Bonds often take a backseat to stocks when individual investors think about building their portfolio, but they play an important role in creating a diversified investment strategy.
Adding bonds to a portfolio of stocks can help offset market volatility while providing investors with a more “fixed” income stream.
But bonds tend to be more difficult to understand than stocks.
Keep reading as we break down the basics of how bonds work, the types available, pros and cons of including them in your portfolio, and tips for navigating the bond market.
What Are Bonds?
Simply put, bonds are a type of loan from an investor to the bond issuer, which may be a business, the federal government, state government, or a municipality.
Bonds play an important role in the market for both investors and issuers.
They allow investors to convert capital into a fixed-income investment while helping corporations to raise capital without giving away ownership, municipalities to fund projects that exceed tax revenue, and the federal government to control the money supply.
Here’s how they work from an investor’s perspective:
In return for purchasing a bond, the issuer promises to pay interest at a fixed rate, known as a coupon payment, at set intervals until the bond matures.
When the bond matures, the issuer repays the investor the bond’s face value, also known as the par value.
The return you earn by holding a bond until maturity is measured by “yield to maturity,” which takes into account future cash flows and is measured based on coupon, maturity, and present/future value
For example, let’s say you buy a bond with a face value of $1,000, a 10-year term, and an $80 annual interest payment.
If you buy the bond at face value, the yield to maturity is 8.0%. Alternatively, you can also purchase bonds at a higher or lower price than face value. This is referred to as a premium or discount, respectively.
A bond selling for higher than face value is selling at a premium and a bond selling at less than face value is considered discounted. Depending on the prevailing market interest rates, if you decide to sell your bond before it matures, you could sell the bond for a profit or a loss.
Investment Risk
While bonds are generally considered less risky than stocks, they’re not risk-free. Investors assume two primary risks when purchasing bonds—credit risk and term risk.
Credit risk represents the likelihood that the issuer will default on the loan and be unable to pay the promised interest and principal (more on this in a bit).
Bonds with lower credit quality offer higher yields but are riskier investments, due to the increased risk the borrower will not be able to replay all, or a portion of the loan. The reverse is also true—bonds with strong credit quality offer lower yields but are a safer bet for investors.
Term risk represents the volatility investors experience when purchasing longer-term vs. shorter-term bonds. Bonds with a longer maturity timeline (10+ years) offer higher yields but are riskier than shorter-term bonds (4-10 years).
The increased risk of longer-term bonds is caused by the fact that as maturity increases, you are betting the borrower will be in good enough financial health to keep making payments 5, 10, 15, etc. years down the road.
Types of Bonds
Investing in multiple kinds of bonds allows investors to diversify their portfolios based on the risk profile of the bonds they choose. Here’s a brief overview of three major categories to consider.
Government Bonds
The Federal government issues multiple types of treasury securities with different maturity timelines. Because they have the backing of the U.S. government, these bonds have a low default risk and are generally exempt from state and local income tax.
Generally speaking, bonds with longer terms pay higher interest rates than bonds with shorter terms. Here’s how each type works.
U.S. Treasury bills: Also known as T-bills, these short-term government bonds have maturity dates ranging from four weeks to one year. Because the terms are so short, interest accrues and is paid to the investor, with principal, once the bill matures.
Treasury notes: These securities offer mid-range maturity dates of 2, 3, 5, 7 and 10 years and pay interest to investors every six months until maturity.
Treasury bonds: This type of bond offers investors a long-term investment option with maturity dates of 20 or 30 years, paying interest every six months.
Treasury inflation-protected securities (TIPS): TIPS are another type of treasury bond that offer investors a mid- to long-range investment timeline with interest payments every six months like treasury notes and bonds.
But unlike notes and bonds, investors don’t get a fixed principal amount back. TIPS are designed to protect against inflation risk by increasing the principal value of the security when there are increases in inflation.
Interest rates on these bonds stay fixed, but if the principal/face value of the bond increases, the interest payments will increase as the face value does, since interest payments are a percentage of face value.
Commensurately, if there is deflation, the price of the bonds will decrease for the purpose of paying out interest. At maturity, the bond will still pay out your minimum principal investment in this scenario.
So if the principal price is higher at maturity than on the purchase date, you get the higher value.
Municipal Bonds
State and local governments issue municipal bonds to help with budget deficits and finance projects that exceed current tax revenue, such as building new schools or replacing aging infrastructure.
Municipal bonds are exempt from federal income tax, and if you live in the state issuing the bond, they’re also exempt from state and local taxes.
Municipal bonds have a slightly higher credit risk than government bonds as illustrated during the pandemic when the credit rating of multiple municipalities across the country was downgraded. However, they’re generally considered a safer bet than corporate bonds.
Corporate Bonds
Corporate bonds are debt obligations issued by businesses. Because they are riskier than government and municipal bonds, they typically pay higher interest rates.
Rating agencies such as Moody’s and Standard & Poor’s assign corporate bonds a risk value from AAA to C based on the company’s ability and willingness to repay its debts.
Those rated AAA, AA or A are considered investment-grade bonds, meaning the issuer is likely to fulfill its debt obligations.
Bonds rated BAA, BA or B are considered moderate to high-risk investments, and those with a rating of CAA, CA or C are very high risk. This last category is often referred to as high-yield or junk bonds to indicate their higher probability of default.
Think of it as the difference between purchasing a bond from Apple vs. a company that’s experiencing financial difficulty.
Pros and Cons of Investing in Bonds
All investments, including bonds, have benefits and drawbacks. Here are several to consider before adding bonds to your portfolio.
Pros
Predictable income: Bonds are fixed income securities, offering predictable interest and principal payments that provide investors with a steady stream of income.
Tax advantages: Bonds may be exempt from federal, state and/or local income taxes, depending on the type you purchase.
Lower risk and volatility: Investing in bonds can be less risky than investing in stocks, providing stability to an investment portfolio with the right bond strategy in place. If yuo are investing in junk bonds, for example, those are not really low risk.
Cons
Lower returns: Bonds typically have lower average returns than stocks and a lower return over inflation in the long run.
Default risk: If the company or government can’t pay its bills, you may not receive your full interest and principal payments. However, when companies run into financial trouble, bondholders are typically among the first in the line of creditors to get paid.
Choosing the Right Bond for Your Portfolio
While bonds can help stabilize a portfolio, there are multiple factors to consider to ensure you have the right bond strategy in place.
Interest rate changes: When you buy a bond, you’re locked into the interest rate you receive at the time of purchase. If rates increase, you could miss out on higher returns. Bonds with longer maturities are riskier than shorter-term bonds. As interest rates change, they’re more sensitive to price fluctuations that affect the return an investor can earn.
Credit rating: Bonds have different credit risks, with government bonds being the safest and junk bonds being the riskiest.
Investment goals: While bonds provide a predictable income stream that can help stabilize a portfolio of stocks, they typically have lower returns and lower returns compared to inflation than stocks, limiting portfolio growth.
Diversification: Investing in individual bonds concentrates your risk to a handful of issuers. Investors can mitigate this risk by investing in bond mutual funds, bond index funds or bond ETFs, which diversify your bond portfolio. Purchasing shares of a bond fund or ETF allows you to invest in thousands of different bonds, reducing the risk that a single company or government will default and destroy your investment.
Navigating the Bond Market
Navigating the bond market can be trickier than navigating the stock market because individual bonds don’t trade on exchanges the way stocks do.
Investors must purchase bonds from a broker who connects the investor and bond issuer. Because bonds are traded in a decentralized environment, there’s a lack of price transparency in the bond market.
Investing in bond funds can help mitigate this risk. Because bond funds are comprised of thousands of individual bonds, interest payments are generally made every month.
Being strategic about the funds you invest in and diversifying your bond portfolio can help you optimize returns while minimizing credit risk.
Next Steps
If you’re ready to start building your bond portfolio, Plancorp can help you create an investment strategy as part of a comprehensive financial plan.
A financial advisor will work with you to understand your risk tolerance and investment timeline to determine an asset allocation model that supports your financial goals.
Hundreds of low-cost bond index funds and ETFs as well as government bonds, municipal bonds and corporate bonds are available to help you achieve your goals, and we can help you select the options that are right for you.
Check out our free guide on pursuing a better investment experience for detailed advice on improving your odds of success when choosing investments.
