Investing in Bonds 101 - What Bonds Are & How They Work
As you learned in an article called What Is a Bond?, bonds are a type of fixed income investment in which the bond issuer borrowers money from an investor. The investor receives the bond and, in the case of traditional plain-vanilla bonds, a promised schedule of interest payments, called coupon payments along with a date when the loan will be repaid in full, known as the maturity date. Some bonds are issued at a discount and mature at full value. These are known as zero coupon bonds. Other bonds have special privileges attached to them, such as the ability to be converted into common stock on specific terms, specific dates, and at specific prices (known appropriately enough as "convertible bonds"; a close cousin to convertible preferred stock).
Bonds can be issued by all sorts of institutions and governments including Federal governments (known as sovereign bonds; in the United States, that means Treasury bonds and savings bonds), state governments (known as municipal bonds), corporations (known as corporate bonds), and more. One of the primary appeals of bonds, from the perspective of the bond issuer, is that they lower the cost of capital. Consider a rapidly growing business with a high return on assets, perhaps a restaurant rapidly opening new locations. By using borrowed money on favorable terms, the company can open additional locations sooner than would be otherwise possible. This leverage increases return on equity due to the three components you learned about in our discussion of the DuPont return on equity model.
Bonds are rated by bond rating agencies. At the top of the ratings are so-called investment grade bonds with Triple A rated bonds being the best of the best. At the bottom are junk bonds. As a general rule, the higher the investment grade, the lower the interest rate yield because there is less perceived risk involved in owning the bonds; that is, the chances are believed to be higher that you will be repaid, both principal and interest, on time and in full.
Bonds frequently compete with other investments such as money market accounts and money market funds, certificates of deposit and savings accounts. Investors are drawn to those which seem to offer the better trade-off between risk and yield at any given moment. Each has different benefits and drawbacks for those looking for passive income and who don't want to worry about the fluctuations that come along with owning dividend stocks or cash-generating investment real estate.
One major risk in the quest to make money from bonds is inflation. Some bonds, such as Series I savings bonds and TIPs have at least some degree of built-in immunity from inflation eroding the investor's purchasing power but investors don't always behave in the most intelligent way. If you doubt this, look at what happened not that long ago in Europe. Fixed income investors were buying 50 and 100-year maturity bonds at historically low interest rates, all but guaranteeing that, in the long-term, they lose practically all of their purchasing power. It's an asinine way to behave but folks sometimes lose their minds, reaching for yield when they should content to sit on cash reserves, instead. For this reason, bonds are not always safer than stocks when you begin to look at the bigger picture rather than volatility in isolation.
Determining how much of a portfolio should be invested in bonds depends on a variety of factors. Situations differ from investor to investor, influenced by everything from investable assets to alternatives available at any given moment in the capital markets. Smaller investors tend to invest in bond funds to achieve better diversification as individual bonds generally need to be bought in blocks of $5,000 or $10,000 at a time to achieve a good price, though you can probably get away with $2,000 or $3,000 if you are buying from a low-cost broker with a lot of bond liquidity on hand in the particular issue you are considering. You get much better pricing the larger the block you acquire. This is the reason asset management companies, registered investment advisors, and financial institutions tend to have higher minimum investments for clients who want to have individually managed accounts focused on fixed income securities (we're still working on the specifics but to give you an idea of the requisite size, at my asset management firm, through which I will manage my own family's wealth along with the wealth of affluent and high net worth individuals, families, and institutions, we're planning on setting the minimum for fixed income accounts at $500,000 or more). On the upshot, in this period of low interest rates, fees on fixed income accounts are usually significantly lower than on equity accounts. It wouldn't be unusual to see managed bond accounts with fees ranging anywhere from 0.50% to 0.75% for investors with accounts worth between $1 million and $10 million.
A significant percentage of bond investors seek an investment mandate known as capital preservation. That is because money invested in bonds is usually irreplaceable capital, such as that earned from the sale of a family business after years, decades, or generations of work, acquired from a short but highly lucrative career such as professional athletics, inherited, or accumulated over a lifetime of work when the bond investor is too old without a sufficient life expectancy and/or health to rebuild should it be lost. From time to time, other types of investors are attracted to the bond market, usually well-meaning fools who employ leverage to buy speculative junk bonds, which tend to make them a lot of money for awhile before it blows up in their face and they swear it off for life only to see the cycle repeat itself 10 or 20 years later.
Finally, some of the unique advantages bonds offer to their owners include the ability to precisely time cash flow. By building bond ladders and acquiring bonds with certain scheduled coupon payment dates, the investor can help ensure that cash is available at the precise time he or she needs it. Additionally, certain bonds have unique tax aspects. Consider the advantages of investing in municipal bonds. Not only do you provide funding to build your local community - schools, hospitals, sewers, bridges, and all of the trappings of civilization - but, presuming you follow the rules and acquire the right type of bond based on your location, you should be able to enjoy tax-free income, as well as the interest is exempt from taxes. Be sure to pay attention to asset placement, though. For example, you should never hold tax-free municipal bonds through a Roth IRA.
I've written a lot about bonds and fixed income investing both here at Investing for Beginners and on my personal blog, where I tackle some of the more advanced concepts not necessarily appropriate for new investors who probably should be investing in things like index funds, instead; e.g., how to use Treasury bond yields relative to the earnings yield of equities to determine relative overvaluation.