What Are Bonds?
While the investing world is often found preoccupied with discussing the stock market, serious investors understand the relevance and importance of bonds and the role played by the bond market.
In simple terms, a bond as an instrument represents a loan given by the investor to the bond instrument issuer. It is a debt for which a return is promised, either at a variable or fixed rate. Unlike stocks, bonds do not come with any ownership in the borrowing entity. It is simply debt security that represents a loan made by an investor to the borrowing entity.
The borrowing entity here can be the government, a company or any other organization that intends to borrow money from investors via this route. So, you essentially lend money to the borrower, for which they issue you a “bond”—an instrument acting as proof of transaction, stating the terms of the loan, like interest rate, tenure, etc.
The investment return you get on the bonds depends on the terms of the issue of the bond. Return on the bonds can be a fixed interest rate agreed to be paid periodically over a set period of time or a variable rate of return, tagged to a benchmark like the SOFR (Secured Overnight Financing Rate).
Types Of Bonds
There are many different types of bonds. Every bond is defined and governed by its unique characteristics and features. Broadly, the following are the most common types of bonds that investors come across in their investing journey:
1. U.S. Treasury Bonds
Bonds issued by the U.S. Department of the Treasury are known as U.S. Treasury bonds. While the purpose of these issuances is mainly to raise money for government expenditure, they are also popularly used for monetary policy transmission. These are further classified into:
- Treasury Bills (T-bills): Short-term debt securities that can be purchased at a discount to face value and mature in a few days to a year at face value. T-bills do not pay any interest.
- Treasury Notes: Medium-term debt securities that pay semi-annual interest and mature in 2-10 years at face value.
- Treasury Bonds: Long-term debt securities that pay semi-annual interest and mature in 20-30 years at face value.
- Savings Bonds: Non-marketable debt securities with fixed interest rates, redeemable after a specified holding period. Series I and Series EE are two common types.
2. Inflation-Protected Bonds
Also known as Treasury Inflation-Protected Securities (TIPS), these debt securities seek to protect investors against inflation by safeguarding the purchasing power of their investments. The principal value of these bonds is adjusted for inflation as measured by the CPI index. Interest payments are then made on these adjusted principal values. At maturity, the investor receives the greater between adjusted or principal value. TIPS are considered a relatively safe investment since they are issued by the U.S. government. However, it is important to note that the interest rate on TIPS may potentially be lower than other investments of similar tenure since these offer a built-in inflation hedge.
3. Municipal Bonds
Often referred to as “munis,” these debt securities are issued by state or local governments, or by a government agency. These bonds are issued primarily to finance infrastructure and other public works projects and services that benefit the community. Examples of such projects are the maintenance of schools, hospitals, transportation systems or parks, etc. A key benefit of investing in these bonds is their tax-exempt nature. In most cases, holders of municipal bonds are exempt from paying federal income tax on the interest income earned from these securities. This makes these a popular investment choice among investors that fall in the higher income tax brackets.
4. Corporate Bonds
Corporate bonds are debt securities issued by corporations as a means to raise money. Funds from bond debt issuances are mostly deployed toward business operations, expansion plans, working capital, etc. The company pays regular interest payments on these bonds and returns the principal amount on maturity. Now, bonds issued by corporates can be of two kinds:
- High-yield bonds: Also known as junk bonds, these bonds are issued by companies with a lower credit rating. To compensate for the additional risk, these bonds offer a higher rate of interest to investors. The higher yield compensates for the higher potential risk of default, bankruptcy or financial distress. Bonds rated below BBB- typically fall under the high-yield category.
- Investment grade bonds: Bonds issued by entities that are considered to have a low risk of default by credit agencies are known as investment-grade bonds. Companies issuing investment-grade bonds typically have a good track record of interest and principal repayments, implying good creditworthiness in the market. Being relatively safer with a rating of BBB- or higher, the return on these bonds isn’t as high as high-yield bonds.
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Factors To Consider When Choosing Bonds For Income
When choosing bonds for income, there are a few factors you should consider:
Safety: The safety of invested money is the most critical factor for any investment. The borrower’s creditworthiness and their ability to repay the borrowed amount and to make interest payments on time must be assessed before buying bonds. Credit rating agencies like Standard & Poor’s, Moody’s and Fitch Ratings, assign bond issuers with credit ratings ranging from AAA (most credit-worthy, lowest risk) to D (in default, highest risk). You must know the issuers’ credit ratings before investing in their bond issues. Bonds issued by the U.S. Treasury are generally considered the safest. However, they may also come with lower yields compared to corporate bonds.
Yield: Once you’re assured of the safety of your investment, the next key factor that lures investors to choose bonds (especially over stocks) is the periodic return in the form of interest payments. Of course, you would prefer an investment with a higher coupon rate. However, you must also keep in mind how this return translates to yield. Yield is a measure of these interest payments received relative to the price paid for the bond. When investing in bonds, investors are primarily concerned with what their return on investment is expected to be, assuming that the security is held until maturity. This is indicated by the YTM or yield-to-maturity, which is basically the interest rate relative to price. A higher YTM often entails higher risk as well.
Liquidity: Refers to the ease with which the bonds can be sold and converted back to cash. Some bonds are tradable while others are not. And, even among those that are tradeable, some are more easily tradable than others. The higher the liquidity, the minimal the price impact (spread) on the sale.
Maturity: Bonds can have short-, medium- or long-term maturities. The lower the term, the less time the security is subject to interest rate fluctuations, and lower the yield. The higher the term, the higher the interest rate risk and the higher the yield. Longer-term maturities are also subject to inflation risk as inflation erodes the purchasing power of fixed income over time.
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Best Bonds For Income Investors
Here is a quick list of some best bond choices that you may want to consider for your income portfolio.
U.S. Treasury Bonds & Notes
Being issued by the U.S. Department of the Treasury, these are considered the safest bet in the U.S. bond universe. It is also what makes them the best bonds choice for investors with low-risk appetites. Keep in mind that the lower risk is also accompanied by a lower yield relative to corporate bonds. T-notes of a term 2, 3, 5, 7 and 10 years can be bought directly from the Treasury website here. T-bonds with a 20-30-year term are also available for those with a very long-term investment horizon. Depending upon your investment horizon and return expectations, you can choose between the various bonds offered by the U.S. Treasury. ETFs (exchange-traded funds) such as iShares 20 Plus Year Treasury Bond ETF (TLT
TLT
BIL
IEF
SHY
GOVT
VT
Inflation-Protected Bonds
The U.S. Department of the Treasury also offers TIPS for those concerned about inflation. These have been detailed earlier in the article. TIPS are offered for a period of 5, 10 or 30 years and can also be bought directly from the Treasury website. ETFs such as iShares TIPS Bond ETF (TIP
TIP
VTIP
High-Quality Corporate Bonds
If you’re looking for income from your bond investment and are ready to take the additional risk for that additional yield, high-quality corporate bonds may just be your pick. Within the corporate bond universe, investors prefer to go for bonds issued by a company with a higher credit rating, strong financial health of the issuing company with an interest coverage ratio above 1 (indicating that the company can cover its interest payments comfortably). Bond funds offer a great way to get diversified exposure in corporate bonds. If you have safety, yield and liquidity in mind, here are a few you could consider:
As you’ll notice most of the above are investment-grade implying higher credit rating and thereby ensuring safety, and robust trading volume ensuring liquidity. Yield is just moderate yet commensurate with the risk these bonds hold, specially compared to high-yield or junk bonds.
Municipal Bonds
Municipal bonds are attractive to investors looking for stability and safety of capital and tax exemption. It is because of these attributes that these tend to have lower yield than risker corporate debt. iShares National Muni Bond ETF (MUB) and Vanguard Tax-Exempt Bond Index Fund (VTEB
VTEB
Bond FAQs
What is the difference between a bond and a stock?
While both bonds and stocks are investment vehicles, they differ in terms of ownership, risk, return and investment objective. While a stockholder is a partial owner of the company with voting rights, a bondholder is essentially a creditor who loans money to the firm. Stock returns (dividends) are not guaranteed and even the principal amount invested is subject to market volatility. Bonds come with interest payments which are assured and the principal repaid on maturity (barring a case of default). Returns from bonds on average are lower than stocks given the risk-return profile of these instruments.
What is the risk of investing in bonds?
While less risky than stocks, bonds are subject to interest and inflation risk, credit or default risk, liquidity risk (for tradeable bonds), call risk (for callable bonds), currency risk (for international bonds) and market risk.
How do I buy bonds?
To buy bonds, you must first determine the kind of bond that would suit your investment objective. It is important to research the bond market through research platforms, financial news websites and bond market databases to help shortlist the particular bonds you would like to invest in. Once shortlisted and read through (bond details and covenants), open a brokerage account (if you do not already have one) and place an order for the ones selected. After buying bonds, it is also important to track and monitor your holdings. Treasury bonds can also be directly bought from the government. The U.S. Department of the Treasury’s platform – TreasuryDirect, can be accessed at www.treasurydirect.gov.
With inflation running at 3.7%, dividend stocks offer one of the best ways to beat inflation and generate a dependable income stream. Download Five Dividend Stocks To Beat Inflation, a special report from Forbes’ dividend expert, John Dobosz.
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