Bonds can be a good and safe investment for you if you are uncomfortable with more risky investments such as stocks or real estate.
If you’re looking to earn passive income to supplement your salary or save money for retirement, owning bonds will give you peace of mind. You’ll receive a good return on your investment with little risk of loss.
Bondholders are Creditors
Here's the main reason I buy bonds. If you purchase corporate bonds, you will be first in line if the corporation fails and is facing liquidation. You, as a secured bondholder will be regarded as a creditor. Corporate stockholders are paid last, after creditors, suppliers, employees, and banks. I enjoy being first in line.
If you purchase government bonds, the good faith and credit worthiness of the government will protect your investment.
The Bond Market is Huge and Varied
The bond market is far larger than the stock market. It gives you a multitude of options in price, risk, yield, duration, and types of issuers for you to choose from. You can select several options and create a robust, balanced portfolio.
What Are Bonds?
A bond is essentially a lending transaction. When you buy a bond, you are lending money to the bond issuer in exchange for interest payments, also known as yield, and more money when the bond comes to full maturity.
Bonds are a financial instrument used to pay for a variety of projects, such as construction, infrastructure improvements, capital expenses, and expansion.
Investors buy bonds in order to supplement their income, build wealth, save for retirement, or live off of interest payments.
Types of Bonds
Here are some of the types of bonds you can consider:
U.S. Savings Bonds
These are a form of managing federal government debt--a full-time job nowadays. They're sold at a discount, well below face value. They mature over a certain specified time frame. For instance, Series EE bonds are sold at half their face value and mature in 20 years.
They are an extremely safe investment. You will never lose your money after buying them. However, you will receive no interest payments. And, monetary inflation that may build and build at compound interest over the years before maturity may eat away at your investment. You will never receive a high return on your investment with savings bonds.
These are also known as T-bonds. They are debt securities issued by the U.S. government. Unlike savings bonds, they do issue periodic payments of interest. At maturity, the bearer will sell the bond and receive par value. The money is used to finance the federal government’s debt in a similar manner as savings bonds.
These bonds aren't just issued by cities. Libraries, schools, hospitals, counties, and states also issue them to fund local projects, such as construction of buildings and infrastructure improvements.
They pay relatively low interest. But, depending on your tax bracket, they do offer one appealing advantage: They are generally tax-free. I buy them as a tax shelter.
As the name implies, corporations issue these bonds, generally to finance capital improvements, construction projects, and business expansion.
They offer higher yields than government bonds, but are more expensive to purchase. You can buy them in the form of Rollover IRAs for your retirement.
The investor receives a fixed or variable series of interest payment rates at preset intervals until the bond matures. At that time the investor receives the value of the bond.
This is a form of corporate bond that allows the investor to choose to receive interest payments for a time and then convert the bond into a specified amount of the company’s common stock.
Bonds Owned by Foreign Governments
These offer high risks and high opportunities to investors willing to take a flyer. If the government does well, the investor stands to reap large rewards.
But in volatile countries, your investment may be subject to wild swings of value, even nationalization. In the latter case, the investor has no recourse for recovering the investment.
Bonds Owned by Foreign Companies
The investor faces similar opportunities and risks depending on how well the foreign company is managed and what affairs of state are like in the company’s home country, including the dangers of nationalization.
Foreign firms may offer higher yields when issuing bonds to compensate investors for these risks.
The length of time till bond maturity occurs allows the investor even more options. This is what tenure means in the bond market.
Here are some useful terms to learn about tenure. Study these options as you build your investment strategy:
Calculators are available online for investors to check this statistic for any bond.
Different Types of Tenure
Choose whichever fits your investment strategy and needs. If you won’t be retiring for at least 20 years, consider buying long-term bonds. Do so, before they completely disappear.
You will also want to know about bond ratings as you build your strategy. These ratings symbolize the stability and growth of bond issuers of all kinds.
Ratings are symbolized by an alphabetized system, the A's standing for the highest ratings.
How does this system work? Let’s take Standard and Poor’s for example. The highest, strongest rating in their system is the triple-A bond, or AAA. From there on, the letters change in this fashion: AA+, AA, AA-, A+, A, A-, BBB+, and so on down to CC, and D, which stand for the weakest ratings.
These ratings are never perfect and can’t be used as firm predictors of future earnings and capabilities for any issuers of bonds. Use the ratings in conjunction with other indicators of future performance when setting your investment strategy.
Check with raters such as Moody’s and Fitch, as well as Standard and Poor to learn more about the bonds you're interested in.
How Are Bonds Rated?
Raters base their judgments on the issuer’s financial situation, growth, and ability to repay.
U.S. government bonds are rated as extremely safe. In exchange for safety, they offer lower interest rates.
There are two main categories of bonds, based on credit ratings:
Investment-grade bonds. These are deemed safer for investors and are given high credit ratings. In exchange for greater perceived safety, issuers offer lower yields on their bonds. If you desire safety over risk, these bonds are golden. The trade-off is low yield.
Junk bonds. These are also known as high-yield bonds. They are deemed by the raters to be high risk and so are given lower credit ratings. To offset these factors, issuers offer higher yields. Junk bonds are generally issued by start-up companies or companies dealing with high debt ratios.
Some junk bonds are issued by what brokers call “fallen angels,” companies that have lost their high credit ratings for various reasons.
The dangers of junk bonds are obvious. These companies are often in trouble and may default. Their bonds suffer from more price volatility.
The opportunities are also obvious. The investor may wind up with a huge windfall if the start-up company grows rapidly or the fallen angel improves its finances dramatically.
How can you purchase bonds? Any traditional brokerage firm can arrange to purchase bonds for you. Or, you can open an account with an online brokerage. Choose one that offers no requirement for a minimum purchase and charges no transaction fee.
Check out over-the-counter markets where the traders trade directly and use no intermediary. They have no physical home, such as those used by central exchanges or stock markets. All trading is done online. These characteristics will save you time and money.
U.S. Treasury bonds are traded widely. You can buy them directly from the Treasury or through a broker.
Bond ETFs are a new and useful way to buy bonds. What are they? The letters stand for Exchange-Trade Funds. These funds are similar to mutual funds for shares of stock.
The bond ETF fund manager selects bonds and pulls together a portfolio for investors, saving the investor a lot of work. Each ETF is based on a particular investment strategy devised by the fund manager and mathematicians--believe it or not.
When calculations are performed on bond funds, such as ETFs, to estimate future yields, a mathematically weighted calculation must be performed. There are too many bonds involved to calculate all of them separately with any certainty of accuracy for ETFs.
Online analytics allow these experts to choose between a bewildering variety of bond ETFs. 430 of them are ranked highly and are available for purchase in the United States.
These experts are no doubt experimenting with an even larger number of combinations of bonds. The average investor can't hope to select the one best suited to any investment strategy. Way, way too many options.
If you’re worried about your ability to choose the best bonds for your own portfolio, your best bet is to invest with the experts through an ETF.
Are you into high-tech expert AIs? Check out the latest in bond investing: Robo-Advisors. These automated systems will build and manage a bond ETF for you based on your investment needs for a low annual fee. This means the potential number of different bond ETFs will soon explode. Have fun pondering that thought!
Bonds are a solid, safe investment. One that will give you an excellent chance at generating a second income and creating a well-financed retirement.
The best investment strategy in bonds is the one that you set up with three things in mind: How many years you want to invest until you receive your payout, your comfort level with risk, and how much money you want to earn.
If you fear risk, your best bet is government securities. If you enjoy high risk and a higher payout, invest in the most interesting of the junk bonds available. If you appreciate a well-balanced portfolio, go with the bond ETFs.
Keep track of inflation and economic growth rates. Adjust your investment strategy accordingly. With careful planning, your investments in bonds will prove to be both a good and safe road to a comfortable life.