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Bonds are one of two primary and popular investment tools besides stocks for wealth accumulation. The bond investment gives a stable income – regular fixed income and coupon interest over a certain period. Moreover, it is a low volatile kind of investment as quality bonds have fewer price fluctuations than stocks.
If you think investing in bonds like investing in stocks: buy a stock, fold your handstand, sit and wait for the price to appreciate, you may make some serious mistakes! Unlike stocks, bond investing requires entirely another approach when you plan to include it in your portfolio.
What are bonds?
A bond is a promise to repay the principal and interest owed to bondholders. It is a loan made to a government agency, e.g., treasury department, a municipal government, or a commercial corporation, in return for interest payments and principal at the end of a loan period.
Let’s say if you invest in savings bonds or buy Treasury bonds both issued by US Government, you lend money to the government for use and receive interest regularly as and principal subsequently. Such financial institutions like insurance companies or corporations like General Electric, Ford Motors may issue short to long-term bonds for operating and cash flows. They offer bond investors good opportunities.
Buying bonds: where to begin?
Unlike stock investing, most bonds are denominated in $1,000 increments and not listed in public markets. An investor may have to buy over-the-counter and find it no more convenient than the open market. It may increase the difficulties in building their investment or retirement portfolios like 401k plans. However, there are several ways to access and make bond buying easy:
- Online brokerages and traditional brokers
Except for traditional brokers, now you can buy bonds online through online brokerages; most major brokerages offer online access to investors to buy individual bonds. A brokerage will provide you with two kinds of quotes: an offer from a seller and an initial offering from an investment bank.
An investor may buy bonds at a discount off face value from investment banks. The other comes from existing bondholders who intend to sell. If a buyer accepts the bid price, he can buy it through the broker. Investors can all buy bonds online.
A company or government agency may issue multiple kinds of bonds available in the market. You should distinguish the differences among bonds, and I will suggest you consult your financial consultant before dropping money on one!
- Exchange-traded funds(ETF)
It is a kind of pooled fund investment and belongs to one member of the mutual funds family. As the name implies, it buys a lot of bonds in his portfolio. When you subscribe to a unit, you own a proportion of all the bonds held in a fund and get all the dividends and interest payments.
You will have several advantages in investing in exchange-traded funds:
- A bond fund diversifies and reduces risks by owning different kinds of bonds but still provides a stable income stream to fund holders.
- One of the benefits of investing in ETF is you can buy a large denomination of bonds with a small amount of money.
- Direct investment in the US Government
Another attractive way for investors to buy bonds online is directly investing in US treasury securities. You do not need to pay commission or expenses for the government. Using TreasuryDirect makes investors zero-cost and easy in portfolio building.
What to watch for when you buy bonds?
Bond investing is a do-your-homework job. You should do it in a step by step process. Three points to consider if you plan to buy bonds:
1. Can the borrower pay his bonds?
The most important question you have to ask yourself is the creditworthiness of the bond issuer. It is all about the issuer’s commitments and ability to pay on time. Three principal three rating agencies are responsible for assessing a company’s pros and cons.
A credit rating will be assigned to a bond once an agency completes the assessment. An investment grade “AAA” is a statement a bond can give an investor the maximum quality assurance of its financial strength and commitments. But you have to note that the “investment grade” bond pays the least interest, like US treasury bonds.
There are three major popular bond types in the market:
- Corporate bonds
As a rule of thumb, a quick way to see if a company can pay its debt is to look at its past payment history. They provide a reliable reference to how it is willing to pay in the future.
A company’s financial statements are an excellent start to track its payment history. You can access the vast information through the US Securities and Exchange Commission website or the company’s site as well.
Another point to note is you can evaluate a company’s ability to pay the debt. By examining the financial statements, you can use a company’s operating income (a more reliable indicator to assess its financial strength), divided by interest expense, to look up a figure. You will find out an average number by calculating over 5 to 10 years (combine all those figures, then divided by years).
What do the numbers mean?
- 4 or higher: A company has the most robust financial strength to pay up the debt.
- 2.5 to 4: It is at the lower end of financial commitment and ability.
- 1 to 2.5: A company may have some capability to repay a debt.
- Below 1: A company may find it difficult to pay.
It is not a golden rule but, combined with analysis of relevant financial data, gives a clear picture of its fundamentals and outlook.
- Government bonds
Government bonds are different from corporate bonds because they are commercial entities and don’t need to prove their capability. However, the bonds they issue, especially the federal government, are rated “AAA” as the safest one globally. The federal government’s bonds pay the least interest among all bonds. People view the interest rates as “the risk-free rate.”
- Municipal bonds
The bonds issued by municipals or local governments are entirely different pictures from the federal government. They have individual financial and fiscal policies, and you should look at their delinquency and default history before making any decisions. Bond investors should refer to the Electronic Municipal Market Access(EMMA) site for local government bonds information. They may reveal more about the current and past rating history.
2. When is the right time to buy bonds?
The general trend: bond prices go in a countercyclical manner. When the interest rates are up(mostly the economy is upping), bond prices will go down. However, when the interest rates go down(the economy cools down), the prices will go up.
The recent trends of interest rates since the 1980s are going down though we see some small ups in the midst. Therefore, it is not wise to time the market if you intend to include bonds as your long-term savings or retirement plans.
Some investors use the “laddering” strategy to protect their investments: reinvesting the proceeds from the maturing bonds into new bonds. It may reduce the interest rate risk but possibly at the expense of lower yield. You should consult a financial advisor before doing it.
3. Which bonds are right for my portfolio?
As said earlier, there are all kinds of bonds for investors, so how should we choose? It depends on an investor’s criteria like risk tolerance, tax brackets, and income requirements. Let’s see the characteristics of the major types of bonds:
- Federal Government Bonds: They are investment-grade bonds and sell for discounts to investors. On expiration, bondholders redeem the bonds at face value.
- Municipal bonds: Issued by local and state governments, they are tax-exempt bonds and best suitable for high tax income earners.
- Investment-grade corporate bonds: The bonds are quality bonds of “AAA” ratings. The creditworthiness is excellent. They pay more interest than the treasury bonds.
- High-yield bonds: The interest paid is much higher than other grades of bonds, but investors should be aware of the default’s risk.
A well-balanced portfolio of bonds should cover all types of bonds. It comprises of
different maturities, so it reduces interest rate risk and principal repayment risk. You should also adopt the “laddering strategies” to maintain the proportions of bond allocations.
You may notice investing in bonds requires an initial large sum of capital for the $1,000 increments as necessary. Investors may find it challenging to keep a balanced portfolio as large capital outlays are required for multiple bond purchases.
Exchange-traded funds of all types of fixed income securities or bonds are the right way out! When you hold a stake in them, you own a part of all the bonds they hold. Besides, you should choose low-cost funds as it may reduce your return.
What do you need to know before buying bonds?
Doing homework is a requisite before you throw your money into it. Take the following steps and see what you will have from them:
- Always do your research.
Bond investing is, in fact, a loan business. A debtor is committed to paying back money owed to a creditor at a specified time. As a creditor, you have to know the terms and conditions of a loan contract before sending the money to a borrowing company’s account.
As mentioned earlier, you should consider interest rates, maturities, default risk, and, lastly, the creditworthiness of your debtor.
- Stay away from the junk bonds!
If you are eyeing for high yields offered by junk bonds, you will likely make serious mistakes. I am talking about a long-term investment! Imagine how serious it might be when your savings or retirement account is holding a portion of the junk fund. They may spoil your dreams at any time when they default.
- Look into the cost of your investment.
You are now fully aware bond investing is a long-term investment. Bond’s interest provides a regular and stable income stream to bondholders. But the cost is a primary factor in investing decisions. You should choose the lowest-cost bond providers. TreasuryDirect offers zero commission and is the best way to buy treasury bonds.
However, investors may be frustrated by the large capital outlay of bond denominations(mostly in $1,000 increments). Bond funds provide investors with access to an extensive array of bonds with a moderate amount of money. But you should clarify the cost of investing in funds. Don’t let cost outrun your investment returns!
You have nowadays more ways of investing in bonds:
- Online brokerages,
- Bonds funds,
- Invest through TreasuryDirect.
While it is easier than ever to invest, you should do thorough research and look away from junk bonds and high-cost bond investments. It is not necessary to time the market if you hold for long-term.
Of those mentioned, research is the most time-consuming task among others. A timely and trustworthy analysis is essential to your judgment. Investoralist provides relevant information regarding bond investing.
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