When it comes to investing, stocks usually get all the love. They make headlines, drive growth, and can often account for big movement in your portfolio.
Bonds, on the other hand … well, what exactly are bonds?
Millennials of a certain age might instantly think of a savings bond masquerading as a birthday gift from an older family member. Those bond-giving relatives might recall war bonds, while others might equate bonds to those purchased to help fund school or local government projects.
Here’s the thing: All are correct.
At their core, bonds represent debt and are a form of borrowing. But for those doing the lending, they’re another mode of investing — one that’s often safer than stocks — because they’re considered fixed-income investments.
Interested in learning more? Let’s dive into the world of bonds.
What are bonds?
The best way to think about bonds is to consider them IOUs.
On a small scale, it’s like lending a co-worker $10 for lunch. Since $10 is a small amount, it’s no big deal. He forgot his wallet, you fronted him the money, and, since neither of you have Venmo, the debt will (hopefully) be repaid tomorrow.
But when loans get exponentially larger, it gets more difficult to borrow money. For example, if your local school district needs $10 million to upgrade its facilities, the board of directors can’t walk into a bank and ask for a loan.
That’s where bonds come in.
Issuing bonds are a way for governments, corporations, and other organizations to borrow large quantities of money. Instead of going to the bank, borrowers ask everyday citizens and/or investors to help fund projects they couldn’t otherwise afford — like building new schools, improving roads, or paying off company debt.
Of course, borrowers don’t expect your money for free, which is why buying bonds on the bond market qualifies as investing. Bond issuers offer “extra” to lenders in the form of interest payments, which are made at a pre-determined rate over an agreed-upon time. Once that time is up, the interest payments stop, and your initial investment is returned in full.
Sticking with the school example from above, here’s a hypothetical look at how bonds work:
Ridgemont School District needs $10 million to renovate its elementary, middle, and high school facilities. In order to raise the funds, the district offers $1,000 bonds that pay 5% annually over 10 years.
The $1,000 is how much the bond costs, which is also known as its face value. The 5% interest paid out by the school district is also referred to as its coupon rate, while the 10 years represents the bond’s maturity date — which is when interest payments end and your initial investment is returned.
If you purchase this bond, you’ll receive a total of $50 annually (5% of $1,000) for the next 10 years. Once the bond matures, you’ll also get back your initial $1,000 investment. In total, you’ll have earned $500 on your $1,000 investment.
“I’m bond … _____ bond.”
Although the issuer sets bond terms like coupon rate and maturity date, investors should know about five main types of bonds:
U.S. Treasury — Treasury bonds are issued directly by the U.S. government and are used to raise money and/or make payments on debt. Treasury bonds are often considered the safest bonds on the market because they’re backed by the “full faith and credit” of the U.S. government.
Agency — Agency bonds are issued by U.S. government agencies or government-sponsored enterprises, which are chartered by the government but owned by stockholders. While bonds issued by U.S. government agencies carry the “full faith and credit” of the U.S. government, just like Treasury bonds, those issued by government-sponsored enterprises don’t carry that same level of safety.
Municipal — Municipal bonds (or “munis”) are issued by states, cities, counties, or other public entities to fund various public projects, like building bridges or improving roads. A major plus of municipal bonds is that the interest you earn from them isn’t subject to federal taxes and may also be exempt from state and local taxes.
Corporate — Corporate bonds are issued by corporations in good financial standing to fund improvements, expansions, acquisitions, or to refinance debt.
Pro tip: Municipal and corporate bonds that are investment grade bonds have little risk of default because they have a medium or high credit quality rating by bond-rating agencies S&P Global’s or Moody’s.
High-yield — High-yield bonds are issued by corporations that have weaker balance sheets than companies that issue corporate bonds. High-yield bonds typically carry higher risk and are also referred to so delicately as junk bonds.
Stocks vs. bonds
While stocks move the market (and your portfolio), bonds can also play a vital role in your investing strategy. Aside from diversification — which is making sure that all of your eggs (i.e. money) aren’t in one basket — bonds are typically much safer investments than individual stocks and the overall stock market.
The reason bonds are considered less risky is because the face value you paid is actually a loan that represents debt owed to you. Investments in stocks, on the other hand, are considered equity.
When you purchase equity, you buy interest in the company and have a claim on future results. Shareholders have a vested financial interest in how the company performs, so their investment is directly tied to the company’s success. If the business does well, shareholders make money. If it doesn’t, they lose money. And, in the extreme case where a company declares bankruptcy … well, shareholders are left with nothing.
But when a company is in debt to you, its stock performance has zero bearing on your return. The company can become the next Apple or go the way of Enron — it doesn’t matter. It’s still required to pay you the interest rate and return your initial investment. In fact, if a company does go bankrupt (like energy giant Enron did in 2001), it’s legally required to repay bondholders before shareholders.
Bonds are not tied to a company’s success in the same way stocks are, and because of the reduced risk, there is a limited return. But they’re also a way for you to avoid risk and ensure a stream of income — which can also potentially offset volatility in your stock holdings.
How to invest in bonds
Investing in bonds is as simple as buying stocks — and bonds offer many of the same options as their more popular (and risky) brethren.
Individual Treasury bonds (like those EE Savings Bonds gifted to you as a child) can be purchased on Treasury Direct (a website operated by the U.S. Department of the Treasury Bureau of the Fiscal Service that is not affiliated with Ally or Ally Invest), but if you’d rather work with your brokerage, most — including Ally Invest — sell Treasury, Corporate, and Municipal bonds. And, just like with stocks, you can diversify your bond holdings with bond mutual funds and bond exchange-traded funds (ETFs).
An important note: Bond mutual funds and ETFs don’t have maturity dates like individual bonds. Instead, they’re composed of thousands of different bonds that are bought, sold, and traded like stocks.
If you’re interested in investing in bond funds, consider the following when choosing the right fund for you:
Average maturity — Funds generally say this in their name. “Short-term” funds invest in bonds that mature in one to three years, “intermediate-term” in three to 10 years, and “long-term” in more than 10 years. The longer the average maturity, the higher the average yields — and greater the risk.
Credit quality — The fund’s credit quality depends on the bonds in its portfolio, like corporate or high-yield bonds.
Credit risk — Independent rating companies such as S&P Global’s, Moody’s, and Fitch Ratings use a letter scale to rate their perceived risk of bonds. These range from AAA (best) to C and D (default).
Performance — This indicator shows how the fund has performed over a certain period of time. (You can typically choose, whether it’s five years or one quarter.) A fund’s performance score is based on the value of the bonds it currently holds and their income distributions.
Yield — Yield is the measure of interest compared to the bond’s fluctuating changes in value. It can be calculated by dividing the coupon or interest rate by the bond’s current price.
The Fed’s impact on bonds
The value of a bond isn’t directly connected to a company’s successes or failures, but it can be affected by them. The value is related to decisions made by the Federal Reserve System — which is the central bank of the U.S. and commonly referred to as the Fed.
The Fed influences a great number of financial matters, including the country’s interest rates. How often the Fed changes federal fund interest rates varies — there were four adjustments in 2018 and three in 2017 — but each time it does, the value of bonds is affected. To make a very long and complicated financial story short, here’s how rates generally affect bonds:
- When interest rates rise: bond prices usually fall.
- When interest rates fall: bond prices usually rise.
- Every bond carries interest rate risk.
Imagine in 2016, you purchased a $1,000 corporate bond with a 5% coupon rate that matured in five years. At that time, the national interest rate was 0.50%. However, two years later — after several incremental hikes — the federal fund interest rate had risen to 2.25%.
Since interest rates increased, bond coupon rates likely did too — while yours stayed the same. So if you (or the manager of a bond fund) wanted to resell the bond, the 5% rate won’t look as appealing. The bond would have to be sold at a lower value than you bought it for because it would no longer be worth the same value in present-day dollars. This strategy is referred to as tax-loss harvesting and can help you reduce the amount of taxes you owe by offsetting gains elsewhere in your portfolio.
Conversely, if interest rates had fallen, you could have sold your bond for a premium.
But it’s all about timing. No matter what happens with interest rates, if you hold onto your bond until it reaches full maturity, you will always get the full face value of the bond you purchased, which is what can make it one of the safest investment options.
Bonds as part of your portfolio
We mentioned earlier the importance of including both bonds and stocks in your portfolio, so you might be wondering how much of each you should hold. As with all of your investments, the answer is up to you — but there are some tried-and-true guidelines.
One of the most popular is the Rule of 110. To follow this rule, subtract your age from 110. The resulting number represents the percentage of your portfolio that should be comprised of stocks. The rest is then made up of bonds and other investments. (Clever, right?)
This means that a 30-year-old should have 80% of their investments in stocks and 20% in bonds; a 60-year-old should have 50% stocks and 50% bonds; and so on. The thought process behind the Rule of 110 is that younger investors have more time until they need their money, so they have greater tolerance for risk. Since stocks are riskier than bonds, more of their money should be in those growth-oriented investments.
Older investors, meanwhile, should take less risk because they have less time to rebound from stock market volatility or even a bear market. Plus, those nearing retirement (or already retired) might already be tapping into their nest egg.
Of course, The Rule of 110 isn’t really a rule — it’s merely a suggestion. What matters most is choosing an asset allocation you’ll be comfortable with now and in the future.
Financial news is often dominated by the stock market, which makes sense — stories about big gains and sharp losses get the most clicks. But if you’re interested in moderate, low-risk investments, bonds can give your portfolio the balance it needs and the peace of mind you crave.
If you’re interested in adding bonds to your portfolio, contact us today to open an account with us. Our Self-Directed Trading lets you pick individual bonds or bond funds to add stability (and a little growth) to your portfolio.