Welcome to lesson #4 in your “How to Become A Better Investor in 15 Days” course. Today we are going to talk about bonds… (and no, not jail bonds!)
While bonds might not be the most exciting of topics in the 15-day boot camp, bonds are a solid investment vehicle that proves themselves worthy of consideration year after year.
In lesson #3 of this series, you learned about stocks and you should now have a firm understanding of how they work. As Clint mentioned, stocks take form in a variety of ways, which is why most people are better off investing in index funds rather than individual stocks (It’s a safer bet for most investors, especially beginners).
That being said, perhaps the safest bet when it comes to investing is investing in bonds, which are generally seen as low-risk investment vehicles and are used for diversification and stability purposes!
Today our focus for covering bonds will include:
- Types of Bonds: Including Government Bonds, Corporate Bonds, and Mortgage-backed Bonds
- We will cover the different types of bond terms
- Whether or not high yield bonds are worth it
What are Bonds?
Bonds are fixed-income security investment vehicles that provide returns in the form of fixed periodic interest payments as the investment matures. The payments from bonds are known in advance, and unlike variable-income investments where the payment can change based on factors like interest rates, bonds are typically viewed as a super-safe investment vehicle!
To put it simply, bonds are investment products used by corporations and the government to fund various projects and operations. By buying bonds, you’re essentially investing in said project/operation, with a guarantee of a return on your upfront investment paid out periodically overtime.
Think of it this way: You’re (investor) giving the government or a corporation a loan (buying a bond), and they are giving you an agreed-upon amount back based on your bond with periodic interest payments.
That being said, there are many different types of bonds, many carrying low-risk features.
Most investors look to purchase bonds and include them in their portfolio to diversify and have a low-risk feature. Bonds are not seen as volatile investment vehicles like stocks can be which you learned about in your last lesson.
Bond Terms to Know
Here are a few terms to know before reading this article:
- Face Value: The amount the bond will be worth upon the maturity date. Used for calculating interest payments back, or coupon rate.
- Maturity Date: When the bond is matured (over) and the investor (bondholder) is paid back the face value.
- Coupon Rate: The rate of return the issuer of the bond (Government, Corporation) agrees to pay back each year until the bond reaches the maturity date.
The most common types of bonds include Government Bonds, Corporate Bonds, and Mortgage Bonds. Here are how the three line up:
In order to support government spending – be it for fixing federal deficits, economic boosting, you name it – the government offers bonds as debt securities. In return for buying bonds, or essentially helping fund the government, the government bond will pay back periodic interest payments called “Coupon payments” to investors.
Basically, you are giving a loan to the government and they’re paying you back with an agreed-upon interest amount. For example, if you bought a bond with a face value of $10,000 with a 4% coupon rate, you would receive $400 each year for 10 years!
Bonds investors are typically paid two times per year and at the end of the bond, or it’s maturity date, they are paid back the face value of the bond. Sticking with our example, if you were to choose an investment bond that was government-backed at $10,000 for 10 years, you would pay $10,000 for that bond. Each year you would receive $400 back for 10 years, then year 10 you would receive the $10,000 face value of that bond.
Pros of government-backed bonds include:
- Low or almost risk-free investing
- No state or local taxes on bonds
- Steady interest income return
Cons of government-backed bonds include:
- Not an aggressive form of investing, low rates of return
- If not US-backed, defaulting is possible
- Interest is fixed, thus bond interest doesn’t account for inflation.
- Corporate bonds return rate can be higher
Similar to government-issued bonds, corporate bonds are similar in that investors agree to purchase bonds from corporations in order to see an agreed upon periodic interest return, typically at a higher rate than government-backed bonds.
Companies that want to raise additional cash will issue bonds that can be bought through a brokerage firm or broker. The advantage for corporations is that they can still raise funds without having to sell more shares of their company.
Pros of corporate-backed bonds include:
- Corporate bonds that are higher risk, have a higher reward
- Payouts every 6 months
- Yield more typically than government counterpart
Cons of corporate-backed bonds include:
- Corporate bonds have different ratings and risks, so it’s best to do thorough research
- Corporate bonds have different ratings, be sure to avoid “Junk bonds”
When you think of mortgage bonds you might think of the 2007 real estate crash. Mortgage bonds are typically leveraged by banks that house countless mortgages. In order to expedite their profit margins, banks will bundle mortgages they own to sell as bonds to make a short term profit.
Since the 2007 recession, mortgage bonds have had a negative connotation and reception at times, but they’re still solid investment vehicles.
Unlike government or corporate-backed bonds, mortgage bonds are backed by actual real estate holdings. So long as the pool of mortgages makes their payments, they’re typically safe investments (In the case of 2007, the payments weren’t made due to sub-prime mortgage failures, thus the whole thing went upside down).
Pros of mortgage bonds include:
- Actually safer than corporate bonds
- Backed by a tangible good, real estate
- Real estate can be liquidated, thus making a mortgage bond a good investment
Cons of mortgage bonds include:
- Some can be redeemed before the maturity date, thus losing interest dollars
- Heavily reliant on real estate industry
Short, Intermediate & Long Term Bonds – What to Know:
Knowing the different types of bond investment vehicles is one thing, understanding the length of bond investing is another. Generally speaking, bond terms are commonly looked at in three ways:
- Short-term (less than 5 years)
- Intermediate-term (5 to 10 years)
- Long-term (more than 10 years)
The key to bonds is knowing that shorter terms, typically mean lower risk and lower yields, while longer terms can mean higher-yields, but also higher risks. According to The Balance, choosing the right bond term means really determining what sort of yield you’re aiming for:
- Short-term bond funds: 3.03%
- Intermediate-term bond funds: 5.65%
- Long-term bond funds: 8.53%
A way to help with bond investing is to use what is called a bond ladder, which we will discuss in the section below. However, when deciding on what bond terms to invest with, it’s important to consider the ratings of the bonds. Standard and Poor's and Fitch use a similar rating system for bonds that ranks bonds from best quality to the worst (AKA the junk list):
Should you invest in High-Yield Bonds?
High-yield bonds will typically have a higher return than lower yield bonds, however, with that return comes greater risk. That risk is defaulting, which makes investing in high-yield bonds riskier compared to it’s higher rate counterparts.
Additionally, while higher-yielding bonds will often have higher returns, they are also more volatile. High yield bonds dropped over 25% from 2007 to 2008. While that might be seen as an anomaly, it’s important to keep in mind.
That is why most who invest in high-yield bonds will use an investment tool called a “bond ladder”. Bond ladders will help boost returns and take advantage of bonds maturing at different periods by staggering investments and mixing different types of bonds.
You can read about bond ladders in detail here, but the premises is straight forward:
- Take your initial investment amount and divide by the years you wish to have the ladder
- Increase the “Height” of your ladder based on when you make each investment (months or years)
- Mix up your bond ladder with different types of bonds
If you want to tap into high yield bonds, the best route to consider is looking into ETFs (Electronically Traded Funds) which are covered below and later in the investing course!
How to Buy a Bond:
Buying bonds is simple and it’s a good idea to look into bonds to diversify your portfolio. That being said, two questions are commonly asked when it comes to bonds:
- How do I buy bonds and two,
- How much should my portfolio consist of?
First, you can start by visiting the U.S. Treasuries website, Tresaurydirect.com to purchase a government bond. That being said, you will want to make sure you know how much to buy and there are deeper concepts such as bond ladders to keep in consideration.
That being said, it can be best to go through a brokerage to help you purchase treasury bonds, corporate bonds, and municipal bonds from brokers like Fidelity or Charles Schwab. Another unique feature of bonds is that they can be purchased through ETF’s.
For example, with my Vanguard brokerage account, I regularly purchase the popular VOO fund that has allocations for bonds. On a scale of 1-5, five being the most aggressive, the VOO is a four so the bond percentage is less.
Bonds offer stability in a portfolio and depending on your age and level of aggression with investing, you will want to increase your bonds with age. However, with bonds being a lower-yield investment, 15% is generally the rule of thumb investors use for bond allocations.
Final Word on Bonds:
I remember when I was little I overheard my mom say that my grandpa had savings bonds for my brother and me.
While I was a young boy at the time, I truly never understood what that meant until the last few years when I really began to dive into investing and different ways to invest. Diversification meant looking into bonds and making sure I had a portion of my portfolio that included bonds.
As a recap, here is the need to know information on bonds:
- Investments (loans) for Government, Corporations, Municipals, Mortgages
- Are generally regarded as risk-free or low-risk investment vehicles
- Most returns are not as significant and can be less than inflation
- A fair amount of bonds in a portfolio is 15%, that number can increase as your portfolio matures and becomes less aggressive
- Pros of bonds to keep in mind are that they are generally regarded as safe and the income is predictable
Perhaps the biggest drawback we haven’t covered when it comes to bonds is that bonds are not easily liquifiable. Unlike the previous lesson where you learned about stocks, you can’t buy a bond on Monday and decide to sell it on Tuesday. You’re essentially locked in for the duration of the bond unless you sell it “Over the counter.” You can buy bonds at discount from others looking to unload their bonds.
That being said, if you’re considering bonds, 10-15% of your portfolio is a fair number for starters and if you’re younger, you still have time to be aggressive with other forms of investing!
Stay tuned for tomorrow’s lesson which Nathan from Millionaire Dojo will cover everything you need to know about cash investing including brick and mortar-savings, certified deposits, online savings and more!
Nathan will help you decide which are the best cash investments, the pros and cons of each and how to pick the best options for you!
Josh writes about ways to make money, pay off debt, and improve yourself. After paying off $300,000 in student loans with his wife in less than five years, Josh started Money Life Wax and has been featured on Forbes, Business Insider, Huffington Post, and more! In addition to being a life-long entrepreneur, Josh and his wife enjoy spending time with their chocolate lab named Morgan, working out, being outside, traveling, and helping others with their finances! I got serious with money when I used Personal Capital to track my finances.