When building an investment portfolio, most people focus on an asset allocation that includes two main types of assets: stocks and bonds. While we hear about stocks all the time (thanks to a financial media fixated on the Dow Jones Industrial Average and the S&P 500), we don’t really hear much about bonds. However, bonds can be a good addition to your portfolio. They offer a certain degree of safety, and they can also provide a regular source of income.
Bonds are not risk-free investments, though, so there is the possibility of loss. Your bond investments aren’t insured by the FDIC, and you need to be aware of that. However, when carefully considered, bonds can make a solid addition to your investment plan.
What are Bonds?
Unlike stocks, which represent equity or ownership in a company, bonds are loans. When you invest in loans, you are actually investing in debt. You loan your money to an organization for a set period of time. The organization uses the money to fund its operations and pays you interest over the life of the loan. When the bond’s term ends, you receive your principal back.
Bonds can be useful, along with dividend stocks, in an income portfolio; or they can provide you with a little more stability in any portfolio.
The reason that bonds are considered “less risky” than stocks and some other investments is due to the fact that you are supposed to receive your principal back. With stocks, you can lose your principal, but with bonds, even if something happens and you don’t receive your interest, you often recover some of your principal.
Risk of Default
Of course, there is still the risk of default. An organization can choose not to pay what it owes. However, before things get to that point, you have still collected interest on the bond, so you don’t usually lose everything (although that’s certainly a possibility). Investing with bonds comes with its risks, but many agree that bonds represent one of the less risky asset classes. When you decide to invest, it’s important to remember that you can still lose out.
Bond Price vs Yield
As you read about news on bonds, it’s important to keep in mind that prices and yields move inversely to each other. This means that
- When bond prices rise, yields are going down.
- When prices drop, yields head higher.
Remember that the yield is the interest that you are paid. Also, keep in mind that a higher yield often means greater risk. Organizations need to pay a higher yield in order to encourage investors to take on the greater risk of default.
Four Main Types of Bonds
There are different types of bonds, most of them classified according to the type of organization issuing them. Here are some of the main types of bonds that you are most likely to invest in:
- U.S. Government Bonds: These types of bonds are issued by the U.S. Treasury, and are often referred to as Treasuries. You can purchase different types of U.S. Treasuries from TreasuryDirect.gov. In addition to “regular” bonds with different term lengths (ranging from one year to more than 10 years), you can also find different types of inflation-protect bonds that guarantee that your yield will be adjusted to keep pace with inflation.
- Foreign Government Bonds: You can also invest in bonds from foreign governments. Many governments issue bonds to raise capital for funding operations. While U.S. Treasuries offer relatively low yields (they are considered some of the safest investments on earth), some governments offer higher yields. For example, Emerging Market governments are known for their higher yields. But with that higher yield comes a higher risk of loss.
- Municipal Bonds: Municipal bonds are issued by cities, counties, and states in the U.S. You can purchase bonds to help with different projects. Often, you receive a tax break on the interest earned from municipal bonds — a tax break you don’t get when you earn interest on many other types of bonds.
- Corporate Bonds: These are bonds issued by companies. Many companies issue bonds for funding, and you can often see a certain level of stability while receiving a decent return. The riskier the company, the higher your potential return.
You can purchase any bond, usually, with the help of a broker, online or offline, or from entities directly. It’s also possible to invest in bonds using index funds and ETFs.
How to Invest in Bonds
There are many options when it comes to investing in bonds.
- If you want to invest in US Treasury securities, you can do so by setting up an account at TreasuryDirect.gov. You can buy bonds through a brokerage, but there is usually a premium to do that. It’s often cheaper to just get them from the source.
- Other bonds can be purchased via a brokerage firm, or directly.
- Another option is to invest in bond index funds or bond ETFs. These are low cost, and you get exposure to a variety of bond investments, rather than picking them on your own.
Are Bonds Safe?
Many investment professionals consider bonds as relatively safe. Some even believe that there are bonds that are just as good as cash. However, like stocks, it largely depends on the organization that is issuing the bonds. While bonds are considered safe, there are still risks that come with investing in them:
- Default: One of the main risks you face is that the bond issuer will default. Since it’s a loan, there is a chance that the organization will reach a point at which it can no longer make payments and honor its obligations. When that happens, you get to keep whatever interest you have been paid so far, but you might not get your entire principal back — and you certainly won’t receive future interest payments.
- Inflation: Another risk you run is that of being stuck with negative real returns. If bond rates are low, they might not keep pace with inflation. In this case, you end up with losses, since the value of the dollar erodes at a rate that exceeds your return.
You can get an idea of how “safe” a bond investment might be by paying attention to the ratings given to the debt.
Corporations and governments have their credit rated. The higher a credit rating, the more likely it is that your bond will be paid in full. You can learn about how likely an organization is to default by paying attention to ratings. Bonds are rated by agencies like Fitch, Moody, and Standard & Poor. A bond that is rated AAA is considered less likely to be defaulted on than one that has a BB rating.
|Standard & Poor’s / Fitch
|Standard & Poor’s / Fitch
The reason that some investors choose riskier bonds is that there is a chance at a higher return. A company or government with a low credit rating has to offer higher interest rates in order to attract bond buyers.
However, even the safest bond could default. Even US Treasuries aren’t completely safe, and you need to keep that in mind as you invest in bonds.
Miranda is a professional personal finance journalist. She is a contributor for several personal finance web sites. Her work has been mentioned in and linked to from, USA Today, The Huffington Post, The San Francisco Chronicle, The New York Times, The Wall Street Journal, and other publications. She also has her own blog at Miranda Marquit.