Passive income bond investing can provide one of the truest forms of passive income and should be a part of everyone’s investment portfolio.
To now, most of the strategies in our passive income myth series may have disappointed the investor looking for true passive income. Blogging and real estate rentals both offered nearly unlimited upside but a lot of work in exchange. Income investing and indirect real estate investing offered more moderate returns but also a more passive form of income.
In this last article, we will examine what could be the most passive strategy of them all. Bond investing shares similarities with income investing but goes a step further with more safety and a longer-term, hands-off approach to investing. For those serious about true passive income, it may just be the answer to your prayers.
Passive income is technically an income you make on a regular basis that involves little effort on your part. You get paid every month, quarter or year but don’t participate in management or contribute work in the investment or business.
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What is Passive Income Bond Investing?
There are two ways for a company to raise money to finance its operations, issuing stock to investors or selling bonds. Bonds are loans taken out by governments, corporations and even public works programs with the promise to pay interest every year. Bonds are sold for a set number of years, called its maturity. The company pays interest payments, usually twice a year, until the maturity of the bond when it pays the face value of the bond to investors.
McDonald’s issues $50 million in bonds with a maturity of 30 years
The bonds have a face value (cost) of $1,000 and an interest rate of 3.5%
McDonald’s pays investors 1.75% in interest, twice a year for 30 years
At the end of 30 years, McDonald’s pays the $50 million back to investors at $1,000 for each bond they hold
The basics of bond investing are straight-forward and simple. You are loaning money to a company or government for a set interest rate and a set number of years. In the event that a company cannot continue in business or make payments, bond investors are paid before stock investors. While stock investors are likely to get nothing in a bankruptcy, bond investors might get some of their money back even if it is only $0.60 on the dollar.
Because bondholders receive a fixed interest rate and get paid before stockholders, bonds are safer investments than stocks. They provide a stable income at lower risk but do not offer the upside return you might get in stocks. While stocks could zoom higher in any given year, your bond investments are going to pay that fixed return if you hold them to maturity.
There are details to bond trading, buying and selling frequently, that make them a little more complicated. Most investors should buy bonds to hold until they are paid off at maturity, using bonds for a stable source of passive income and a diversification from the risks in stocks.
Risks and Return to Passive Income Bond Investing
The fact that bonds are much safer than stocks makes them a great investment and they’re found in the portfolios of pension funds, insurance companies and banks. All individual investors should hold a portion of their money in bonds to protect from stock market ups and downs. Those needed more stable, passive income and safety like retirees may even choose to hold the majority of their money in bonds.
Long-term corporate bonds, those issued by some of the most stable companies, have provided a 7.4% return annually over the last decade. This long-term return may change if interest rates begin a slow, steady climb higher but rates have been dropping for more than three decades. Even if interest rates increase, bonds will continue to be a necessity in a diversified investment portfolio.
Since bonds pay a fixed interest rate and have a fixed final payment at maturity, the only thing that changes is the price you pay for the bond. Bond prices change because the interest rate paid on other bonds and loans changes while the individual bond’s rate doesn’t change.
If interest rates increase then investors can earn more interest on other bonds. To attract buyers to a bond if people want to sell it, the bond price must decrease.
On the other hand, if interest rates decrease then the bond’s price will increase. This is because the fixed-rate bond is now paying a higher rate compared to what investors are getting in the market. Investors can lock-in the rate by buying the bond but they will have to offer a better price to current owners.
This sets up the biggest risk in bond investing. If interest rates start to increase, the value of your bonds will decrease. The beauty of being a long-term investor though is that you will still make the same return on the investment if you hold it until the bond matures. You bought the bonds and have a right to a fixed payment that doesn’t change regardless of the bond’s value.
The danger is only to those that choose to sell their bond investments before maturity and may be forced to sell at a lower price because of higher interest rates.
Companies issue bonds across many maturities, from short-periods of a year to as far out as 99 years. Since rising interest rates means the bond’s fixed rate is not competitive against newly issued bonds at higher market rates, then it stands to reason that longer-term bonds (those with longer to pay at the lower rate) are going to see their prices fall further than short-term bonds. Bonds that will mature in a couple of years will give investors the opportunity to reinvest their money in new bonds at higher rates so prices do not react quiet so negatively to higher rates.
The trade-off is that longer-term bonds usually offer higher rates to start out. If a company is going to ask an investor to lock-up their money for longer, in this loan, they have to offer a higher interest rate than they would if the loan is only for a few years.
The other major risk to bonds is from inflation. Because bonds pay a fixed payment until maturity, inflation will slowly eat away at the value of that payment. Buy a 30-year bond with a $20 semi-annual payment and you’ll get that same $20 twice a year for 30-years. Over three decades, that $20 is going to buy less. If inflation stays relatively low then it is not much of a problem. As inflation increases, interest rates tend to increase as well and push the value of bonds lower.
The credit quality of each company is rated by firms like Moody’s and Standard & Poor’s. Investors look at these ratings to decide if the interest rate offered is worth the risk of loaning a lower-rated company money. The lower the rating, the higher the interest rate the company must offer to attract investors. If a company’s finances deteriorate, its credit rating may get lowered. This new, higher-risk means that new investors will require a higher rate and will not pay as much for previously issued bonds. Like interest-rate risk, this downgrade-risk is not as big an issue for investors that hold their bonds to maturity because they will continue to receive the fixed payments.
Those are the basics of bonds; interest-rate risk, downgrade-risk and the difference between short- and long-term bonds. Like stocks, there is a whole world of information and analysis within bond investing. Also as with stocks, if you plan on being a long-term investor and holding your bonds to maturity, you don’t really need to know every facet of bond trading.
Building a Portfolio of Passive Income from Bond Investing
There’s no consensus to how much of your total wealth you should have invested in bonds though nearly everyone agrees you should have some money in the asset. If you are younger, say under the age of 35, then you can probably withstand a little more risk in your portfolio and will invest more in stocks and other assets rather than bonds. Even if the stock market tanks, you have at least 30 years for the value of your investments to rebound and move higher. Stocks will outperform bonds over the long-run but bonds serve a very important purpose as well.
If you are older or need income from your investments to help pay expenses, you will want a higher percentage of your investments in bonds. This goes back to the idea that, unless a company defaults, you are guaranteed to get a fixed rate of return in bonds. If the stock market happens to crash around the time you are ready to retire, a too true fact for many in 2008, the bond investor doesn’t have to worry because his money is safe.
The graph below isn’t meant to reflect a rule for how much of your total investments you should have invested in bonds but more of a visual aid. Notice that the young investor has very little in bonds, holding more stocks and other investments for higher returns. As the investor moves closer to retirement and not losing money becomes more important that seeing the value climb, more money is put to bonds. The retiree that is using his portfolio for passive income to cover living expenses has nearly all his portfolio in bonds, relatively safe and providing a constant return.
Online investing platforms like Motif Investing have made it fairly easy to buy bonds without a broker. Your first decision is how much return do you need from your bond investments and at what time horizon do you want to invest. Remember, bond investing is not generally meant to make you rich but to protect the value of your portfolio and earn a respectable return. As with any investment, if you chase higher returns, you’ll be forced to take more risk.
The graphic below shows current average interest rates paid for different categories of bonds at different maturities. Notice that the safest bonds, those backed by the U.S. Treasury, pay the least while bonds of lower-rated companies and local governments pay higher rates. Bonds of longer maturity, to 30-years here, pay higher rates as well.
Bond ratings go all the way down to CCC- though they are only shown to A in the graphic below. High-yield bonds, those from companies with weak financial positions and poor credit, are offering rates as high as 9% for 30-year terms but also offer the risk of bankruptcy before the bond matures.
One popular bond investing strategy is called “laddering” and provides a trade-off between lower rates on short-term bonds and higher interest rate risk of long-term bonds. In this strategy, you invest in a group of bonds at different maturities. You might buy bonds that expire in 3, 5, 8 and 10 years. You get higher rates from your longer-term bonds but the shorter-term bonds pay off sooner. If interest rates increase, you will have your money back from the shortest-term bonds in three years and can reinvest in more bonds at the higher rate in the market. This is also a popular strategy for people that need passive income because it provides a constant stream of extra income as the near-term bonds mature and return your investment money.
Once you’ve decided on the characteristics of the bonds in which you want to invest, a search is made fairly easy on most online platforms. The screener below allows you to search for bonds across many different characteristics.
From the search, you can select the bonds you want for your portfolio. It is fairly easy to do your own bond investing but customer service on the online platforms are usually more than willing to talk you through the process for your first few investments.
An Alternative to Bond Investing for Passive Income
One popular alternative to bond investing for passive income is to buy shares of exchange traded funds (ETFs). These are like mutual funds, where a manager buys individual bonds and then allows you to invest in the entire portfolio with just one purchase. While most people are more familiar with mutual funds, I prefer ETFs for several reasons:
- ETFs trade on the stock exchanges just like stocks. You can buy and sell them easily and commissions are usually very low. Mutual funds do not trade during the day so the price you get when you buy or sell isn’t known until the close of the market.
- ETFs are usually much cheaper than mutual funds. Mutual funds may charge expense fees of 2% or higher and up to 5% to buy and sell the fund. ETFs normally charge expense fees of less than 1% and you can buy or sell shares for as little as $5 with an online investing platform.
There are thousands of ETFs. Some invest in stocks, others in bonds and still others that invest in real estate, commodities and any other investment. Bond ETFs hold the individual bonds and use the payments to either reinvest in more bonds or pay out to shareholders. When bonds mature, more are bought so the fund doesn’t mature like the bonds in the portfolio.
The fact that bond ETFs do not mature means there is no yield-to-maturity for the fund. You really don’t know what kind of return you will get because it all depends on when you sell the fund, not when it matures. The bonds in the portfolio lose value when interest rates increase so the shares of the ETF also decrease in price with rising rates. This means you could be left with a lower return if you have to sell shares at a time when rates are increasing.
Even with the risk to share prices, bond ETFs are a good strategy for passive income. Over the 17 months when stocks in the S&P 500 fell more than 50% to March 2009, the Aggregate Bond fund below actually provided a 6.8% return to investors.
There are fewer bond ETFs than those that invest in stocks. It is fairly easy to put together a diversified portfolio of bonds with just a few ETFs. Two of my favorite bond ETFs are:
The iShares Core US Aggregate Bond (NYSE: AGG) pays a dividend yield of 2.28% and charges a super-low 0.09% expense ratio. Bonds issued by the U.S. Treasury make up 38% of the fund and another 30% of the fund is invested in bonds like Fannie Mae with the banking of the government. Since the bonds are very safe, the return is not going to be as high but will be more stable. The fund has provided investors with a 4.77% annual return over the last ten years.
The SPDR Barclays High Yield Bond (NYSE: JNK) pays a dividend yield of 5.77% and charges a 0.4% expense ratio. The fund holds 802 bonds that mature in an average of 6.4 years. The time to maturity is important because an increase in interest rates affects short-maturity bonds less than it does longer-dated bonds. This means the bonds in the fund should not decrease in value quite as quickly as the prices in the longer-dated Aggregate Bond fund.
Another reason to hold shares in the high-yield fund is because of the way the bonds react to the economy and interest rates. An increase in rates will still decrease the price of high-yield bonds but not as much as with other bonds because high-yield bonds follow the economy more closely. Since the companies that issue high-yield bonds are riskier than other companies, uncertainty over the companies’ ability to repay debt is higher. A growing economy, usually happening the same time interest rates are increasing, means these companies have a better chance at paying debt. That lower risk to payment usually helps high-yield bond prices not fall as much as other bonds.
There are hundreds of other bond ETFs to buy but you really don’t need too many for a diversified portfolio. You might consider adding a fund with foreign bonds as well but that would be the extent you would need.
One of four investing funds I created in Motif Investing is a Ready-Made Retirement Portfolio. The group of nine stocks and ten funds has 25% invested in bond funds for stability and cash return. That’s probably not as much as an older investor would want in bonds but is perfect for a millennial investor or someone with decades left to retirement. The fund has beaten the return of the stock market (S&P 500) by 0.5% and is less risky through the bond investments.
Passive Income Potential: Bond Investing
Bond investing provides one of the most passive streams of income you can find. The market for bonds is very large and prices reflect the trade-off between rates, credit quality and bond maturity. This means there is not much work to be done on your part when selecting bonds because there is not much likelihood that any bonds trade for a huge discount to their fair value. You select bonds at a credit rating with which you feel comfortable and a rate and term that you need.
Since bonds are best held to maturity for most investors, guaranteeing the return available when you bought the bond, there is less to worry about with stocks. While many investors spend countless hours analyzing and deciding whether to sell their stock investments, bonds are a real buy-and-hold investment because they have a fixed return and a fixed lifespan.
Start-up costs are the one drawback to bonds because individual bonds are generally more expensive than individual shares of stock and financing is not usually offered. Most bonds have a face value, the amount you will get back when it matures, of $1,000 each. There are circumstances where you will pay less than this but you are still looking at several hundred dollars for each bond you buy. This makes it difficult for new investors to start out with a diversified portfolio of bonds from different companies and different maturities.
The time commitment for investing in bonds is next to nothing. You select the bonds in which you want to invest given how long you want to invest and the credit quality you want. Once you buy a bond, your return is locked-in unless the company files bankruptcy or you sell the bond. This makes bonds a real set-it and forget-it investment.
Income momentum is respectable for bond investing though not as good as with income investing or indirect real estate investing. You can reinvest your bond payments into more bonds for faster income growth but the lower rate of return means that growth is not likely to be very fast. Bonds are not meant as the get-rich-quick investment but more the protect-my-future investment.
Continuity of income is another upside for bonds since you are assured of getting your fixed payments and the maturity payment at the end of the term. Invest in high enough quality bonds and the risk of default is next to zero. Even if the company defaults, you may receive some money back while stock investors will get nothing.
The scale below presents my passive income potential for bond investing. Each of four factors is scaled in reverse with 1 being the worst or the most unfavorable to a true passive income investment.
Overall, bond investing ranks highest on our scale among the passive income strategies. The returns are among the lowest as well but you are virtually guaranteed a fixed return if you hold your bonds to maturity. This certainty is the power of bond investing and it’s offered in very few other investments.