this scenario. If you purchased the original bond at a substantial discount, for considerably less than its par value, selling it now can increase the yield on your original investment.
The price to yield equation can make investing in bonds confusing for beginners, and it can be a difficult learning curve to say the least. As a general rule of thumb, it is always recommended that investors in individual bonds have a diverse portfolio that includes a healthy mix of short term, intermediate, and long term investments. Because long term securities are so sensitive to changes in interest rates, a selection of short term and intermediate bonds can help act as a buffer against potential losses. For first time investors, and sometimes even more experienced speculators, it often makes better financial sense to invest in a bond fund as opposed to individual securities.
Before you begin buying any bonds, you need to consider your overall objective. If it is to achieve long term capital gains, then your portfolio should be weighted towards intermediate and long term maturities. While these are most affected by changes in interest rates, they have the potential to deliver the highest return on your investment. Long term securities, particularly zero coupon bonds, can pay predictable dividends if you are willing to ride out the changes in the market, and hold on to your investments until they reach absolute maturity. If you know how to manage your portfolio, or hire a money manager to handle your investments, you can maximize your gains by selling portions of your holdings when interest rates are low. Of course, this strategy is much closer to playing the stock market, and negates some of the safety and stability of investing in the bond market.
If your ultimate objective is to realize a steady stream of income, which can be reinvested or used as a retirement supplement, than it is best to stick to shorter term securities. Bonds with a maturity of 1 to 10 years offer greater stability than longer term investments, and the returns are easier to predict and manage. Spread your money around, and invest in a variety of different fixed income securities, either by purchasing individual bonds or by investing in a mutual or bond fund. For a safer, and more stable, income stream, create a bond ladder that provides intermittent pay outs which can be reinvested to produce increasingly larger yields over time. We'll talk more about laddered portfolios below.
As to where you should buy your bonds, there are three outlets available to investors:
If you do decide to invest in individual bonds, you need to find a way to both protect your principal and maximize your returns. A bond ladder can help investors earn a steady stream of income from their security holdings, while increasing the potential for greater returns should interest rates rise in the future. While that may sound complicated, in practice it is much easier than it seems.
A bond ladder is a portfolio of individual bonds that mature at different rates. We've talked about the importance of a diversification, and this is where it comes into play. Short term investments form the bottom rungs of your ladder, intermediate bonds are situated in the middle, and long term securities take their place at the highest point. This basic structure produces two key benefits:
Building a laddered portfolio is relatively simple, if you have the necessary money to invest. The most important considerations are the number of rungs on the ladder, the spaces between them, and the materials used in the construction.
Building a laddered bond portfolio is a popular investment strategy, as it offers a degree of regular income as well as the potential to reinvest and extend profit potentials. However, building a bond ladder requires a fairly substantial financial investment. While it is possible to build a diverse portfolio with more limited funds, you should expect to invest at least $60,000 or more in any decently constructed bond ladder. You will also need the assistance of an experienced broker to set up and manage your portfolio, and that means paying commission and management fess over and above the costs of your investments.
Bond ladders are not without their risk, and it takes some understanding of the market and attention to detail to reap their full benefits. While the advantages of a laddered portfolio are many, there are some definite disadvantages that investors should be aware of.
For many investors, both novice and experienced, managed mutual funds provide a greater opportunity for success than a laddered portfolio. They are generally safer than buying individual bonds, and the cost to invest is much more reasonable. For many financial advisers, the benefits of managed mutual funds far exceed those of buying individual bonds. If you are a beginner when it comes to bonds, consider the following benefits of investing your money in a mutual fund.
Whether you decide to invest in a mutual fund, or to buy individual bonds, it is important to be well informed. While investing in bonds is statistically much safer than the stock market, it too has some very definite risks. Before you earmark any of your savings for investments, consider all of the options and fully research all of the potential investment opportunities.
The main area where laddered bond portfolios would be safer than a bond fund would be if there was a disorderly exit from the bond market. If other investors in a bond fund sold their stakes, the forced redemptions could in turn realize losses for people who didn't sell at the bottom of the market. This risk is substantial enough the Federal Reserve considered imposing exit fees on bond funds to discourage investors from selling funds into a weak market.
Any investment product comes with some degree of risk. While bonds are generally safer than stocks, and considerably more stable, there is always the opportunity for loss. From time to time issuers do go into default, particularly when it comes to corporate entities with questionable credit ratings. That's why all investors, particularly those with little or no experience, need to rely on sound financial advice before speculating in any market. If you are uncomfortable locking up your capital for an extended period of time you may want to look into shorter duration CDs or flexible money market accounts.
Fixed income investments can be a valuable source of income, and properly used can help you to grow your wealth, prepare for retirement, and even leave a healthy inheritance for your family. However, they are not for the faint of heart, and before you decide to dive into the world of investments you must first decide if you can afford to gamble with your hard earned money. Understanding your own toleration for risk will steer you toward your best options.