When thinking of exciting investment opportunities, bonds probably aren't the first thing to pop into your mind. They’re not the default option for wealth accumulators looking to significantly grow their nest egg, and recently, bond yields haven’t been anything to brag about.
So, are bonds still relevant, even today?
To a healthy, diversified portfolio, investing in bonds can be a great option in your back pocket. Why? Because typically, stocks and bonds react differently to market conditions, making bonds a nice fixed-income “cushion” when the markets take a nosedive.
As they’re relatively considered a lower risk investment, it is important to remember that bonds do default from time to time. But because of the lower risk, bonds often play an essential role in any investor’s wealth-building (and sustaining) journey.
Let’s take a closer look at what bonds are, the advantages of investing in bonds, and if bonds are the right investment opportunity for you.
What Are Bonds?
Bonds are fixed income representing a loan made by an investor (you) to a borrower (government, corporation, etc.). Think about bonds like “IOU”.
By purchasing a bond, you give the government or corporation upfront capital that they’ll promise to return to you with interest. Governmental entities can use bonds to raise money to fund special projects, like infrastructure spending.
Corporate Bonds are units of larger corporate debt offerings that are issued by companies and considered tradable assets. A company will issue a bond to raise capital without having to use a third party financial entity, like a bank. Various types of Governmental agencies will use bonds to raise money for things like schools, roads, and dams.
Bonds allow individual investors to assume the role of the lender. The market allows lenders to sell their bonds to other investors or buy bonds from others.
There are 4 broad categories of bonds: corporate, municipal, government, and agency.
- Corporate bonds are debt issued by a company to raise capital.
- Municipal bonds are debt obligations issued by state, county, local, and other government entities to raise money for the public good.
- U.S. Government bonds, also known as Treasury bonds, notes, or Treasury bills are issued by the U.S. government to support government spending and obligations.
- U.S. Agency bonds are issued by a government-sponsored enterprise or by a federal government department (other than the U.S. Treasury).
While there are multiple different types of bonds, all of them share the same 5 characteristics:
- Face value: This refers to the dollar value of the bond when it is issued and is the price that the issuer pays at the time of maturity.
- Coupon rate: This is the annual interest paid by the bond in dollars, divided by the face value. For example, a bond that pays $50 in annual interest with a face value of $1,000 will have a coupon rate of 5%.
- Coupon dates: This is the date when the bond issuer is required to make an interest payment to the investor. Coupon dates can range from every 6 months (or less), to once a year to every 3 years.
- Maturity date: This is when the bond's principal amount is paid to investors. Maturity can be as short-term as a day to as long as 30+ years.
- Issue price: The issue price is the price at which the bond issuer initially sells the bonds. The issue price and the face value can be the same, but that is not always the case.
How Do Bonds Work?
Now that you have a general understanding of what bonds are, it’s time to get a bit more technical.
Let’s start with cost. Bond prices are usually inversely correlated with interest rates, so when rates go up, bond prices tend to fall and vice versa.
The borrower (issuer) issues a bond that includes the terms of the loan, interest payments to be made, and the time that the principal must be paid back (maturity date). The interest payment (known as the coupon) is part of the return that the bondholder will earn in return for loaning their funds to the issuer (the entity that borrowed the funds).
As we discussed, the initial price of a bond is face value—but the market price is different. The bond's market price depends on a few factors, including the issuer's credit quality, the time until maturity, and the coupon rate compared with the overall general interest rate environment at the time.
There are 3 ways to make money by investing in bonds:
- Bonds can be sold by the initial holder to other investors after they have been issued, which means that the investor does not have to hold the bond to its maturity date.
- The borrower can repurchase a bond, under certain circumstances, of course. An investor could be motivated to repurchase a bond if, for example, interest rates decline, if the borrower's credit has improved, or if the borrower can get new bonds at a lower cost to them.
- The investor holds the bond until its maturity date and collects interest payments on them.
Advantages Of Investing In Bonds:
There are several advantages to investing in bonds:
1. Bonds Provide Fixed Income
Everybody would start investing if they could guarantee their money would grow, but the market is volatile. The return rate of stocks and alternative investments like cryptocurrency isn’t promised.
That’s why bonds can be a great investment opportunity. Because bonds offer a fixed rate of return, investors know what to expect.
The returns may not be high, but a predictable rate of return, if held to maturity, is pretty rare in the investing world.
2. Bonds Enable You To Diversify Your Portfolio
We believe that a strong investment portfolio is a diversified one.
Bonds can help diversify your portfolio due to their low correlation to other asset classes, meaning that they perform differently than conventional investments. Bonds can be a shining light in a portfolio when the market inevitably spirals downward.
3. Bonds Can Offer Tax Benefits
Different taxation rules for government, corporate, and municipal bonds can help reduce your tax burden.
U.S. Government bond obligations are exempt from state tax but generally offer lower interest rates than corporate bonds. Municipal bonds tend to be more popular for those in a higher tax bracket because they usually aren’t subject to federal taxes. Note that tax rules on municipal bonds are different for every state.
4. They’re A Strong Entry Into Investing
With a set rate of return and a relatively low level of risk, bonds can be an excellent way for beginners to get their feet wet in the world of investing.
High quality investment grade bonds generally are some of the safest investments available, so if you’re cautious about investing, bonds could be a great place to start depending on your investment goals.
Are Bonds Good Investments?
The short answer is generally yes! Higher quality investment grade bonds are generally considered a relatively lower-risk way to invest your money, and if you’re looking to diversify your portfolio without betting on the stock market, bonds can be a great option.
If you’re interested in how bonds can help diversify your portfolio to reach your financial goals, get in touch with our team at Pro Wealth today.
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