What these securities can do for a diverse investment portfolio.
Ask 100 people to describe where investing takes place, and 99 of them will probably answer, “the stock market.” Stocks may be the most well-known investment vehicle, but a healthy long-term strategy will take other kinds of investments into account — such as bonds.
A bond is a kind of loan. Where a stock represents buying a tiny portion of a company, a bond represents money you’re loaning to an organization with the expectation of being paid back after a set amount of time. Until that time, the bond will also pay interest, known as the “coupon,” at set intervals. You might get a 10-year, $5,000 bond with a 3 percent quarterly coupon. That means four times a year, you’ll collect a 3-percent interest payment, and at the end of 10 years, you should get your $5,000 back.
The most widely known kind of bond is a type of government bond known as a treasury or “T” bond. But there are also bonds issued by other entities, like municipal bonds, mortgage bonds, and corporate bonds. The government also issues small-denomination savings bonds for investors. What unites them all is that they’re all a form of debt. The bondholder is a kind of creditor, and the bond issuer has promised to pay that debt — the bond — along with interest.
Bonds are not risk-free. In fact, the higher the risk of default, the higher the coupon usually is. Sometimes bonds default when the issuer can’t make good on their promises, just like a homeowner who can’t keep up with a large mortgage.
A wise bond investor or portfolio manager will evaluate the credit rating of a bond issuer before making the decision to invest. Agencies like Moody’s and Standard & Poor’s will rate bonds from AAA (for the most reliable) down to C or D (for the riskiest). The top-rated bonds are considered “investment grade.” These might default, but only in very rare circumstances. Anything below a BBB (in S&P) or Baa3 (in Moody's) is considered “high yield” or, in more cautionary language, “junk” bonds.
Take note: “Junk” doesn’t mean they should be avoided entirely, just that they’re considered a high-risk, high-yield investment. They’ll often deliver higher returns than reliable “investment grade” bonds. Good investment guidance from a financial professional familiar with your goals can be necessary to get the most out of high-yield bonds while attempting to avoid the pitfalls.
Profiting from Bonds
As the financial environment changes — say the issuer’s credit rating changes from a high-risk category to an investment-grade ranking, or say that you buy a bond at a high-interest rate and then the Fed lowers interest rates — a bond can sometimes grow in value beyond what you originally paid for it. In those cases, it’s also possible to sell bonds at a profit, or “premium.”
In other words, there are three ways to make money from bonds: the bond can mature, and you get the face value back; the coupon can generate a small, regular payment; or a bond can be resold at a premium.
Beyond that, one of the main reasons why a few bond holdings can be a good idea is precisely because bonds are not stocks. The bond market responds differently to current events than the stock market, so a bearish outlook in one might be bullish in the other. Interest rates that generate a bond premium are just one example. In fact, right now, it’s possible to get a better return on individual bonds than it is in a money-market account.
The financial weather is always changing, but as a general rule, the bond market doesn’t fluctuate as much as the stock market. While not risk-free, it’s typically a less bumpy ride for the long-term investor.
Many bonds are sold over the counter, meaning you need to find a broker or dealer to handle transactions. FINRA, the Financial Industry Regulatory Authority, posts data like transaction prices, making it possible to track the performance of bonds, but it’s not exactly like following trades on Wall Street. An experienced advisor can help navigate these markets.
Additionally, for many single investors, an individual bond’s minimum purchase price (for example, $10,000 or $20,000) can be intimidatingly steep, and the wait for maturity (10, 20, or even 30 years) can be impossibly long. With an expert’s advice, it’s still possible to access the stability (and maximize the profitability) of bonds in any portfolio. Pooled investment funds like bond mutual funds or bond ETFs can allow smaller investors to diversify without breaking the bank. There are also advanced techniques that make bonds easier to deal with. For instance, laddering bonds means grouping them in such a way that the maturity dates are staggered, allowing for a steadier flow of cash which can be taken out or re-invested in other bonds or anything else.
Bonds might not maximize the size of returns in a portfolio, but they can maximize a stable, consistent return. They’re considered “fixed income” investments because they can deliver regular payments on a predictable schedule. That’s why bonds can be a solid choice for a healthy, diversified portfolio.
If there’s anything else you’d like to learn about bonds, ask us! We’d be happy to share the pros and cons of bonds and review your portfolio with you.
CONTACT US today to speak with one of our advisors about your investment options.
The return and principal value of bonds fluctuate with changes in market conditions. If bonds are not held to maturity, they may be worth more or less than their original value.
A diversified portfolio does not assure a profit or protect against loss in a declining market.
The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.