Bonds provide stable income, capital preservation, tax benefits, diversification, and inflation protection; for example, TIPS adjust to protect against inflation based on changes in the CPI.
Definition and Types of Bonds
Government Bonds
Government bond instruments are issued by national governments to generate revenue for their spending. Government bonds backed by the issuing government are considered low-risk investments. Take U.S. Treasury bonds (T-bonds), for example, which are among the safest investments in the world. These bonds typically pay a fixed interest rate every six months and have maturities of 10 to 30 years.
Corporate Bonds
Companies issue corporate bonds to raise funds for a variety of purposes, such as building new plants and equipment, acquiring other companies, or growth capital. Bond Risks – Corporate bonds may offer a nice yield, but they come with risk, which depends on the credit rating of the issuer. Established companies like Apple or Microsoft have safe investment-grade bonds, while less solid entities have high-yield junk bonds, which carry a higher risk of default but offer higher returns.
Municipal Bonds
Municipal Bonds: Municipal bonds, or “munis,” are issued by states, cities, or other local government entities to finance public projects such as schools, highways, and hospitals. One major advantage of municipal bonds is that the interest income is usually exempt from federal income taxes, and sometimes from state and local taxes, making them an attractive option for people in high tax brackets. The two most common types of these bonds are general obligation bonds, which are backed by the full faith and credit of the issuer and backed by its taxing power, and revenue bonds, which are secured by the revenue of a specific project financed by the bond issue or agency.
Zero Coupon Bonds
Discount Bonds – Zero coupon bonds do not make periodic interest payments. Instead, they are issued at a discount and redeemed at par. Example: An investor might pay $600 for a zero coupon bond with a par value of $1,000, which will be redeemed at maturity for $1,000. The purchase price and par value minus the interest earned. They are suitable for investors seeking to receive a fixed amount of money at a future date.
Convertible Bonds
Convertible bonds come with the option to convert the bond into stock of the issuing company. It offers investors the opportunity for stock price appreciation. For example, if the company’s stock performs well, bondholders have the right to convert the bond into equity, giving the bondholders a share of the gains. Because of this conversion feature, convertible bonds pay lower interest rates than regular corporate bonds.
How Bonds Generate Income
Coupon Payments
Most bonds earn income through regular coupon payments. These are interest payments made to bondholders (usually every two years). The interest percentage, or coupon rate, is the return a bondholder receives on a bond based on its value. To put this into context, a $1,000 bond with a 5% coupon rate would pay $50 per year, but would typically pay $25 in two installments every six months. This brings us to one of the main attractions of bonds for many investors seeking regular income: providing a steady stream of income.
Interest Rates
Bonds generate income, which is determined by the interest rates set by central banks. When interest rates rise, the value of the same bond or note will theoretically fall, giving existing investors an increased return relative to its reduced price. Conversely, falling interest rates mean new bonds have lower coupon rates. For example, if the Federal Reserve raises interest rates, older bonds with lower coupon rates may become less marketable, which in turn could reduce their market value. It’s important to understand the relationship between bond prices and interest rates so that you can get the most out of your bond investments.
Bond Yields
One key metric for judging a bond’s income-generating ability is the bond’s yield. This is the return an investor can expect if they hold the bond to maturity. There are many ways to calculate yield, but the most common method is the current yield, which is equal to the bond’s annual coupon payment divided by the bond’s current market price. For example, if a bond has a par value of $1,000 and a $50 annual coupon payment is trading at $950, the bond’s current yield is 5.26% ($50/950).
Yield to Maturity (YTM)
Yield to Maturity: – This is another concept that measures the total return an investor can expect if he holds a bond to maturity. This includes each coupon, par value compensation, and any capital gains or losses from buying the bond at a price different from par. For example, if an investor purchases a $900 bond that pays $50 in coupons per year and expects to receive $1,000 in par value at maturity, the YTM calculation will represent all of these considerations and provide a complete view of the bond’s income potential.
Reinvesting Income
Bond Reinvestment Strategies to Strengthen Your Piggy BankBond reinvestment is perhaps the simplest and most convenient way for bond investors to increase their bond income. For example, if a bondholder receives coupon payments at regular intervals, all of these payments can be reinvested in other bonds or any investment vehicle. Reinvestment of this nature can lead to compounding of returns, which can improve a person’s total income in the long run. On the other hand, take the example of $50 in coupon payments reinvested at a 5% interest rate each year: these additional earnings have a compounding effect, which improves the total return an investor receives from a bond portfolio.
Bond Maturity and Duration
Understanding Bond Maturity Dates
This refers to the date when the principal, or par value, of a bond is returned to the investor. When a bond is issued, it is assigned a maturity date, usually 3 months, 12 months, 10 years, or 30 years. Short-term bonds have maturities of 1 to 5 years, intermediate-term bonds have maturities of 5 to 10 years, and long-term bonds have maturities of 10 to 30+ years. For example, U.S. Treasury bonds have maturities of 10 to 30 years, while Treasury bills have maturities of 1 year or less. Related: Bond yields have a maturity date—here’s what it means
Types of bond maturities
Bonds have different maturities to suit different investment strategies.
- Fixed-maturity bonds: These bonds have a specific maturity date, providing predictability to investors. For example, a 10-year corporate bond issued in 2024 will mature in 2034.
- Callable bonds: The issuer of a callable bond has the option to repay the bond before the bond’s maturity date. This usually happens when interest rates fall, allowing the issuer to refinance at a lower cost. Investors in callable bonds may face reinvestment risk if the bond is called early.
- Perpetual Bonds: Also known as “bonds,” these bonds have no maturity date and pay interest indefinitely. These bonds are rare, but provide continuous income as long as the issuer remains solvent.
Importance of Maturity
What is Maturity: A measure of a bond’s sensitivity to interest rate changes, measured in years. It is not a measure of maturity because it takes into account the present value of all of the bond’s future cash flows, including coupon payments as well as principal repayments. For example, a bond with a 7-year maturity could lose about 7% of its value if interest rates rise by 1%. Maturity provides investors with a way to measure the sensitivity of prices to changes in interest rates.
Calculating Maturity
While the formula used to calculate maturity is complex, the principle is simple: the average time it takes to get back the money you paid for the bond, based on all of the bond’s cash flows. Bonds with longer maturities are more susceptible to interest rate changes than shorter-maturity bonds. For example, zero-coupon bonds have a duration equal to their maturity date (since they pay no interim interest), while bonds with higher coupon rates generally have shorter durations.
Portfolio Maturity and Duration Management
Investors can offset interest rate risk by judiciously adjusting the maturity and duration of their bond portfolio.
- Laddering: Buy bonds with staggered maturities so that a portion matures each year. This option in turn provides you with liquidity and mitigates your reinvestment risk.
- Barbell Strategy: This strategy involves holding both short-term and long-term bonds, but with fewer intermediate-term bonds. The strategy balances the higher yield of long-term bonds with the flexibility of short-term bonds.
- Bullet Strategy: Investors focus on bonds with similar maturities, arranging the portfolio to meet specific future cash needs, such as funding a child’s college education
Risks Associated with Bonds
Credit Risk
Credit risk (also known as default risk) is the risk that a bond issuer will not be able to pay the interest on a sovereign bond or repay the principal when it matures. For example, junk bonds (high yield bonds) have better credit risk than investment grade bonds. The creditworthiness of bond issuers is rated by rating agencies such as Moody’s, Standard & Poor’s, and Fitch as an indicator of risk to investors. Generally speaking, any bond rated AAA by Standard & Poor’s is considered to have the least risk, while any bond rated below BBB is considered to have higher risk.
Interest Rate Risk
The risk that changes in market interest rates will change the value of a bond. During periods of rising interest rates, the value of outstanding bonds generally decreases because newly issued bonds have higher yields and older bonds are less attractive. For example, if an investor holds a bond with a coupon rate of 3% and market interest rates rise to 4%, the valuation of the 3% bond will decrease. Duration is a major factor associated with interest rate risk because the longer the maturity, the more sensitive the bond is to interest rate fluctuations.
Inflation Risk
Inflation risk (or purchasing power risk) is the concern that a bond’s cash flow will not continue to keep pace with inflation, eroding the real value of the return. If an investor holds a bond with a 2% coupon rate and inflation rises to 3%, the investor’s return is actually negative. Inflation-indexed bonds, such as TIPS, adjust principal and interest payments based on inflation and are designed to help reduce this risk.
Liquidity Risk
Liquidity risk occurs when an investor cannot sell a bond quickly and the bond price is discounted significantly as a result. Liquidity risk is often increased in less liquid markets or bonds issued by less well-known institutions. For example, municipal bonds may be less liquid than U.S. Treasuries, which are extremely liquid and have very high trading volumes; Liquidity Risk: Investors should understand the bond market and its trading volume to determine the likelihood of selling a bond before maturity.
Call Risk
Call Risk The risk that a bond issuer will pay back the bond before maturity, especially if interest rates are falling. This may be the case with callable bonds. For example, if a company issued a bond with a 6% coupon rate and interest rates fall to 4%, the company may call the bond to refinance at a lower rate, allowing you to reinvest at the new rate with a lower yield. This may mean a loss of income for investors with a high income stream that needs to be reinvested at a lower rate.
Benefits of Investing in Bonds
Steady and Predictable Income
There are many good reasons to invest in bonds, one of which is that regular interest payments make them a predictable source of income. Bonds typically pay interest or coupons at regular intervals, generally twice a year. For example, a coupon is essentially an annual rate (although it can be paid more frequently or less frequently), and a $1,000 bond with a 5% interest rate would pay $50 in interest each year. This steady, reliable source of income is very attractive to retirees or any investor looking for a stable source of investment.
Capital Preservation
Bonds are generally considered to be safer investments relative to stocks, primarily because of their capital preservation. A bond is a loan made to the bond issuer in exchange for the loan amount, regular interest payments, and repayment of the bond’s face value at maturity. Assuming the issuer does not default, a 10-year U.S. Treasury bond will return $1,000 when the bond matures. This attribute makes bonds a perfect investment choice for investors who do not want to take on too much risk.
Diversification
Adding diversification can reduce the overall risk of a portfolio. In our investment world, stocks and bonds are highly correlated, except that when stocks go up, bond prices go down, and when stocks go down, bond prices go up. For example, in the 2008 financial crisis, the stock market was hit much harder than high-quality government bonds, which paid dividends to a diversified portfolio. Holding some bonds in your managed portfolio can achieve a more desirable risk-return balance.
Tax Benefits
Some bonds include tax benefits that make them more attractive. Municipal bonds also typically provide tax-free interest income at the federal level as well as at the state and local level. This favorable tax status makes municipal bonds particularly attractive to high-tax investors. In addition, U.S. Treasury bonds are exempt from state and local income taxes, so the following are common examples of tax benefits.
Inflation Protection
It is worth noting that some bonds are specifically marketed as inflation protectors. The principal value of the bond can be adjusted based on changes in the consumer price index (Treasury Inflation-Protected Securities (TIPS)) to ensure that such investments keep pace with inflation. On an annualized yield basis, if inflation rises by 2%, the principal (mirror image) of TIPS will also increase by the same percentage, so they can act as inflation protectors and preserve investors’ purchasing power over time.
