Investing in Bonds
What is a bond?
Bonds are debt instruments. As a buyer of a bond you are essentially lending money that you expect to be repaid. The bond’s issuer borrows a certain amount of money from you (the bond value) and promises to repay it with interest at a predetermined maturity date. The interest rate may be fixed or variable, and will generally be a reflection of the creditworthiness of the issuer.
Investors who are interested in the bond market will be best served by first determining whether bonds are the right asset class to satisfy their greater financial goals. A consultation with a fiduciary advisor through Zoe Financial’s network can be the first step towards establishing those goals, formulating investment strategies that are in line with achieving them, and determining whether stocks or bonds will be an effective part of the strategy.
Common Types of Bonds
Investment grade bonds typically fall into one of seven categories, each of which reflects different risk exposures and potentials for returns.
- Treasury Bonds are issued by the U.S. government to finance the administration of its services and to service its debt. They tend to generate lower returns than other classes of bonds with similar maturity dates because they are backed by the full faith and credit of the government and thus have a very low risk of default.
- Government Agency Bonds are issued by federal housing and other agencies, and are backed by mortgages and other secured interests that are insured by the U.S. government.
- Corporate Bonds are issued by private corporate entities to finance their own operations. Ratings from various independent agencies will give investors an idea of the relative riskiness of a specific corporate bond.
- High Yield or “Junk Bonds” are for investors with a higher tolerance for risk. They are typically issued by entities with low credit ratings and therefore carry a higher risk of default, exposing the investor to the potential of losing the entire amount of their investment. Because of this risk, they tend to offer higher returns than government bond investments.
- Foreign Bonds are issued by governments or corporations in currencies other than the US dollar.
- Mortgage Backed Bonds and their derivatives, credit default swaps, were a significant component of the 2008 financial crisis. Although investment banks and other entities continue to offer these bonds, they are now subject to much tighter regulations that are designed to prevent a repeat of that crisis.
- Municipal Bonds are offered by cities, counties, and their agencies to finance regional projects and local government operations. Like corporate bonds, municipal bonds carry ratings from independent agencies to give investors a clearer picture of their relative risk levels.
The Differences Between Premium Bonds, Savings Bonds, and other Bond Classes
The terminology of the bond market occasionally includes similar names for different bonds. For example, savings bonds are a form of debt that is issued by the U.S. Government, but they are not treasury bonds and they cannot be traded in a secondary market. Further, a premium bond may be a debt instrument that is issued by foreign government (Canada and the United Kingdom issue premium bonds). Yet more broadly, the term premium bond can refer to a bond that is trading at an amount that is greater than its face value or par value in the secondary market. Investors may be willing to pay a premium for some types of bonds if the issuer is making regular interest payments that represent a solid rate of return in exchange for the bond’s premium price.
Important Considerations for Bond Investments
The label that is attached to the bond is never as critical as the bond’s substantive identity and performance. A bond investor should focus on that identity and performance rather than on any labels when comparing different types of bonds.
Bond investors will make the most objective decisions when they consider:
- whether the bond’s identity and performance match the investor’s goals;
- markups and commissions charged by a broker for bond transactions;
- the actual yield of a bond in comparison to its stated interest rate;
- the bond’s default risk;
- how frequently the bond is traded, and how easy it is to get pricing information on those trades;
- whether bond interest that is paid to an investor is taxable, and the tax rate that will be applied to that interest.
Zoe Financial: Bond Investments in Today’s Market
Financial advisors in Zoe’s network know that no one investment product or strategy is right for every investor. This is particularly true for bond investments. Our mission is to first help our clients match with the right fiduciary financial advisor to then determine their investment goals and make appropriate recommendations.
- www.finra.org: Tips Before You Invest in Bonds – http://www.finra.org/investors/tips-before-you-invest-bonds
- www.sec.gov: Bonds – https://www.sec.gov/fast-answers/answers-bondshtm.html
- www.cnbc.com: How to Build a Better Bond Portfolio: 3 Advisors’ Takes – https://www.cnbc.com/2018/06/05/how-to-build-a-better-bond-portfolio-3-advisors-takes.html