Bond Investing

Bond Investing - What are they, and how to invest in them

Bond – Investing Bonds: Juggling All The Variables

Bad Ian Fleming reference aside, the prime function of a bond is that you're lending money to a corporation for a fixed term, and getting a fixed rate of return, called the coupon rate, based on the original capital invested, out of it. The trick is figuring out how much of your investment portfolio should be in bonds versus other investment vehicles.

The principle advantage of bond investing is that they're rated in their risks. The bond has a term where it pays off (say 10 years) at which point you get your initial investment back. Bonds will pay a steady income of whatever their return rate is, taken as a percentage of the initial investment. Thus, if you invest $100,000 in a series of bonds that return interest at a coupon rate of 3.5%, each year, you'll get $3,500 of interest income. The big advantage of bonds is their steady income stream, and that you get the initial investment back when you're done.

So, what's a sensible investment strategy for bonds? Well, it depends on the type of bond you're buying. Short term (less than five year) bonds tend to have low coupon rates, but have the advantage that your assets aren't tied up for long periods of time. A mix of short term bonds means that if an emergency strikes while you're retired, you're very likely to have a bond maturing to give you an immediate lump sum of cash. Medium term bonds tie your money up for longer stretches of time (typically more five to seven or ten years.), while long term bonds tie your money up for 10 to 30 years or more. The coupon rate will also vary with the credit worthiness of the company the money is lent to; lower credit ratings result in higher coupon rates, and the highest credit rating is typically governmental bonds; this is one reason why the 30 year Treasury bill (or T Bill) is used as a baseline bond metric.

There's more to bond investing than the coupon rate. Since bonds can be bought or sold at any time, very few people hold bonds to their full maturity, and bond funds keep portfolios of bonds with different maturity rates. In general, when the interest rate goes up, the price of an existing bond goes down, because buying a new bond at the higher rate gives a higher rate of return. When the interest rates go down, the bond price of an existing bond goes up, because it gives a higher rate of return than a newly purchased bond would.

Finally, there's the yield of the bond, which is a bit more involved, but simple to calculate. The yield rate is the ratio of the annual return of the coupon rate divided by the current purchase price of the bond. For example, that $100,000 bond with an annual payout of $3,500 has a yield of 3.5% if it's bought at $100,000. If it were purchased at $90,000 (due to an increase in interest rates), it would still return $3,500 per year, and would have a yield of $3,500/$90,000 = 3.8%. Just like the purchase price varies inversely with the interest rate, so does the yield.

Bond Terms

If you want to find a glossary of bond terms, you can visit the website of the Bond Market Association. For more information about bonds, you can also read one of its publications, An Investor's Guide to Bond Basics.

Bond Funds

"Bond fund" and "income fund" are terms used to describe a type of investment company (mutual fund, closed-end fund, or Unit Investment Trust (UIT)) that invests primarily in bonds or other types of debt securities. Depending on its investment objectives and policies, a bond fund may concentrate its investments in a particular type of bond or debt security—such as government bonds, municipal bonds, corporate bonds, convertible bonds, mortgage-backed securities, zero-coupon bonds—or a mixture of types. The securities that bond funds hold will vary in terms of risk, return, duration, volatility, and other features.

Zero Coupon Bonds

Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount a bond will be worth when it "matures" or comes due. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus interest that has accrued.

Municipal Bonds

Municipal bonds are debt securities that states, cities, counties, and other governmental entities issue to raise money for public purposes—such as building schools, highways, hospitals, sewer systems, and other special projects. A primary feature of many municipal securities is that the interest you receive is generally exempt from federal income tax. The interest may also be exempt from state and local taxes if you live in the state where the bond is issued.

Corporate Bonds

Corporate bonds are debt securities issued by private and public corporations. Companies issue corporate bonds to raise money for a variety of purposes, such as building a new plant, purchasing equipment, or growing the business.

US Savings Bonds

Chances are, even if you have never received a savings bond in your name or had anything to do with them, you probably have some idea of what a U.S. savings bond is. If not, it’s okay; they seem to be dwindling in popularity as of late, as fewer people are educated every day on the benefits of a U.S. Savings Bond. If you aren’t really sure what a U.S. savings bond is and how they may or may not have a place in your life, read on for more information.

Investing Money In Bonds

Bond investing offers almost as many options as investing in stocks. Bonds are a critical component of the diversified portfolio, and taking time to compare stocks vs bonds in terms of one's investing goals is important to creating a balanced portfolio.