With the uncertainty of a possible recession in our future, and with the certainty of economic fluctuations over the course of our lives, bonds may be an appealing option to some investors who desire a more stable way to put their money to work.
People often underestimate the bond market, especially those younger and farther away from retirement, usually favoring the stock market instead for its presumed higher rates on return at the cost of increased risk.
However, bonds can be a useful tool in hedging losses when investing in to the market as a whole and should not be overlooked when creating a stable and diversified portfolio. Keep in mind that bonds are still susceptible to risk, no matter the type.
By familiarizing ourselves with what bonds are and how they work, we can start learning how to intelligently pick bonds and decrease overall risk.
What is a Bond?
Bonds are often viewed as an investment tool for older people, when in reality, they can be useful to younger people as a means of diversifying their portfolio.
A bond is essentially a loan made by an investor to a borrower, typically a government or company trying to raise money, that earns interest over time. The amount of interest earned and the intervals at which the interest payments are made depend on the bond.
Pros and Cons
The type of a bond is typically determined by the issuing entity and each has their own pros and cons.
Similar to stocks, deciding which bonds to add to your portfolio is ultimately a personal decision based on your understating of the market and how it affects the bond's issuer.
Bonds are still susceptible to losses, despite their reputation as being stable and secure, as is anything that is being exposed to the market. Money stored in bonds can also be less liquid depending on the length of time that it takes for a bond to reach maturity.
Typically bonds that reach maturity quicker will have lower interest rates than ones that take decades to mature. It is important to evaluate a bond's yield against the length of its term to see if it is a bond worth investing in. It is impossible to predict the future, and rates may rise and fall to speeds and at levels unprecedented, which is why thorough analysis of the issuing entity is always recommended before letting them play with your hard earned cash.
Types of Bonds
Bonds issued by a government entity at the federal level. Keep in mind that, typically, the larger the entity (at least in the US) the less likely they are to default on the bond.
This is especially the case for the US federal government, as they control the printing machines and can theoretically always supply the cash that they owe.
Sub types of US government bonds include: Treasury Bills, Treasury Notes, and Treasury Bonds, which increase in term length respectively. Among other types of bonds issued by the US government are some that are designed to protect your money from inflation, such as Series I Savings bonds and Treasury Inflation Protected Securities (commonly abbreviated as TIPS).
Bonds issued by a state, county, city, or other type of local government (often shortened as "munis"). In the US, these can have some form of tax exemption and can come in two main types.
General Obligation municipal bonds are used by these smaller governments to pay off debt and/or to build something such as a new park, while Revenue Based municipal bonds are used to raise money for plans that will generate some sort of income, such as a toll road. Revenue based municipal bonds can also have the profits from its respective project to be distributed to the lender as well.
Similar to how corporations can issue stocks, they can also issue bonds. A big advantage of owning bonds versus stock wit a company is that if it were to go bankrupt, the bond holder has priority over the stock holder when it comes to splitting up its assets.
The tradeoff for this is that bond prices may not fluctuate at the same rate as its company's stock, and therefore are limited on the growth, but also losses, on your investment.
These are often sorted as High Grade bonds, often issued by companies that are determined to be less likely to go bankrupt and default on their loan, and High Yield bonds (often called "junk bonds") that pay more interest but are deemed more likely to go bankrupt. These ratings can range from AAA for the "best" bonds, to C for some of the more "riskier" companies, depending on the organization that determines the rating. Just because a rating is high does not guarantee that company is not at risk of bankruptcy. Visit your brokerage's website for more information on bond ratings.
Bonds associated with entities located outside of the domestic market. These come in three different flavors whose differences rely on the country and currency of issue. Domestic Bonds are issued and traded within the company's domestic market and in the native domestic currency.
These bonds are subject to regulations of said company's native country as well. Eurobonds are issued outside of a country's domestic market in the domestic currency. Even though the prefix "Euro-" is in the name, it does not specifically pertain to European markets alone. Foreign bonds are issued by a foreign country into a domestic market in the company's native currency and is subject to the domestic market's regulations.
International bonds are also susceptible to fluctuations in the valuations of currencies, which can positively or negatively impact your yield.
With the various forms of bonds available in the market, it can be overwhelming to consider which ones to add to your portfolio.
As the market is unpredictable, one can never know when it is the best time to start putting your money in to bonds versus stocks, or to put your money into the market at all.
There is no definitive way to completely eliminate risk; however it is possible to mitigate it to some degree by researching the bonds that you are interested in before investing anything in to them. Interest rates can also affect bonds as when they go up, the price of bonds issued at lower rates will go down and as the interest rates of new bonds decrease, the price of a bond with a higher interest rate will go up.
This is a gross oversimplification as the Principal Amount, or the amount borrowed by the business or government entity, must be taken in to account when determining the face value of a bond when trading.
The length of time that you decide to put your money away for while the bond matures must also be considered before investing in them. Ultimately, the person who knows your finances the best is yourself (hopefully), and you alone can decide which bonds are right for you to invest in.
Disclaimer: This article is not financial advice and is intended only for educational purposes. Investments are not FDIC insured and carry risk. Please check with your brokerage for more information.