A Beginner's Guide to Bond Investing
What is the definition of a bond?
Corporations, towns, governments, and other institutions raise money by selling bonds to the general public when they require money for important initiatives. Consider a bond to be an IOU issued by the entity that is borrowing funds from you. In exchange for the loan, you'll be given a fixed interest rate for a certain amount of time. You should receive the full face value of the bond when it matures.
Bonds of several kinds
Each sort of bond has its own set of risks and rewards, depending on the issuer. Federal government securities (treasuries), municipal (munis) or corporate bonds, mortgage and asset-backed securities, and foreign government bonds are all options. All bonds work on the same principle: interest is paid in exchange for a loan that is not repaid until the debt is repaid.
How to Purchase Bonds
TreasuryDirect.gov is a website where you may buy government bonds in the United States. To acquire the other sorts of bonds, you'll need an in-person broker or an online service; before you start trading, make sure you understand the minimum investment requirements, commissions, and other expenses.
Face value, coupon, and maturity date are the three features of bonds. The fourth characteristic is duration, which is a calculated figure that can be used to gauge interest rate risk.
Bond trading has its own vocabulary and approach. Here's a rundown of the most commonly used terminology among investors.
The face (par) value of your bond is the amount you will get from the issuer when your bond matures. The face value of a bond is not always the same as the principal, which is the amount you paid for it. These names are often used interchangeably, although they are not interchangeable.
Some bonds sell at a higher premium than face value, while others trade at a lower discount. The value of a bond fluctuates over time, based on factors such as market circumstances, interest rates, and the issuer's credit rating.
Payments made with coupons
The coupon is the amount of interest paid on a bond. Bonds used to come with physical coupons that you had to tear off and redeem to get your interest payments. Electronic coupons are used in today's world.
Short-term bonds are less risky and pay lower interest rates than long-term bonds. Long-term bonds pay a higher interest rate to compensate the buyer for market fluctuations, interest rate changes, and risks related to the issuer's capacity to pay the coupon or repay the bond's face value at maturity.
Date of bond maturity
The maturity date of a bond is the date on which the issuer agrees to pay you the entire face value of your bond. Maturity dates commonly range from one to thirty years after the issuance date. When you acquire a bond, you don't have to keep it until it matures. Bonds, like most other securities, can be purchased or sold on the open market at any moment during their life cycle. Bonds with longer maturities are more susceptible to interest rate movements.
Bonds give a pretty consistent income stream. Fixed-income securities are so named because the amount of money you get and the dates on which you receive your payments are both known ahead of time. The risk factor of fixed-income assets is often smaller than that of equities. Of course, any investment involves risk.
Bond Investing's Risks and Rewards
Even if the issuer isn't doing well, bondholders are paid. If you invest in corporate bonds, your rate of return is the same whether the company succeeds or fails. You are less vulnerable to changes in the issuer's performance.
Advantages in terms of taxes
Not only can bonds generate a regular income stream for investors, sometimes that income stream may be tax-free, making them attractive if you have a high tax burden. The type of bond, the issuer, and your residence state will all have tax implications. Discuss bonds with your tax expert to see whether they can help you decrease your tax liability.
While bonds are regarded as secure investments, you should be aware of the following risks:
• Interest rate risk: Also known as market risk, interest rate risk refers to variations in bond values as a result of changing interest rates. Bond prices and interest rates behave like the two halves of a seesaw: as interest rates rise, the price of current bonds falls.
• Credit risk: Your goal as a bond investor is to collect monthly coupon payments and the face value of your bond when it matures. When the bond issuer's financial difficulties have a negative influence on your payments, this is referred to as credit risk.
• Inflation risk: Your bond investments may lose value if the Federal Reserve raises interest rates to combat inflation.
• Reinvestment risk: For long-term investors, falling interest rates may force you to reinvest your interest and principle at new, lower rates.
• Selection risk: There's a chance you'll pick a security that underperforms the market. With careful study, you can lower your selection risk.
• Timing risk: The possibility that an investment underperforms after you buy it or outperforms after you sell it.
• Other costs: Don't forget about commissions, markups, markdowns, and other fees related with investing. If such costs are too high, they can dramatically reduce your net profit.
Stay away from junk food.
A bond issuer's insolvency and default on the bond are always a possibility. In that instance, you'd have to go through a lot of legal hoops to get even a small amount of the money owed to you for the bond's coupon and face value. Don't be swayed by the greater yields offered by high-risk trash bonds.
When you incorporate bonds in your portfolio, you diversify your investment while also mitigating potential dangers. As you are ready to start trading bonds, keep these strategies in mind.
Reduce the overall risk of your investment
Stocks can rise in value over time, with sometimes spectacular results. They can, however, become stagnant, lose value, and, in exceptional situations, lose their value entirely. Because the issuer has guaranteed to repay 100 percent of the bond's face value, bonds can be a more secure approach to protect the value of your investment while still obtaining appropriate returns.
Bond investments still carry a degree of risk. Some bonds may have more risks than stocks, depending on the issuer. It's possible that the issuer will miss interest payments. They could not be able to return the bond's face value, which means your money is gone. Bonds, on average, are a lower-risk (and thus lower-return) investment than stocks.
Use asset allocation and the 100-percent rule to your advantage.
Asset allocation is one approach to reduce risk in your investing portfolio. Subtract your age from 100 to get the percentage of your portfolio that should be invested in equities. For a 30-year-old, this means putting 70 percent of your assets in stocks (100-30) and the rest in bonds (30%). As you become older, the scales begin to shift in your favor. The Rule of 100 suggests that you invest 45 percent of your assets in stocks and 55 percent in bonds when you're 55. At 70, you may decide to invest 30% in stocks and 70% in bonds.
Invest for a shorter period of time.
Bonds may be the best option for preserving cash and generating a return on your investment in a short period of time (five years or less). For financial goals like college tuition, you'll probably want to transfer more investments into capital-preserving assets like bonds.
Bonds are a good investment to make before and after retirement.
Bonds may decrease your exposure to the stock market's potential fall as you approach retirement. If you have all of your money invested in stocks and the market is down, you may decide to wait for a rebound rather than sell. If you're retiring, you could have to sell to make ends meet.
Bonds, on the other hand, can provide a stream of income that you can utilize to pay your bills in retirement while still conserving a certain percentage of your investment capital. As a result, as retirement approaches, some investors prefer to shift more of their portfolios to bonds.
What You Need to Know About Buying Corporate Bonds
A corporate bond is a publicly traded asset issued by multinational corporations. When you buy a bond, you're essentially lending the corporation money (issuer). Bond proceeds are used to fund high-cost business activities such as construction, research, and manufacturing. Bonds, also known as fixed-income or debt securities, are purchased and sold on a commission basis through a brokerage firm.
The purpose of bond investment is to receive competitive interest payments (coupons) on time and to have your debt fully repaid at maturity.
Diversify your investing portfolio.
Corporate bonds carry more risk than municipal (munis) or government bonds if you're looking for bonds to round out your asset allocation. Corporate bonds, which pay a higher interest rate, could be a good fit for a portion of your portfolio if you're willing to take on more risk. The prospect of the issuer being a takeover target is referred to as event risk. If a takeover occurs, the terms of the target's bond debt could alter dramatically, putting you and other investors at a disadvantage.
Risks associated with corporate bonds
Credit ratings assist investors in calculating some of the risks associated with a given bond. Corporate, on the other hand, have a more difficult time assessing credit risk than munis. Aside from the type of bond and the issuer's creditworthiness, there are several additional elements to consider: the issuer's industry's trends; whether the firm is best of breed for its particular sector; the management team's quality; and the broader economic situation. Don't take the credit rating for granted if you have concerns about the issuer's core business or the wider business or economic climate. Make your own investigation.
The worst-case situation for a bond holder is an issuer default. Default can have two effects on your bond investments. First, coupon payments would be temporarily halted or stopped altogether. The second, and considerably more serious, scenario is when an issuer fails to pay bondholders face value at maturity as pledged. Even if you are able to collect payment, you would most likely just receive pennies on the dollar, not the whole amount invested.
Corporate bonds rated investment-grade or higher have a low risk of default, though this is not guaranteed. The default rate for high-yield bonds, sometimes known as trash bonds, is substantially higher. Except for the most advanced, well-capitalized, and savvy fixed-income investors who can bear the risk, these assets should be avoided.
Aside from the risk aspects, investment in corporate bonds entails a number of complicated restrictions. Corporate bonds may have stock components, floating coupons, or other distinguishing characteristics. Before investing, read the tiny print and be sure you comprehend fixed-income products.
Corporate bonds are also fully taxable at the federal, state, and municipal levels, unlike tax-exempt munis and treasuries, which are not.
Time horizon for investment
Your investment time horizon may vary depending on your objectives, asset allocation, risk tolerance, and available capital. Choose a bond that has a maturity date that corresponds to your financial goals. As the time horizon for achieving a financial objective approaches, some investors progressively change from higher-risk investments like equities to high-quality, investment-grade corporate bonds. Keep your time horizon, after-tax yield, and risk tolerance in mind when comparing bond investments.