Investing in Bonds

“The essence of investing is the management of risks, not the management of returns.” – Benjamin Graham

When people talk about the market, stocks get all of the attention and headlines. Stocks have historically been one of the highest performing financial assets while also displaying high amounts of volatility. There are also many instances where certain stocks have performed really well and made early investors very wealthy.

For these reasons and many more, the stock market overshadows the bond market. Bonds are considered boring compared to stocks.

But in terms of sheer size the bond market is much larger than the stock market. According to the McKinsey Global Institute, the size of the global bond market recently reached $93 trillion, almost twice the size of the $54 trillion world stock markets (these numbers obviously change as markets move).

Credit allows the business world to function properly (when used with prudence). Without the ability to borrow on credit it would be difficult for businesses to start-up or expand. It would also be very tough for most of us to buy a home and obtain a mortgage.

Not many investors understand the nuances of investing in the bond market. Most just assume that you invest in bonds for safety once you get close to retirement age to decrease your risk of loss and lower portfolio volatility. There is actually much more to investing in bonds than meets the eye.

That is why I have decided to do a common sense series of posts on the various characteristics of investing in bonds. There is so much to think about when investing in bonds.  So I will split this up into a six part series that will run over the course of the next few weeks to get you up to speed on the bond market and how you should think about bonds in the context of your investment portfolio.

I’m going to start today with the basics and work my way up to actual investment strategies and the main risk factors involved with bond investments. Here is an outline of the topics I will be covering in future posts:

Part 2 – Why Bother Investing in Bonds?
Part 3 – The Risks of Investing in Bonds
Part 4 – Investing in Bond Funds
Part 5 – Bond Investment Strategies
Part 6 – Interest Rate Risk

WHAT IS A BOND?
A bond is simply a loan that pays the borrower (or investor) of the bond an interest payment in some form while also paying back the amount of the loan. It could be a loan to a corporation, a government, a homeowner or any entity that needs to borrow money.

Think of all the things that you take loans out for. It could be your mortgage, car loan, credit cards, student loans, etc. These are forms of credit that require you to make principal and interest payments on a periodic basis. The maturity of a bond is simply the length of time the borrower has to pay off the loan and make interest payments.

A bond is basically an IOU. An individual bond has a set maturity and makes periodic interest payments, called coupons. There is also a stipulated maturity date in which the entire principal value (size of the IOU) must be paid back to the investor or lender.

Bonds are also called fixed income (Wall Street jargon) because they are essentially a fixed cash flow in the form of an interest payment. This element of a fixed payment has made bonds more stable in the past than stocks (but this is not always the case)

TYPES OF BONDS
Here are the main types of bonds to consider for investing purposes:

Government Bonds: These are bonds issued by a national government that offer a specific interest payment over a specific period of time (usually from 90 days to 30 years in maturity). When you hear about bond interest rates the most popular investment is the 10 Year U.S. Treasury note. U.S. Treasuries are the reference point that all other bonds are priced from. Interest rates vary by country (risk) and maturity length (generally higher interest rates for longer term bonds).

Corporate Bonds: Corporate bonds are issued by corporations such as Apple, Microsoft or Johnson & Johnson. Different issuers have different interest rates based on their risk of default and credit rating. I will expand on these issues in a future post on bond risks.

Municipal Bonds: Munies are state or city-issued bonds that usually offer tax exempt interest payments (so don’t use these in a 401(k) or IRA because you won’t get the tax break). General obligation municipal bonds are backed by the taxing power of the city or state that issue them. Revenue bonds are issued for specific projects (toll roads, airports, bridges, etc.) and the payments for these are backed by the revenue that comes from the project.  LL Cool J actually invests heavily in municipal bonds.

Mortgage Bonds: Mortgage Backed Securities are bonds that are backed by a pool of mortgages. So the mortgage on your home is more than likely owned by an investor in a bond with other mortgages and they collect the principal and interest payments that you make on your mortgage. It would be very difficult for banks to make as many mortgage loans as they do without having bond investors willing to buy them.

High Yield Bonds (Junk Bonds): High Yield bonds are issued by creditors with less than stellar credit ratings. They are basically a riskier type of corporate bond. They could be issued by younger or smaller companies or even large companies that are struggling. As the name suggests, there is a higher interest rate on these bonds to give investors a risk premium in the event of a default or non-payment of interest or principal because of financial difficulty of the company. Junk bonds actually act more like a hybrid between stocks and bonds because they have a higher level of risk than investment grade bonds.

There are many other types of bonds that you could find in a diversified bond fund but for the most part these are the main types that you should familiarize yourself with for investing purposes.

Check back next week for Part 2 on the reasons to include bonds in your investment portfolio.  Bonds are not for everyone but certainly play a large role in many investor’s portfolios.

Source:
Bond Market Size vs. Stock Market Size

What would you like to learn about investing in bonds?