Many people begin investing with stocks. While you probably understand you should diversify, bonds can be confusing. In case you’re interested in bonds, but don’t know where to start, here are the basics of bonds and bond funds.
Bonds may help provide income and stability
To understand the basics of bonds, it may help to think of them as securities similar to loans. Governments and corporations issue bonds to raise money. The money is generally used to finance new projects, refinance debts, or maintain operations. Regardless, the issuer typically makes interest payments at regular intervals, and repays the full investment at the end of a set period of time (maturity). Bonds can be very beneficial in your diversified portfolio, due to:
Interest payments from bonds can help you build an income stream. The income stream can then be used to supplement your existing income, create a source of retirement income, or be reinvested.
Preserve Your Capital
If you’re concerned about protecting your capital investment, bonds may be a good choice. In most situations, your original investment is repaid, depending on the financial health of the issuer. However, if you’re interested in more immediate financial needs, other short-term options may be more appropriate. Likewise, if longer-term needs are your goal, investments with more growth potential may be more appropriate.
Investment-grade bonds usually have the financial strength to make interest payments, and repay your original investments. They’re also less volatile than stocks. Bonds may also perform well when stocks struggle which provides an excellent potential for diversification. If you want to lower the volatility of your portfolio, bonds may be a good fit.
Individual bonds vs. bond funds
Some people prefer to enter the bond market through bond mutual funds and/or ETFs. Both can provide professional management and diversification. Bond funds are different from individual bonds, as they don’t have a set maturity date, and generally provide less protection for your principal, due primarily to interest rate and credit risk. Most bond funds and ETFs don’t have a set maturity date, and generally provide less protection for your principal.
Most types of bonds share common features, like a fixed interest rate and a set maturity date. However, they can provide different levels of income potential and risk. Two primary measurements, credit quality and duration, give you a good indication of the income and risk for a bond.
This bond measurement predicts the probability an issuer will pay both interest owed, and principal at maturity. Agencies that analyze security and financial soundness of an issuing company assign a credit rating. Bonds usually fall into one of two categories noted below:
- investment grade
- high yield, or “junk”
In most situations, bond prices fall when interest rates rise. Conversely, bond prices usually increase when interest rates fall. However, this doesn’t affect all bonds the same way. Duration measures the sensitivity of a bond’s price to changes in interest rates. This measurement has three categories greatly influenced by the length of time until the bond’s maturity date:
- term to maturity date
- coupon date
- yield to maturity
When bonds from different issuers are grouped into general categories, they’re called bond funds. Within each category, there may be more- or less-risky options. Some funds, ETFs, and managed accounts may combine different bond categories to create multi-asset options.
Bond investments and your needs
Different types of bonds and/or bond funds provide different advantages. And, like most investment decisions, there isn’t one that is “best”. Your investment strategy and goals are unique to your individual situation and goals. You should identify the type of bonds and/or bond funds that are most appropriate for your investment strategy. And as always, be certain you understand how any investments you purchase work, and how it affects your overall strategy. If you have questions, feel free to contact my office at 336-448-1086, or consult a Certified Financial Planner.