Bonds are much more complex and versatile than they appear. They offer a variety of options for investors in any investment environment.
Investors use bonds in many different ways, such as preserving capital, earning income, managing interest rate risk, and diversifying a portfolio.
Unlike a stock, which guarantees no fixed payment to its investors, a bond issuer sets terms to the lender or bondholder. They do this the same way a mortgage or auto loan sets out all the terms upon closing the house or selling the car.
The period of time before the principal of the loan is fully due and interest payments (or coupons) cease is called the bond’s maturity date. The interest rate that the issuer agrees to buy from the bondholder is called the yield of the bond. Bonds that mature in installments over a certain period are called serial bonds.
Bond Equivalent Yield vs Yield to Maturity
The overall interest rate earned by an investor who buys a bond at market price and holds it until maturity is called the yield to maturity (YTM).
If you have the face value (the bond’s price when it is first issued), the maturity, and the YTM of a bond, you can find its price using a financial calculator.
Consider a zero-coupon bond with a face value of $1,000 and ten years left to maturity. If the YTM of this bond is 10.2%, then the price of this bond is $378.60 (FV = 1000 I = 10.2
PMT = 0 N = 10 Compute PV = 378.60).
The rate an investor uses to determine the annual yield of a bond that does not provide an annual payment is the bond equivalent yield (BEY). It helps an investor annualize monthly, quarterly, semi-annual or other discount bond yields to facilitate an apples-to-apples comparison.
Types of Bonds
Bonds come in a variety of forms, each with their own advantages and disadvantages.
Treasury Bonds: T-bonds are issued by the U.S. government. Due to the absence of default risk, they do not have to offer the same (higher) interest rates as corporate bonds.
Municipal Bonds: Municipal bonds, sometimes called “munis,” are issued by states, cities, and other local government entities to fund public projects or provide public services. For example, a city can issue municipal bonds to build a new bridge.
Corporate Bonds: Corporate bonds usually offer higher interest rates than other types of bonds. However, the companies that issue them have greater chances to default than government entities, making them riskier.
6 Ways Investors Use Bonds
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- Income generation: Bonds give investors a fixed income at regular intervals in the form of coupon payments. A solid bond portfolio can provide decent returns with a lower level of volatility than stocks. They can also generate more income than money market funds or banking instruments. That means bonds are a good option for people who need to live off their investment income. Even when interest rates are low, there are still a lot of options you can use to build a portfolio that meets your income needs. These methods can include high-yield bonds or emerging market debt.
- Diversification: Investing in stocks, bonds, and other asset classes can help you build a portfolio that earns returns in all market environments. Stocks and bonds generally have an inverse relationship, which means that when the stock market is down, bonds become more attractive.
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Greater diversification can give you better risk-adjusted returns over time than narrow portfolios. In other words, it reduces the amount of return relative to risk. For example, Pacific Life offers a diversified fund, the PSF diversified bond portfolio, which invests in different types of bonds.
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- Capital preservation: Capital preservation means protecting the absolute value of your own investment through assets that promise a return of capital. Since bonds generally carry less risk than stocks, these assets are useful for people who are nearing the point where they will have to use the money they have invested.
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For example, this could apply to someone who is less than five years away from retirement. Bonds can help preserve capital during downturns in the stock market. Indeed, stocks can face huge levels of volatility over a short period, such as the crash of 2008. On the other hand, a diversified bond portfolio is much less likely to suffer major short-term losses.
Therefore, it may make sense to increase your allocation to fixed income securities and reduce your allocation to equities as you get closer to your goals.
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- Immunization: Individuals commonly use bonds to meet an expected future cash requirement. Institutions also use this strategy, called immunization. The concept assumes a match between the duration of the bond and the expected cash flows. This can be easily achieved by using a zero-coupon bond in which the maturity matches the duration of the bond. Although this will not provide any income for the duration of the bond, it will provide a direct match. A bond immunization calculator will give you the best combination of bonds to obtain the optimal return with a given investment horizon.
- Risk management: Fixed income securities are generally considered to carry less risk than stocks. Indeed, fixed income assets are generally less sensitive to macro risks, such as economic downturns and geopolitical events. So, including bonds in your investment portfolio reduces its overall risk.
- Tax Advantages: Certain types of bonds can be useful for investors that want to reduce their tax burden. Income on stocks, bank instruments, and most money market funds, is taxable unless the assets are held in a tax-deferred account. On the other hand, interest on municipal bonds is exempted from tax at the federal level. If you own a municipal bond issued by the state where you live, it is also tax-exempt at the state level.
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Income from US Treasury securities is exempt from state and local tax. The universe of fixed income securities offers several ways to reduce your tax burden.
What are the Risks of Investing in Bonds?
Like any investment, buying bonds also involves risks, which include the following:
Interest rate risk: When interest rates rise, bond prices fall. That means the bonds you currently hold may lose value. Interest rate fluctuations are the primary cause of price volatility in bond markets.
Liquidity risk: Liquidity risk is the possibility that an investor looking to sell a bond is unable to find a buyer.
Credit risk: Credit risk (also called financial risk or business risk) is the possibility that an issuer may default on its obligations.
Inflation risk: Inflation is the rate at which the price of goods and services increases over time. If the rate of inflation exceeds the fixed amount of income a bond provides, the investor loses purchasing power.
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