Article By : Patrick Mansfield | U.S. Consumer Finance
Bonds are a great asset class that every investor should consider as a part of their overall investment strategy. Most financial advisors recommend that individuals have at least 10% of their investments in bonds, with the ratio of bonds to stocks increasing as an individual approaches retirement age. This is because most bonds, excluding bonds called "junk bonds," produce very safe, predictable income streams.
In this article, we are going to look at why bonds exist, how they work, and the associated benefits and risks associated with bond investing.
The Purpose of Bonds
Bonds are issued by the federal government, large corporations, and state/municipal governments.
The federal government typically issues T-bills, bonds, and notes via the Treasury Department to finance the budget deficit incurred through fiscal spending. Since all federal bonds are considered risk-free due to the unlimited taxing power of the federal government, they often pay out the lowest amount of interest.
Municipal/state bonds are usually the next safest level of bonds. State, city, and smaller governments issue these bonds to finance the construction of roads, bridges, and other things like sports facilities that will later deliver tax value to the presiding municipality. It is important to note that general obligation bonds (GO) are the safest type of municipal bond, as they are backed by the full taxing powers of the municipality.
Finally, corporations will sell bonds to generate money for financing daily operating activities or to finance investment in plant, property, and equipment that will generate future revenues.
Bonds are graded by rating services like Moody's, and higher rated bonds have lower interest rates since they pose less default risk. With corporate bonds, the highest rating is AAA, and anything below BB is considered a "junk bond" or "high-yield" bond. These bonds are considered very risky by rating services, so they will typically pay much higher in interest (assuming that they are current with payments).
How Bonds Work
A bondholder will typically purchase a bond based on a percentage of "par value." Par value is the face value that is paid to purchase the bond, typically $1,000. The bond has a fixed interest rate (which is usually paid on a semi-annual basis) called the "coupon rate" and a fixed maturity. While holding the bond, the bondholder receives regular coupon payments, and on the maturity date, a bondholder receives a final coupon payment plus the return of par value.
A Treasury Bill is a little bit different because buyers purchase these types of debt based on percentage yield. The "bid" price is the interest rate yield that a buyer hopes to receive when purchasing the bond, while the "ask" price is the yield that a seller is willing to pay to the buyer for purchasing the bond.
Benefits and Risk Associated with Bond Purchases
The largest benefit to purchasing bonds is the safe interest rate income that they can provide combined with preservation of capital. With junk bonds, the benefit is that an investor can potentially receive high yields on their investment.
The risks that face a bond investor are five-fold:
Credit Risk - This is the risk that a borrower will not make timely interest payments or will default entirely.
Call Risk - In falling interest rate environments, borrowers often put a call feature on their bonds that allow them to call back issued bonds and re-issue them at a lower rate to save on interest payment cost. For bondholders holding callable bonds, they face the risk of receiving a lower interest rate on future funds if their bonds are called.
Interest Rate Risk - If interest rates rise, a bondholder will be receiving less interest on his bond than is currently accessible in the broad market. Long-term bonds face higher interest rate risk than short-term bonds.
Liquidity Risk - Some bonds do not have deep markets, which means that buyers or sellers may not be able to transact for the bonds that they want when they want to act.
Inflation Risk - If inflation was to surge while a bondholder owns a bond, there is a risk that the rate of inflation will outpace the interest rate that they are receiving on their bond holdings. This can usually be defended against by purchasing bonds that offer an inflation protection feature that raises the interest rate when inflation increases.
Bonds can be purchased through any broker-dealer, but certain bonds are only suitable for certain individuals. For this reason, as always, it is advised that you discuss the suitability of a bond for your holdings with a qualified FINRA financial advisor before transacting in bonds.