Investors have several options for growing wealth, and bonds are a popular opportunity for those who need to live off of their investment income. While most of the investors are attracted to stocks because of the earnings opportunities they offer, some of them prefer the safety of bonds.
There are no guarantees in the financial markets, but U.S. Treasuries are the bond market segment most likely to perform well when stocks are in a bear market. While stocks can experience huge volatility in a short period, for example the crash of 2001-2002 or the financial crisis of 2008 , a diversified bond portfolio is much less likely to suffer losses. A bond is a debt instrument issued by a company or entity in order to secure financing and raise money.
Bonds, a reliable stream of income
Bonds typically make regular interest payments, and they are a good way to generate a reliable stream of income. When you buy bonds, you are agreeing to lend your issuer a certain amount of money for a certain period of time. In return, the issuer promises to make regular interest payments until the bond matures. The money that investors earn is called yield.
There are two ways to make money from bond investing:
1. Hold bonds until they mature. You will collect regular interest payments (typically twice a year)
2. Buy bonds at a price and then sell them for a price that's higher than what you initially paid
You could also buy bonds, hold them and collect interest payments for several years, and then sell them when their market value increases. If we hold our bonds till ‘maturity’ and the company or government doesn’t fail, we will get back what we put in, plus the interest rate promised.
Prices of bonds are prone to fluctuation. This is not an issue if investor plans on holding on to his capital investment bonds to maturity. In the event of investor selling his bonds before maturity, there are chances that he might have to sell them at a lower price than he had initially purchased them for. Therefore, we can sell our bonds early and the return we receive may not be exactly the same as the ‘coupon’ rate. How much we get back will depend on how desirable the bond’s interest rate is at the time we sell.
The most important types of bonds
In fact, there are several types of bonds you might choose to buy:
Corporate bonds are those issued by companies to raise money for things like capital improvements and research. The interest you receive from corporate bonds is taxable at both the state and federal level. Corporate bonds will also include a 'spread' over government bonds to reflect the greater risk involved in investing in a company. The company must rely on earnings and cash flow to repay the bond. This spread will highlight the riskiness of the corporation. For example, Apple is very highly rated, so the credit spread is low.
Municipal bonds are those issued by cities, states, and other localities to finance public projects and increase public services. The interest you receive from municipal bonds is always tax-exempt at the federal level. Also, if you buy bonds issued by your home state, you can avoid state and local taxes as well.
Treasury bonds, or T-bonds, are those issued by the U.S. government to finance its budget deficits. The interest you receive from T-bonds is exempt from state and local taxes, but taxable at the federal level.
A rise in the price of a bond means a fall in the yield and vice versa.
Six key factors that affect bonds prices
Higher interest rates
Coupons need to be higher to encourage people to lend. If investors can get, say, 5 per cent on their savings, they have less incentive to invest in a bond.
The income becomes less valuable if inflation rises. This is because bonds pay a fixed income, which won't rise with inflation. When bond prices fall, yields rise.
Bonds' fixed coupons become much more valuable in a time of falling prices.
The central bank is a price-insensitive buyer of higher-quality corporate and government bonds. This pushes up demand, so prices remain high and yields low. QE has the effect of creating more demand for certain types of bonds.
In the opinion of the rating agency, the higher the credit rating, the more likely an issuer is to meet its payment obligations. If the issuer’s credit rating goes up, the price of its bonds will rise. If the rating goes down, it will drive their bond prices lower.
This is the best environment for bonds. A recession is usually accompanied by falling interest rates and potential deflation. Yields fall and prices rise.
How to buy bonds
Individual bonds are traded on bond markets. Bonds can be bought through an online service or a bank who offers this service. Managed fund providers also offer bond funds. These fund managers spread buyers’ money across a number of different bonds. A bond fund allows us diversify our money rather than putting it all into one single bond holding, so all our eggs are not in the same basket. Many financial institutions today will provide their clients with the service of transacting government securities. If your bank or broker doesn't provide this service, you can purchase government bonds directly through a government agency. In the U.S. you can buy bonds directly from the federal government through its service, TreasuryDirect.