Wondering how to invest in bonds? Here’s a primer
In 2019, CISI Capital Markets and Corporate Finance estimated the U.S. equity markets had a value of $30 trillion and the U.S. bond markets had a value of $40 trillion.
More than half of all the money that goes into Wall Street investments goes into bonds.
Yet many individual investors don’t understand bonds and how they work, and, worse, don’t have any idea how to invest in bonds.
In this column, I hope to answer some of the questions my clients frequently ask me about bonds, bond funds and other Fixed income products.
Firstly, what is a bond? It is a debt security issued by a government or private entity to raise money for some specific purpose. Most bonds have a denomination (usually $1,000), a coupon (interest rate), credit rating and a date of maturity.
When buying a bond, the bond buyer gives the bond issuer a loan and the issuer is obliged to pay interest on the loan for the duration of the bond.
When the time frame specified on the bond is met, the issuer gives the original investment (principal) back to the bond buyer and the bond buyer keeps all of the interest.
Bonds can be purchased on the primary (new issue) or secondary markets. Primary bond purchases are at par ($1,000 a bond) whereas secondary market bonds can be purchased at par, at discount (less than $1,000 a bond) or at a premium (more than $1,000 a bond).
A bond’s credit quality is rated by one or more of the following agencies; Moody’s, Standard & Poors and Fitch. Corporate bonds are classified as investment grade or high yield depending on the underlying credit worthiness of the bond.
How you purchase a bond can be as important as the bond you buy.
Bond laddering is a long-standing method of purchasing bonds which reduces interest rate risk and diversification risk while providing a more predictable stream of income over time.
Here is an example of a bond buyer who wishes to invest $100,000 in the bond market in five different bonds.
The bond buyer examines the interest rates and notices that he can get the best interest rate for the least amount of time at six years, or 2028. This is just an example so real-life conditions will differ.
The bond buyer buys 20 bonds that mature in 2028. He then purchases 20 bonds seven years out, 20 bonds eight years out, 20 bonds five years out and 20 bonds four years out.
The result is a bond ladder with 20% of the principal investment maturing in 2026, 20% maturing in 2027, 20% maturing in 2028, 20% maturing in 2029, and 20% maturing in 2030.
Bonds pay the accumulated interest into the account money market.
Almost all bonds can be purchased as a collection of bonds (bond funds, exchange traded funds) or as individual bonds. There are advantages and disadvantages to both, and the investor should be well aware of the difference.
The advantages and disadvantages of buying an individual bond are as follows:
- If you purchase individual bonds and hold them to maturity, you are guaranteed back your principal unless the underlying company goes bankrupt. Although the fluctuation of interest rates will affect the value of the bonds (up or down), you will receive all your principal back upon maturity of the bond. Individual bonds can be actively managed in the account by the purchaser.
- If you sell your bond prior to maturity, you are subject to market conditions and could potentially take a loss of principal. Individual bonds have no management fees, and the commission for the purchase of the bonds is removed and held for the seller before bond yields are posted. There will be a fee to sell a bond before its maturity date. There are no commissions to buy or sell bonds if they are purchased in a fee-based account. Bankruptcy risk is higher for individual bonds than it is for a bond fund.
The advantages and disadvantages of purchasing bonds in a bond fund are as follows:
- Bond funds (mutual funds) hold many bonds and this diversification greatly reduces bankruptcy risk.
- Bond funds are more liquid than individual bonds and can be easily sold if cash is needed. Bond funds employ professional managers who have experience with and understanding of the bond market.
Most bond funds charge a commission and have active annual management fees. You can’t actively manage the bonds purchased in the fund and you are never guaranteed the return of your principal with a bond fund since a bond fund has no maturity date.
During a rising interest rate environment, bond funds can be subject to a significant erosion of principal.
There are many different types of bonds issued by many different types of entities.
The federal government issues treasury securities most often as treasury bonds (mature between 20 to 30 years), treasury notes (mature between two and 10 years) and treasury bills (mature between four weeks and a year).
Zero coupon bonds are bonds you buy below par which pay you at maturity of the bond after holding them for specified period of time. U.S. Savings bonds are a form of zero coupon bonds.
Municipal bonds are issued by local, city or state governments for day-to-day operations as well as for specific projects.
The two main types of municipal bonds are revenue bonds and tax-backed bonds. Most of these are tax free and very attractive to individuals who live in highly taxed states. Some of these bonds can be insured against default of principal.
Corporate bonds are issued by companies in the private sector. Corporate bonds are typically seen as somewhat riskier than U.S. government bonds, so they usually have higher interest rates to compensate for this additional risk.
If you wish to invest in the bond markets, my suggestion is to seek the services of a financial professional with experience in this arena. Ask the tough questions to determine if that individual has the knowledge, experience and compatibility to guide you through the challenging world of bond investments.
Marc Spinner is a financial advisor with Waypoint Financial Services in Kennewick.