Investing in Bonds: Types, Benefits and Drawdowns

Investing in Bonds

Investing in bonds? How? Keen to know more about bonds and ways to invest therein? You are at the right place. This guide will help you understand all that there is to know.

Most of us have borrowed money in some form. It can be mortgaged for our homes. Or we are taking a few bucks from a friend when we forget our wallets at home. Hence, borrowing is a part of people’s everyday lives. Likewise, it is practice firms, and municipalities follow too. Even the government does it. How do you ask? By bond issue.   

Bonds are of many types – government, corporate and municipal. Though their names may vary, their core is the same. That is debt instruments for raising capital. When a company issues bonds, it is asking for a specific investment. It assures to repay that investment amount, plus interest over a particular period. So, are you ready to dive into the ocean of bond investing? Let us begin.    

How Bonds Work

When you purchase a bond, you are lending money to the issuing party. This loan is for a specific period. In return, the issuer assures to pay interest at a pre-set rate regularly. Then, on maturity, the issuer promises to repay the principal amount.

For example, you purchase a 10-year, $10,000 bond with an interest rate of 3%. In return, the issuer promises to pay interest on the sum every six months. And, eventually, return your total amount after ten years.

There are exclusions to this rule — for example, zero coupon bonds which do not pay any interest. But, their sale occurs below face value. However, most bonds use the same equation. That is, you invest an amount, get interested in it, and get the principal on maturity.

How to Make Money from Bonds

You can make money by bond investing in two ways. First one is by holding bonds till maturity and getting interested in them. Interest on the bond is often paid two times a year.

The second way is by selling bonds at a price higher than their original value. For example, you buy bonds worth $10,000 at face value. Now sell them for $12,000 when the market value rises. This way, you gain $2,000 indifference.

Types of Bonds

There are many types of bonds. Each class has its own merits and demerits.

  • Corporate bonds – Companies issue these bonds for raising capital for their business operations. It can be for expansion, research, or product development. Corporate bonds often give higher interest rates relative to other types. However, this interest is taxable on all levels.
  • Municipal bonds or muni bonds – Cities, states and other similar localities issue these funds. The purpose is to fund public works projects or provide public services. For example, a city may issue these bonds with redoing a park or building a library. Municipal bonds are of two types: revenue and general obligation. The income streams related to revenue bonds support them: a Suppose, a county issues revenue bonds for building an express road. Now, the toll proceeds may be a means of repaying bond-holders. General obligation bonds have the backing of the credit of the issuer. This means that a city can sell assets, charge taxes or anything needed to repay bondholders. Both types pay interest which is exempt from federal taxes. You can buy bonds issued by your home state issues to avoid paying local and state taxes. Interest on muni bonds is quite lower than comparable corporate bonds.
  • Treasury bonds or T-bonds – The US government issues these bonds. Interest on these bonds is taxable at the federal level. However, it is exempt from local and state taxes. Treasury bonds carry a maturity period of 10 years and over. They have the backing of the credit and full faith of the federal government. Hence, virtually they are risk-free. However, they do not give a high-interest rate as corporate bonds.

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Investing in Bonds, How?

The fact that stock trading happens on a public exchange, their buying/selling is easy. But, you cannot trade bonds publicly. Instead, you can trade them over the counter. This means that investors need to purchase bonds from brokers. However, treasury bonds, are an exception. You can buy them from the federal government directly. There is no hassle of involving a middleman.

Now, this system has a problem. Bond trading does not happen in a centralized place. Hence, it is tough for investors to know if they are getting a fair price. For example, a broker may sell a bond at a premium. Another broker may charge an even higher price. Thankfully, the Financial Industry Regulatory Authority (FINRA) governs bond trading to some extent. It posts trading prices as that data becomes available. However, investors can still face a delay in getting that information. This is not a reason to not buy bonds. It is only something you must know.

How to Evaluate Bonds

Bonds have lower risk than stocks. However, they are not entirely risk-free. It is not that complicated for a bond to default. So, how to know which bond issuers are high-and-low risk-prone? The best sign is your bond’s ratings. A bond rating gauges the financial health of the institution issuing the bond. There are three leading bond rating agencies. These are Fitch, Standard & Poor’s (S&P), and Moody’s. They use a mix of numbers, letters and symbols to show the bond issuers’ soundness.

Fitch and S&P’s rating systems are alike. They rank bonds from best to worst:

  • AAA
  • AA
  • A
  • BBB
  • BB
  • B
  • CCC
  • CC
  • C
  • D

Moody’s has a somewhat distinct system:

  • Aaa
  • Aa
  • A
  • Baa
  • Ba
  • B
  • Caa
  • Ca
  • C

From here, symbols and numbers are added for a further break-down of ratings. Fitch and S&P employ plus/minus sign to create a hierarchy of soundness. Hence, a bond with rating A+ is better than an A- or a simple A. Moody’s employs numbers to indicate the same point. Thus, Aa1 is the best rating, and Aa2 and Aa3 follow.

The higher a bond is rated, the safer it is to invest in it. But, top rating bonds often provide lower interest rates than low-rating bonds. Reason? Because investors get the reward of taking an extra risk about low-rating bonds. Bonds with rating Baa3 or BBB- are junk bonds. This means they are not investment grade. However, their potential for yields is much higher.

Examining a bond’s rating can help determine if it is investment worthy or not. However, this is not a full-proof system. Times change and a high rating bond can downgrade the next year. So, monitor how the bonds are doing rating wise. You may want to sell a bond if its rating keeps on falling.

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Benefits of Investing in Bonds

One merit of buying bonds is that they are comparatively safer to invest in. Bond values do not vary like stock prices. Hence, they will not keep you up at nights.

Another merit is they provide a steady income stream. Bonds pay a fixed interest at least two times a year. So, you can depend on that money to arrive as expected. Treasury and Municipal bonds also have the benefit of tax savings on interest.

Besides, some investors prefer muni bonds as they are an opportunity to invest in communities. When investing in a muni bond, you may contribute toward improving local amenities. Be it, redoing a park, building a hospital or developing a local school. Hence, it has a social angle together with the potential of tax-free income. This makes some investors give up higher interest in corporate bonds.

Drawbacks of Investing in Bonds

Locking up of Funds

Yes, there are many reasons to invest in bonds. But, bonds are free from their set of demerits. For one, bonds need you to lock your amount for extended periods. For example, you buy a bond with a 12-year term. Now, your money is tied up for ten years. You can always sell your bonds, but there is a risk of market value not declining. 

Interest-Rate Risk

Bonds are long-run investments. Hence, you are bound to face the interest-rate risk. Every bond pays a specific sum of interest. But, suppose you purchase a 10-year bond giving 3% interest. Now a month later, the same issuer gives 4% interest on the same bond. All of a sudden, your bond value falls. If you hold onto it, you will forego possible earnings by being stuck with a lower rate. 

Not Risk-Free

Though bonds are relatively secure, they are not entirely risk-free. If an issuer defaults, you will lose interest payment, getting back your principal or both.

Not Real Long-Term Growth

Another major factor is that bonds are not very favorable to long-range investment growth. Why? Because the ROI on bonds is way lower than that on stocks.

Think about this: Between the years 1928 and 2010, the average return on stocks was 11.3%. In contrast, bonds’ average rate of return was only 5.28%. Imagine you save $300/month for retirement over 30 years. Now, if you amass bonds and average a 5.28% return, you will have $251,000. But, if you buy stocks and average an 11.3% return, your retirement account will have $759,000. This is important. Because in the absence of such growth, you won’t keep up with inflation when you retire. Forget maintaining your buying power.

Lack of Transparency

The last demerit of bonds is the lack of transparency in the bond market. Brokers can easily charge higher prices. You will also find it difficult to know if the price you quoted is fair.

Is Investing in Bonds Right for You?

Bonds have both merits and demerits. So, the question stays: must you invest in bonds? There are many situations in which investing makes sense. First, if you have amassed stocks in your portfolio, bonds are good for diversification. This will save you from market fluctuations. 

Second, if you are not the risk-taking type, bonds may be a better option than stocks. Yes, the safest option is none other than money in the bank. But, you get a better deal on interest payment with bonds.

One more reason to invest in bonds is if you are retired or nearing retirement. During that life stage, you might not have the time to surpass share market downturns. Hence, bonds are a safer bet. The common advice is to move from stocks to bonds during old age. And it is not bad advice.

Building a Bond Ladder

One drawback of bonds is locking up funds for a long time. Hence, it is an excellent call to form a bond ladder.

With a bond ladder, you have several bonds maturing at separate times. For example, you have $20,000. You can invest this in one 20-year bond. Or you may invest $5,000 into a 5-year bond, another $5,000 into a 10-year bond and so on.

So, if interest rates increase during the overall time-period, you have more access to your money. This is much better than placing all your money in one investment.

Investing in Bond Funds

The problem with purchasing individual bonds is that investors have to verify each issuer. Therefore, most investors like putting money in bond funds.

Under this, investment money is pooled in one bucket. This is then used to purchase different bonds. The advantage of bond funds is that the diversification they offer. Consider this: you are buying bonds from a single issuer, and it defaults. Abruptly, you are out of luck. So, own a fund which invests in several bonds. Hence, if even one defaults, the effect will not be as severe. However, bond funds are subject to the interest-rate risk discussed earlier.

The Bottom Line on Investing in Bonds

Though buying bonds has its demerits, but mostly they are a great addition to the portfolio. Exploring your option to invest in bonds is worthwhile. This way, you can take the different advantages they provide.

Why is a High-Quality Bond Typically Considered a Lower-Risk Investment than a Stock?

High-quality bonds are types of debts in finance. Entities issue them for a particular period, often one year.

It is a method of loaning money to companies. In this situation, the bond seller consents to repay the principal amount at a defined time. The bonds get interested periodically.

Stocks refer to the capital a company will earn through the sale of its shares. Each share denotes a portion of ownership. These shares take different forms. For example, preferred, unlisted and common. Everyone buys common stock to earn interest or dividend income and capital appreciation.

Both are investments but not without their set of risks. The chances of higher returns are more in stocks. However, the chances of losing money are also high. 

High-quality bonds still have lower risk than stocks.

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Reasons Why a High-Quality Bond Is Considered as a Lower Risk Investment Than Stock

Higher Payout

High-quality bonds offer a higher payout than stocks and other bonds.

Payout in stocks differs as it depends on firm performance. In contrast, in high-quality bonds, the payout is steady across every period. Their payment is certain unless the issuer defaults.

They Are Recession Resistant

Firms which are recession-resistant are those who are not profoundly impacted by the downturn.

Companies not having an investment-worthy rating for their bonds are also recession-resistant. These firms perform well during downturns.

Firms issuing these bonds will be safer to put money in during downturns. In contrast, stocks may rebound.

Bonds do not move similar to the stock market. Hence, changes in the stock market may not impact bond prices like they impact stocks.

Bondholders Will Get Paid First Before Stockholders in Case a Company Fails

A defaulting company, when liquidating, makes stocks and bonds lose value. However, bondholders will be repaid first. Plus, they have a higher possibility of getting their principal back than shareholders.

Bond Appreciation

When the issuer company improves its credit rating, the bonds also appreciate.

Investors must study before investing in a firm to learn about its creditworthiness.

If they buy high-quality bonds before they become investment-grade, they may get higher returns. Also, they can enjoy the security associated with investment-worthy bonds.

Less Vulnerable to Fluctuations in Interest Rates

High-quality bonds are not as prone to market variations as stocks.

Hence, stock investors often buy high-quality bonds for diversification. This decreases the overall risk as it raises the portfolio’s stability.

Stocks do not assure any returns to the shareholder. But, a high-quality bond may guarantee this because there exist coupon payment and principals.

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How to Invest in Municipal Bonds?

The muni bond market is not the same as before. The adage “munis do not default” is not true anymore. Puerto Rico reminds this as it defaulted on $74bn last year.

But, Puerto Rico is not alone here. The rate of municipal defaults is alarming. Moody’s records that, nearly 44% of the defaults between 1970 and 2016 took place since 2007.

Yes, the default among municipalities is not that common. The 5-year collective municipal default rate was only .15% since 2007. This is way less relative to 6.92% for corporate issues. However, it is undeniable that the muni bond market is altering.

David Strungis is the assistant VP at Moody’s Investor Service in New York. He claims the low muni default rate is because problemed governments strive to avoid defaults. They have a high tolerance for making cuts in public services or raising revenues. 

However, the rate of bankruptcy filings is increasing. This is weakening the taboo against bankruptcy. Strungis says, “Bankruptcy taboo is fading. So, problemed governments may seek bankruptcy sooner than before.”

This means the solvency of the issuer is more vital than ever. Because the situation is critical, bondholders will be at the end of the repayment line. The issuers are there to give essential amenities to their constituents. Taking care of the bondholders is not a priority.

Bondholders on the Losing End

A distressed government will not sacrifice critical public services. Instead, it will try to sidetrack money from pensioners and bondholders. This way it will be able to restore public services. Bankruptcy experience and past default tell that it is tough to cut pension benefits. Hence, it is bondholders who will bear the brunt.  

Unfunded pension obligations are increasing. Thus, muni bondholders may need to wait longer for repayments during distress. Moody’s indicates that unfunded pension dues were rarely present 15 years back. Today, they are $5 trillion.

However, one should note that these numbers are obligations. They are not immediately due. Instead, they need to be paid over the coming several years. Muni bondholders should ask how an issuer’s obligations stack up against its profits.

Local Demographics and Industry Can Say a Lot About Creditworthiness

Want to differentiate between a financially robust issuer and a weak one? View its liabilities in respect of the revenue it can produce. An issuer’s obligations may seem a lot when seen alone. But, some of these municipalities are huge revenue producers.

Consider a municipality which is a hub of industry. Or one which has a wealthy population. Such municipalities can offer a robust tax base for revenue. States have natural flexibility to resolve their fiscal issues by raising taxes. Daryl Clements, a leading portfolio manager, suggests seeking issuers with robust economies. Besides, he recommends finding issuers with high revenue streams. These can offer decent coverage of their yearly debt service needs.  

Financial Reports Can Be Deceptive

The problem is issuers also have many tools to turn the game in their favor. They might use a higher rate of return while reporting investments in financial records. This will make their expected revenue seem more prominent than what is reasonably anticipated. Likewise, using a higher discount rate for their liabilities will turn NPV appear smaller. 

California Public Employees’ Retirement System chose to decrease the discount rate on pension liability. It reduced the rate from 7.5% to 7%. This will lead to an extra state contribution of $2 billion every year. It is an anecdote of how the discount rate impacts governments’ liabilities.  

Hence, items in financial records might be smaller or more significant than they seem. It all relies on the monetary experimentation used on them. Discount rate and expected rate of ROI are present in notes segment in annual reports.

Investors Have Research Tools at Their Disposal

Investors can see the financial statements of the issuer on its website. They are also available on the Electronic Municipal Market Access website. This is a free website by

the Municipal Securities Rulemaking Board. The board is the regulatory agency responsible for promoting a fair and transparent municipal securities marketplace.

Lynnette Kelly says, “an investor should always do his/her homework. This is regardless of the type of security he/she is investing in.” Kelly is the executive director of the rulemaking board. She oversaw the EMMA website’s launch. EMMA is excellent because all information is present in one place for free.

This website gives information on issuers and single bond issues. It includes notices about late payments, changes in credit rating, bankruptcy, etc. Once can set alerts for news regarding any specific issuer.   

The Municipal Market Is Here to Stay

The market of municipal bonds is worth $3.8 trillion today. It finances two-thirds of the country’s infrastructure projects. The American Society of Civil Engineers projects that governments should spend $4.6 trillion by 2025. Only then can they meet the country’s infrastructure requirements.

How to Buy Corporate Bond?

The concept of corporate bonds is straightforward. Companies issue bonds to finance their business activities. There are two methods by which firms raise capital. It can either sell its shares by issuing stock. Or borrow money by issuing bonds.

For instance, Acme Corp. issues a 20-year bond worth $10 million. This gives it the money needed to open new stores, build a new factory, etc. Investors buy the bonds of the company because they offer higher returns than government bonds.

Corporate bonds constitute around 18-20% of the US bond market.

Approaching Corporate Bond Investing

There are two approaches to investing in corporate bonds:

Firstly, investors can buy single corporate issues via a broker. People using this approach must be adept at studying the issuer’s fundamentals. This is key to ensuring that they do not buy a bond which may default. An investor purchasing individual bonds must keep their portfolio sufficiently diverse. There must be bonds of various sectors, firms, and maturities.

Another approach is investing through ETFs or mutual funds which focus on corporate issues. Funds do have a diverse set of risks compared to individual bonds. But, they even have the merits of professional management and diversification.

You can use tools like xtf.com or Morningstar to compare mutual funds and funds. Another option is to focus entirely on corporate issues by entities in developed global markets. These funds are riskier than their American counterparts. But, their potential for greater long-run returns is also higher.

How Are Corporate Bonds Valued?

Investors usually assess corporate bonds by viewing their yield spread compared to Treasuries. Treasuries are the benchmark as they are free from default risk.

High-rating firms with financial strength can offer issues with lower yields. It is because investors know that the firms will not default. Examples of such companies are Amazon, Apple, Microsoft, etc.

In contrast, low-rating firms need to provide higher yields. This is important to attract investors to buy their bonds. Investors’ choice is along the range of lower-risk-lower-yield or higher-risk-higher-yield. This depends on their goals. Between 1996 and 2012, the investment-worthy corporate issue market averaged a yield benefit of 1.6% points over Treasuries. 

Investors also have the option of short, medium and long-run corporate issues. Short-run bonds pay lower returns because the company is less likely to default in 3 years. In contrast, long-run bonds give greater yields but are more volatile.

Investment professionals try to deliver above-average yields along this band. They mix bonds of varying yields, maturities and ratings to attain ideal profits. All this, while reducing risk.

How Risky Are Corporate Bonds?

The rate of default of corporate bonds has been low over time. Especially, highly-rated bonds have a very low possibility of default. Between 1920 and 2009, AAA rating bonds defaulted below 1%. Hence, investors in single bonds can decrease their risk by investing in highest-rated bonds.

Exchange-traded funds (ETFs) and bonds have different risks. It is because there is no set maturity date, unlike single bonds. There are two factors which can impact corporate bond funds performance.

  • Prevailing interest rates. Corporate bonds prices are based on their return spread vs. Treasuries. Hence, shifts in government bond return directly impact the returns of corporate bonds. For instance, a corporate issue returns 1% point more than Treasuries. The return on the 10-year note increases from 2% to 3%. Now, corporate issue yield will also need to increase by 1% point so that the spread stays the same. Always remember that yields and prices go in opposite directions.  
  • Investors’ perception of risk. Positive news encourages investors to take the risk of holding corporate bonds. But, economic turmoil can make investors risk-averse. This prompts them to invest in safer options like government bonds.

The Performance of Corporate Bonds

Corporate bonds, over time, have given investors great returns considering the risk-level. iShares iBoxx $ Investment Grade Corporate Bond ETF (LDQ) is a very popular ETF. As of June 30, 2018, it posted a 5.47% yield. The smaller ETFs are not very far from these returns. Such returns are quite low, even after considering the risk.

The Bottom Line

The corporate bond market gives investors a big menu of options. They can find the risk-return mix which suits them the most. Hence, corporate bonds are a core part of diverse, income-centric portfolios.

Feedback

After reading this Investing in Bonds, what do you think? Please feel free to share your ideas of bond investing with us.

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