Investment-grade bond issuance is already off to a strong start in 2024. As of January 11, YTD volume stood at $98.7 billion—9% ahead of last year’s pace (source: PitchBook | LCD). This level of activity is not too surprising, since the average investor’s portfolio likely contains some bonds—even as much as 30-40% may be fixed-income investments.
But why is bond investing so popular? In this article, we’ll explore the different types of bonds, as well as the pros, cons, and ways to invest, so you can decide if bonds are a good investment for your current strategy.
What is a bond?
Bonds are a form of debt, in which investors agree to give money to borrowers—typically corporations and governments. Over a fixed time, the borrower then pays them back with interest.
Unlike stocks, bonds do not provide ownership rights in a company. Instead, they are debt instruments issued by corporations or governmental agencies, where investors become creditors. This distinction leads to generally lower risk than public equities, making bonds an attractive option for risk-averse investors. While bonds may offer lower average returns compared to stocks, they can still be a valuable addition to an investment portfolio, providing stability and income through regular interest payments.
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Understanding different types of bonds
There are three main types of bonds:
Municipal bonds are typically issued by state and local governments. They are often used to fund public projects, such as building schools and roads. One of the primary benefits of municipal bonds is that their interest is generally exempt from federal taxes.
If you are considering investing in municipal bonds, it’s important to understand the difference between general obligation (GO) bonds and revenue bonds. GO bonds are backed by the full faith and credit of the issuer, typically a government entity. These bonds are considered safer because they have the ability to raise taxes or use other sources of revenue to meet their repayment obligations. On the other hand, revenue bonds are backed by specific revenue streams, such as tolls or fees generated by a project. While they offer higher yields, they also carry more risk as they depend on the success of the underlying project.
Treasury bonds are debt securities that are issued by the US government to fund its operations. Also known as Treasurys or T-bonds, they are often considered to be the safest investments, given the US government’s guarantee of payment.
Put simply, corporate bonds are bonds issued by companies. They can generally be divided into two categories based on their credit rating:
- Investment-grade bonds: An investment-grade bond is a bond that is at relatively low risk of default, as determined by three independent credit rating agencies—Moody’s, Standard & Poor’s, and Fitch. Since investment-grade bonds are seen as lower risk, they often come with lower interest rates.
- High-yield bonds: In contrast, high-yield bonds are at higher risk of default, since the companies that are raising capital have a lower credit rating. To compensate for this higher risk, however, they also provide higher interest rates to investors.
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Note: While bonds are generally open to individual investors, there may still be stipulations to consider. For instance, some bonds have minimum investment requirements when offered through a broker. Additionally, factors like residency and citizenship can impact eligibility for government bonds. It’s important to thoroughly research and understand the specific requirements and restrictions associated with each bond type before investing.
How to invest in bonds
There are several ways to invest in bonds:
Investing through a broker
Brokers serve as intermediaries, executing bond trades on their clients’ behalf. In addition, a broker can provide individual investors with the expertise and guidance needed to make informed investment decisions—assisting in navigating the bond market and helping you identify suitable investment opportunities. With their knowledge of the market and access to research and analysis, brokers can help you build a diversified bond portfolio that aligns with your financial goals and risk tolerance. That said, most brokers will charge you a commission for their services.
Investing through an ETF or bond fund
If you have a brokerage account, you may already be familiar with investing in stocks via exchanged traded funds (ETFs). Investing in a bond ETF is a similar process, since they are available to trade on indexes, like the New York Stock Exchange (NYSE). As such, they are more liquid than other types of investments.
Another option is to invest through bond funds, which are essentially mutual funds that invest solely in bonds. Note: Both bond funds and bond ETFs will pay dividends, although fees are typically higher for bond funds.
Investing directly from the US government
U.S. government bond investors can enjoy the benefits of a low-risk investment option with a guaranteed return. These bonds are backed by the full faith and credit of the US government, making them a safe haven for investors. Whether you’re a seasoned investor or just starting out, investing in U.S. government bonds can provide stability and consistent income—while potentially balancing out other riskier investment opportunities.
Benefits and risks of investing in bonds
It’s worth noting that the conversation around bond investing has shifted in response to the Federal Reserve’s anticipated policy changes. According to Morningstar’s Sarah Hansen, “after a dismal year, the bond market is rallying as investors celebrate the likely end of the Federal Reserve’s historic interest rate tightening cycle.”
As such, bond investors are increasingly optimistic that they will have the chance to capture attractive gains when, or if, the interest rate goes down.
Benefits of bonds
Some of the pros of bond investments include:
- Portfolio diversification: Investors may consider bonds to be a welcome alternative to higher-risk strategies, such as investing in public equities. While stocks can offer potentially higher returns, there is also often a greater chance of loss of capital, particularly in a volatile market environment. In fact, many investors opt to include bonds alongside other investments to help balance their portfolio, given that bonds tend to have a low correlation to stocks and other asset classes.
- Income generation: While there are still some risks involved in fixed-income instruments, investors generally hold a bond for a given period and receive regular interest payments—with the expectation that they will also get their principal back upon maturity or over the life of the bond.
To put this another way, investing in bonds can offer several advantages for investors. One of the main benefits is the stability and predictability of bond investments. Unlike stocks, which can be highly volatile, bonds tend to have a more steady and reliable return. Additionally, bonds provide a fixed income stream through regular interest payments, making them an attractive option for those seeking consistent cash flow. Another advantage of bond investments is their potential to mitigate risk in a diversified portfolio. By adding bonds to your investment mix, you can help reduce overall volatility and protect against market downturns.
Risks of bonds
While bond investments can be a valuable addition to any investment portfolio, it is important to be aware of some potential cons. One downside is that bonds are subject to interest rate risk, meaning that if interest rates rise, the value of existing bonds may decrease. Additionally, bonds can be less liquid compared to other investments, which means it may be more difficult to sell them quickly if needed. Finally, bond investments may also carry credit risk, as there is always a chance that the issuer may default on their payments. It is essential to carefully consider these factors before investing in bonds.
To summarize, some potential cons of bond investments include:
- Interest rate risk: Note that the price of the bond and interest rates move in opposite directions. If the interest rate rises, the market value of your bond decreases if you need to sell it. For example: If you buy a 30-year bond and want to sell it in ten years, you might not be able to sell it for the same price you paid.
- Inflation risk: Think about it this way: the real return of your bond is the difference between the interest rate and the inflation rate. If inflation is 3% and your bond pays 3%, for instance, there would be no inflation-adjusted return. If inflation increases, you will then earn a lower real return than expected.
- Default risk: When investing in bonds, it is important to consider the risk of default. Default risk refers to the possibility that the issuer of the bond may not be able to make the scheduled interest or principal payments. This can happen if the issuer experiences financial difficulties or goes bankrupt.
To mitigate default risk, investors can assess the creditworthiness of the issuer by reviewing their credit ratings and financial stability. Diversifying bond investments across different issuers and industries can also help reduce the impact of default risk on an investment portfolio.
Investing in bonds can be a smart move for those looking to diversify their investment portfolio and earn a steady stream of income. Bonds are essentially loans made to corporations, municipalities, or the government in exchange for regular interest payments and the return of the principal amount at maturity. When considering how to invest in bonds, it’s important to carefully assess the creditworthiness of the issuer, as well as the interest rate, and maturity date. Additionally, investors should evaluate their risk tolerance and financial goals to determine which types of bonds, such as Treasury bonds, corporate bonds, or municipal bonds, align with their investment strategy.
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