Guide to Fixed Income Investments: Beating the Market with Bond Investing
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Use this guide to get started investing in bonds to beat the market with fixed income investments
Whenever I switch a conversation from stocks to fixed income investments, expressions go blank and people tune out.
While stocks are almost universally understood as an investment strategy, most investors know almost nothing about bonds. Just mentioning the word brings up images of slick junk-bond traders of the 80’s.
Start a discussion of how bond prices move with interest rates and inflation and you might as well be speaking another language.
A lot investors think investing in bonds is just too complicated or only for Wall Street traders.
The truth is that investing in bonds is likely the best investment you can make when planning your financial future. Unlike stocks, bonds provide a nearly certain return that can be planned over decades.
Bonds have returned an annualized 4.3% over the last two decades versus a return of 8.3% for stocks. That may seem to tip the scale in favor of stocks until you consider bonds did it with about a fifth the risk.
The standard deviation of bond returns, a measure of how much you can expect prices to rise or fall, was just over 3% during the period. That same measure of risk in stocks topped 15% and we all remember what happened in 2000 and 2008.
Adjusting for this risk, the roller-coaster ride in stocks, bonds beat stocks hands down.
Holding a portion of your nest egg in bonds is a must for anyone that wants to avoid losing half their portfolio in the next stock market crash, for investors with less than a decade or two to retirement or for retirees that need a stable source of income.
In short, bond investing is for everyone.
This post started out as an introduction to fixed income investments and grew into a complete guide on bonds. I’ve included a table of contents so you can click through to specific sections.
Bond Investing Risks and How to Avoid Them
Understanding Bond Prices and Interest Rates
Bond Yields and Investment Return
How Are Bond Credit Ratings Determined?
Types of Bonds
What is a Bond Fund?
A Fixed Income Investment Strategy Based on Your Goals
What is a Bond?
If you need $10 to get you through the week, you just have to ask politely. Need $10 million to get you through the year and you’ll have to do more than just say please.
While a business might be making sales and booking profits, cash doesn’t always come in immediately. Land that dream contract and you may need money for supplies well before you get paid on the order.
Even governments need cash to pay for programs and expenses before annual taxes start rolling in.
As a business owner, you could sell stock ownership in your company but that means sharing the profits with investors. Bank loans are one option but may not be offered on terms you need or at a rate you can afford.
Enter bonds, a loan sold to investors with a fixed payment and payoff date.
Institutions from companies to governments, local municipalities and housing authorities can take out loans secured by a bond. Since fixed income investments are backed by assets and a contract, investors are willing to loan the money at low rates. Companies can also use interest paid on the loan to reduce the amount of taxes they pay on income.
Bonds are a critical part of financing for businesses. While taking out loans includes some financial risk, it means more profits for the owners and lower costs to operate the company.
Bonds are always issued for a specific face value, sometimes called par value and usually $1,000 for each certificate. Companies plan out their cash needs for years in advance, how much in expenses can be paid through sales and how much additional cash they might need.
To raise the extra money, the company will make a bond offer including the total amount of the loan, an interest rate offered and how long until the loan will be paid off.
Most bonds pay a fixed rate of interest over the life of the loan, called its maturity. The company pays only interest over the period and then returns the face value of the bonds to investors at the maturity date.
The interest payments on bonds are usually paid twice a year and are called coupons because bonds used to have cut-out coupons that you mailed in to collect your payment. Nearly everything is handled digitally now. Your interest payments will go straight to your investment account and you might not even get a paper certificate of your bonds.
So if McDonald’s needs to raise $100 million for an expansion project or other cash needs, it might issue 100,000 bonds of $1,000 each. It agrees to pay an interest rate of 4% over 30 years and then return the $100 million to investors at the end of that period.
An investor holding a $1,000 bond will receive $20 every six months, that’s 4% of the bond’s $1,000 face value. Depending on the coupon interest rate and the rating, you might pay more or less than $1,000 for each bond when you buy the investment but you’ll always get the face value at maturity.
Bonds are issued for periods from a year to as long as 99 years but most companies issue shorter-term bonds for five to 30 years. The number of years to maturity is an important factor in the interest rate that investors demand for the bond.
Investing in different bonds lets investors customize their portfolio exactly to their needs for cash and returns. Bonds with longer maturities mean higher rates of return while bonds that get paid off sooner mean less risk and opportunities to reinvest the money. Bonds of the highest-rated companies means protection of your investment while riskier bonds can amplify your returns but still involve less risk than stocks.
Most likely, you already have money in bonds and may not even know it. Most of the $40 trillion U.S. bond market is held by life insurance companies, banks and pension funds. These big money players need to earn a return on the money you’ve deposited or paid in premiums that will cover their future commitments but look to the safety of the bond market for protection.
Bond Investing Risks and How to Avoid Them
The risks in bond investing are very different from those you might know from investing in the stock market. Most bond risks arise from the fact of fixed payments over the life of the investment. Some of these risks can be reduced while some can be almost completely ignored depending on how long you hold your bonds.
Interest rate risk is one of the most talked about for bonds but really isn’t as much an issue for those that don’t sell their bonds. Hold your bonds to maturity and you don’t have to worry much about one of the biggest risks…how’s that for a bond investing secret?
Everyone else has to worry about interest rate risk because bond prices fall when rates go up. The reason is pretty simple.
If you’re holding a bond that pays 5% interest payments against current market rates of 4% then you’re doing pretty well, right?
Now if interest rates in the market go up to 6% the deal doesn’t look so great. You can’t change the interest payments on the bond, that’s why they’re called fixed-income investments. You still get the same amount, the face value of the bond, at maturity as well.
So if bond payments don’t change when market rates change, how do investors sell their bonds if they don’t want to hold them to maturity? They’re going to have to lower the price to compete with the new, higher rates in the market.
It works in the other direction as well. If interest rates go down, then those existing bonds with interest rates set when the market was paying more start looking pretty good. Investors raise their prices when they sell the bonds.
Interest rate risk is greater for bonds with more years to maturity. You’d have to lower the price more to persuade an investor to buy that 5% rate bond and hold it for many years.
Reinvestment risk is the cruel twist to interest rate risk. When rates decrease, you might be able to sell your bonds for a higher price but what are you going to do with that money? The rate at which you can reinvest that money is now lower.
While interest rate risk isn’t an issue if you hold your bonds to maturity, reinvestment risk still bites. You can’t do much about it and it’s been socking it to investors since the early 1980s. The rate on the 10-year Treasury has dropped from nearly 15% to just above two percent over the last three decades.
It would be hard to imagine rates following the same path over the next 30 years unless the government starts charging you to hold your money. Reinvestment risk might not be as big an issue as rates increase but investors selling their bonds may start feeling the bite of interest rate risk.
Default risk is one of the worst risks for long-term investors. You won’t have to worry about the U.S. government making its bond payments but everyone else is a big question mark.
A company is legally obligated to pay its bondholders before stock owners but if times get bad enough, there might not be enough cash to even pay bondholders. Credit rating agencies look closely at a company’s ability to repay debt when it assigns a rating and defaults on investment grade bonds are rare.
One of two things usually happens in a default. If there is absolutely no way out and no future for the company, it may be liquidated. In this case, bondholders may get pennies on the dollar for their bonds depending on how much money is left after paying higher-ranked creditors.
If the company wants to continue doing business, it may try to renegotiate with its bondholders. This will be done between an arbiter or judge and a group representing creditors. You may have to take a cut on the value of your bonds and may have to accept longer-dated bonds but you’ll get more than in a liquidation.
Default risk can be minimized by holding fewer high-risk bonds and buying many individual bonds in each rating category. Diversification means that one default won’t hit your returns too badly.
Despite the severity of default risk in bonds, it happens infrequently for most fixed income investments. The average default rate for all corporate bonds is less than 1% with less than half a percent of the highest rated bonds defaulting in any given year.
Inflation risk is another of the worst bond risks for long-term investors because it’s the most uncertain. Your bonds pay a fixed payment whether inflation heads higher or not.
The current 10-year Treasury rate of 2.5% is about half a percent above the annual rate of inflation. That means the return keeps your money buying the same amount of stuff and 0.5% more each year. If inflation increases to 3% then Treasury investors are actually losing money on their bonds.
Of course, an increase of inflation usually takes interest rates up with it. New bonds will offer higher rates but old bonds are going to be hit hard.
As with the downward trend in rates, it’s equally difficult to imagine inflation staying as low as it is now. Higher inflation doesn’t mean you have to lose money on your bond investments. When inflation increases, new bonds pay higher rates. By having some bonds maturing in different years, called laddering, you will be able to constantly buy more bonds at higher rates.
The risks to bond investing, especially the fact that many are tied to economic concepts like rates and inflation, make the investment a tough sell to investors. The idea of facing these risks for low single-digit returns doesn’t sound very appealing to most.
But don’t forget that many of these risks will not significantly affect long-term investors that hold their bonds to maturity. Despite the risks to bond prices, the risks to bond investors are very manageable for the buy-and-hold investor.
Trade in and out of your bonds and you’ll face every one of the risks listed above and can lose a lot of money in the process. Hold your bonds to maturity and benefit from one of the most stable investments you will find.
Understanding Bond Yields and Prices
Bond valuation and investing can be just as complicated as stocks – or it can be extremely easy.
There are a number of rates or yield measures that you will want to know about when investing in bonds. These all measure some kind of return available and will help determine whether you want to include a bond in your portfolio.
The first is the coupon rate, which is the annual amount of interest collected divided by the face value of the bond. It’s the percentage amount the company decides to pay on the bonds. Historically, bond certificates included coupons that would be torn off to redeem the semi-annual payments.
If you know the coupon rate but want to find the amount of interest paid each year, just multiply the rate times the face value.
Since the coupon payments on a bond never change and you will always receive the face value of the bond at maturity, the only thing that can change on the investment is the price. This brings us to the most basic lesson in bonds, how interest rates affect prices.
Interest rates are the cost of money, whether to borrow or invest. The Federal Reserve, the monetary authority of the United States, sets an interest rate for bank borrowing to influence the economy. If the economy gets going too fast and inflation rises, the Fed increases rates to make borrowing more expensive. If economic growth slows, the Fed lowers rates to make borrowing cheaper.
The rate set by the Fed flows through to all other interest rates, pushing interest rates for business borrowing, credit cards and everything else higher or lower.
It all goes back to the interest rate risk in bond investing.
That bond you bought before rates increased still pays the same amount and will yield you the same return on the price you paid. That return might not be so attractive to new investors since they can make more money on other investments after an increase in rates.
To make the return on an older bond competitive with other investments, the price must change to attract investors.
Imagine you paid $950 for a bond that paid $47.50 a year in coupon payments for a 5% yield. That 5% yield might have been great until interest rates increase and other investments are paying 5.5% annually. Nobody is going to buy that bond yielding 5% if they can get a new bond and make 5.5% a year.
Since the $47.50 coupon payment doesn’t change, you might need to lower the price to $863 which would increase the yield to 5.5% for a new buyer ($47.50 divided by $863).
Conversely, you’ll be able to increase your bond’s price if interest rates decrease and that original 5% return is attractive given a 4.5% return on new bonds. An investor might offer you $1,055 for your bond to lock in a 4.5% return given the $47.50 coupon payment.
As a long-term investor, you really don’t need to worry about interest rates and all the factors that go into bond prices. Economic cycles will come and go, taking bond and stock prices for a ride. Trying to time changes in prices, buying and selling to make a quick profit, is the fastest way to lose money.
Investing in bonds of different maturities, those that pay their face value back in different years, means you’ll always be reinvesting part of your money back in new bonds. If interest rates increase over the next decade or longer, that means you’ll be able to reinvest in bonds with higher rates.
Bond Investing Yields and Returns
The current yield is another measure that you will hear when investing in bonds. It is the coupon payment divided by the current price of the bond. A $900 bond price and a $50 annual coupon mean the bond has a 5.55% current yield.
Don’t confuse the coupon rate with the current yield. The coupon rate is set on the face value of the bond and may not be as relevant to new investors. The current yield is the cash return you will get annually if you invest in the bond. After you buy the bond, the current yield may change but will not affect the return you get on your investment.
The yield to maturity (YTM) is one of the most important measures and is the return on the bond if you hold it to maturity, including the regular interest payments and the return of the bond’s face value when the company buys it back.
The YTM is always provided on bonds because the actual calculation is monstrous. One important consideration is that the calculation assumes that you will be able to reinvest all the interest payments at the same rate. This might not be realistic so the actual return on the bond might be higher or lower depending on how you invest the interest payments.
Credit Ratings and Bond Prices
There are three main credit rating agencies; Moody’s, Standard & Poor’s and Fitch. These rating agencies assess the ability of a company to pay its debt and assign a quality rating to new bond offers. Investors use these ratings to determine whether the bond fits with their own investing strategy and whether the return is enough to justify the risk of investment.
A bond is assigned one of the approximately 20 risk categories. These categories are separated into two groups, investment-grade and non-investment grade. The non-investment grade category is also called speculative or ‘junk’ bonds.
A bond’s risk category is used by the issuer to help determine the yield it offers initial investors. Investors will be willing to accept a much lower return on an AAA-rated bond with an almost certain payoff than the return they’ll accept to invest in a riskier BB-rated bond.
Rating agencies follow the bonds on which they assign ratings. If a company falls on tough times and it looks more likely that it won’t be able to make bond payments, the rating agency might downgrade a bond’s credit rating. That means the bond is now in a class of bonds that are paying higher returns to investors because of risk.
Since the payments on the bond do not change, the bond’s price must come down to increase the yield. It’s the same effect as an increase in interest rates. Conversely, a bond’s rating can be upgraded which would send the bond’s price higher.
Types of Bonds
Everyone from governments, local authorities, companies and even individuals can offer bonds to investors. You may not need to invest in each type but it’s important to know the differences in each type of bond issuer and what it can do for your portfolio.
Bond investing is all about different risks with different issuers. A government can generally raise taxes across a huge population to pay its debt so these bonds are usually safer than others but pay lower yields. Some government or local government bonds may offer tax advantages, offering a special benefit to those in higher tax brackets.
It may not seem like it around April 15th but the U.S. government regularly needs to raise money by selling bonds. In fact the Unites States owes more than $18 trillion in government debt.
Bonds issued by governments are backed by the “full faith and credit” of the issuer. Bonds issued by the U.S. government are considered a risk-free investment because everyone assumes that Uncle Sam will always pay his bills. Bonds issued by some other countries…not so much.
The risk in government bonds is reflected in their ratings shown in the graphic.
Of course the difference in risk translates to different returns you’ll earn on these government’s bonds. The ten-year U.S. Treasury Bond pays just 2.5% annually and Germany’s ten-year bond will get you just 0.5% a year.
Invest in riskier governments like Greece and you could earn 7.1% a year…or you could lose everything if the country defaults.
Investment grade government bonds, those rated BBB or better, have defaulted at a rate of less than 1% over more than four decades. Bonds of less financially-stable countries like emerging markets have defaulted at a higher rate but the higher returns can make it worth it.
Foreign bonds are either denominated in dollars or in the local currency. This adds another layer of risk if the local currency rises or falls against the dollar. If your foreign bonds are paid in the local currency, your return will increase if the currency rises against the dollar. Conversely, your return could take a hit if the foreign currency falls against the dollar.
Don’t neglect bonds of foreign countries because of the higher default rate. The benefits of diversification through economic cycles and currency can really help reduce risk in your portfolio.
The upside to investing in U.S. Treasury Bonds is that you pay no state or local taxes on the interest payments. You’ll still have to pay federal income taxes on the interest, unless held in a retirement account or by a qualified non-profit organization.
Just because government bonds may have very little default risk, don’t think they still aren’t exposed to other bond risks. Prices for long-term government bonds rise and fall along with interest rates and bonds issued in other currencies will react to changing foreign exchange rates.
Raising money through debt is an important part of running a business. Issuing bonds means owners can raise money to operate the company without having to share profits with investors. As long as you can make the semi-annual payments and the lump payment at maturity, bonds represent a great source of financial leverage.
Issuing bonds is also a cheaper source of financing for many businesses. A financially stable company can borrow money at 4% while investors might require double-digit returns to take an ownership position in the business.
The fact that bond payments must be made and represent a debt burden, most companies use a mix of bond and stock financing. Rating agencies can penalize a company with lower ratings if it issues more debt than it can handle.
Some companies are so financially-stable that their credit rating is even better than that of the United States government. Over the 35 years to 2006, just half a percent of the bonds issued by the safest companies have defaulted.
The bonds of riskier companies have a higher chance of defaulting but also offer higher returns. Nearly a quarter of the bonds issued with a B-rating over the same 35-year period defaulted but a portfolio of the bonds still yielded better than 5.5% annually over the period.
Municipal bonds are just like government bonds except issued by local authorities like states, cities and townships. While the bonds might not be backed by the stability of the federal government, most carry a strong rating and a great tax advantage.
Besides not owing state or local taxes on the interest payments, you aren’t responsible for federal income taxes on the interest either. For investors in higher tax brackets, that’s a huge benefit and muni bonds are a popular tax planning strategy.
An investor in the 35% tax bracket investing in U.S. Treasury Bonds earning 2.5% annually might only see a real return of 1.6% after paying federal income taxes. That same investor can invest in an A-rated municipal bond earning 3% and keep all the interest without any tax liability.
Investors can compare taxable bonds with tax-free municipal bonds by finding the tax-equivalent yield.
This means finding the return you’ll need to get on a taxable bond to equal the return available on a tax-free municipal bond. To do this, you simply divide the yield on the muni bond by one minus your tax rate (1-tax rate).
For example, if a municipal bond offers a yield of 2.7% annually and you’re in the 25% tax bracket then you divide 2.7% by 0.75 to get 3.6 percent (i.e. 2.7% divided by 1-0.25). Any taxable corporate or Treasury bond would need to offer a yield of 3.6% to offer the same after-tax return as the municipal bond.
Municipal bonds are generally one of two types, general obligation (GO) bonds or revenue bonds.
GO bonds usually have a lower default rate compared to revenue bonds because the payment for the bonds is backed by a broader revenue stream, the local tax base. Revenue bonds are only backed by the cash generated from a specific project. If the cash flows on the project, say a toll-road expansion, are not enough to make payments then the bond might default.
Municipal defaults have been a hot topic over the past several years with the default of Detroit and the potential for a default on Puerto Rico bonds. Municipal bonds have always been seen as extremely safe investments and some are even backed with insurance against a default. Pension funds and insurance companies are heavily invested in municipal bonds for their safety and the potential for default has caught a lot of investors off-guard.
Despite the media hype over defaults or the potential for defaults of some large municipal bond offers, most muni bonds are still extremely safe. According to data from Moody’s, there has never been a default of an AAA-rated muni bond. Just 0.04% of A-rated bonds defaulted over the four decades to 2011, that’s just one default in every 2,500 bond issues at that rating category.
Overall, only 0.13% of all muni bonds defaulted over the 41-year period and investors have earned a 2.73% annual return on a tax-adjusted basis.
Peer Lending as a Fixed Income Investment
Peer lending is emerging as an interesting part of investors’ bond options. Peer lending sites like Prosper and Lending Club connect investors directly with unsecured loans to small businesses and individuals.
These loans are legal contracts and go on the borrower’s credit report but are not rated by credit agencies. The peer lending site issues a rating based on the borrower’s credit history and the loan.
Peer loans have a fixed payment that is deposited in your account on a monthly basis and a fixed maturity, usually either three or five years. Unlike traditional bonds, peer loan payments include interest and the principal. The monthly payment you receive will be higher but you won’t receive a large lump-sum payment when the loan matures.
Since peer loans are not backed by company assets or the tax base of a government, risk is considerably higher on the investment. Default rates are higher for peer loans but the return is also higher.
The process of investing in peer loans is straight-forward and fees are generally lower than investing in other bonds. Fees on loans are paid by borrowers though investors may have to pay annual account fees.
What is a Bond Fund?
Bond funds work just like stock funds, groups of stocks bought and held by a portfolio manager to give you instant diversification and lower expenses.
I’ll talk about bond exchange traded funds (ETFs) here because I believe they offer the best opportunity for investors but you can also get mutual funds that invest in fixed income investments.
Bond funds generally hold investments within a certain type or rating of bonds. There are bond funds that only hold government bonds while others only invest in corporate bonds. You can also buy bond funds that invest in a certain maturity range, say long-term bonds with maturities over 20 years.
Bond funds are a great option for most investors because of the cost to investing directly in individual bonds. You can buy a bond fund for as little as $5 on some discount brokers online why buying an individual bond will cost you a percentage of the investment.
Bond funds also offer much easier diversification. If you want to spread your risks in individual bonds, you’ll have to split your investment among a range of different bonds:
- Different maturities to diversify against interest rate and reinvestment risk
- Bonds of companies in different sectors of the economy to diversify against economic risks
- Bonds of different ratings to balance higher returns with less risk
I share a list of my favorite bond funds and an investing strategy further down in the article. If you decide to invest exclusively in fixed-income bond funds, make sure you buy a few different funds to completely diversify your portfolio.
A Fixed Income Investment Strategy Based on Your Goals
Putting together a simple bond investing strategy according to your own needs will do two important things for you.
First, it puts you directly in control of your own financial future. You won’t have to worry about some money manager making self-interested decisions to increase their own fees or stealing your money outright.
Putting together a simple strategy can also take the stress out of reaching your goals. A money manager is tasked with constantly reaching for higher returns and ‘beating’ the market to justify their added expense. That means taking risks on your money and the potential to miss your goals. Planning your own portfolio around a simple and safe strategy means you can be confident that you will reach your financial goals ahead of retirement.
Step 1: How much do you need in bonds?
Asset allocation is just a way of saying how you will invest your total wealth across the asset classes like stocks, bonds and real estate. Each asset class carries different levels of return as well as different types of risk.
Investing at least a little in stocks, bonds and real estate will help reduce your overall risk in the economy and smooth your annual returns.
Bonds as a group returned 4.6% annually over the decade to 2013. While there’s no guarantee that bonds will offer the same return going forward, we can use past returns as a benchmark for asset allocation.
The actual long-term return on your bond portfolio may change over time and will be more complicated than simply looking at the average yield-to-maturity on the individual bonds.
What you do with the semi-annual interest payments will have a lot to do with your actual returns. If you are able to reinvest your interest payments at higher rates, as interest rates increase, then the long-term return on your bond portfolio will gradually increase.
How much money you invest in bonds depends a lot on your age and other investing factors. Some of the most popular articles on the blog is the series showing how to invest according to your age. The idea is that as you get older and closer to retirement, you should invest a little more of your money in the safety of bonds.
This graphic is just an example of how your investments change as you get older and shouldn’t be taken as what you should do. Always invest according to your own return goals and risk tolerance.
Starting out in your 20s or 30s, you’ll have a great deal of time before retirement and can take a little more investing risk. Use this ability to tolerate risk to get higher returns on your investments through more money in stocks. Most younger investors will hold the majority of their portfolio in stocks.
Don’t neglect bonds and real estate completely as a younger investor. Getting started investing in bonds early will help avoid putting it off like so many investors do. Not only do bonds provide stability but they can also help protect your money while you wait for lower stock prices in which to invest.
As you get older and closer to retirement, your risk tolerance will decrease. You’ll want to revisit your allocation to the three assets every ten years to reduce the risk in your portfolio. Leaving your investments mostly in stocks until you’re ready to retire will leave you exposed to a stock market crash at exactly the wrong time.
Besides changing your allocation across assets according to your changing risk tolerance, you can also change your investments within the asset classes. A portfolio with a high allocation to stocks may still be relatively safe if it’s in safer companies like utilities and consumer staples. Conversely, a portfolio mostly in bonds could be extremely risky if it’s all in junk bonds or risky peer loans.
Step 2: Which Fixed Income Investments are Right for You?
After deciding how much of your money to put into bonds, you’ll need to decide how much to invest in the different bond types as well as different maturities and ratings. This will be less of a concern if you are investing in bond funds which are already spread out over different maturities and ratings.
If you are planning on only investing in bond funds, you can skip over the rest of this step.
As with the asset classes and other investments, the idea here is to diversify your bond portfolio within bonds to smooth returns and best fit your needs.
Even if you have several decades to retirement, you’ll want to buy some shorter-term bonds so you can reinvest money if interest rates increase. Longer-term bonds will offer higher current rates but will lock you into those rates for the period.
While riskier bonds offer a higher yield, an economic recession might increase default rates and lower the yield you get on the portfolio. Include a mix of safer bonds along with lower-rated bonds according to your risk tolerance.
I’ve included a chart of current rates on 10-year bonds for municipals and corporate debt at different ratings. Average rates on government bonds are difficult to find because yields vary according to relative inflation and interest rates in each country. Don’t forget to consider U.S. and other government bonds for your diversified portfolio.
Deciding in which investment accounts to hold your bonds can mean a big difference in returns. You will want to hold your municipal bonds in taxable accounts since the investment is already tax-advantaged.
Other taxable bonds like corporate bonds and peer loans should be held in tax-advantaged retirement accounts. This will protect you from the income tax bite on interest payments.
U.S. Treasury bonds can be held in either a taxed or a tax-advantaged account. Holding them in your retirement account will protect interest payments from federal income taxes but you might not be able to hold all your investments in these accounts. If you’ve already maxed out your retirement contributions on other investments, holding treasuries in a taxable account still offers the advantage of saving on state and local taxes.
While peer lending is yet to be a widely-accepted class for bond investors, I don’t think it will be long before it gains widespread approval. It’s true that peer loans involve more risk than conventional bonds but they also offer a great bridge between the higher returns of stocks and the certainty of bonds.
I have over $20,000 of my own money invested in peer loans and recently interviewed one investor that has earned $10,000 and 12% annually on his p2p investments.
Click for more information on how to get started investing in peer loans.
Because of the higher risk involved with high-yield (junk) bonds and in peer loans, I would allocate no more than 30% of your bond portfolio to both groups. Note that isn’t 30% of your total wealth but 30% of your bond portfolio.
For example, if you hold 50% of your total wealth in bonds then it would mean less than 15% (30% of 50%) in higher risk bond investments. This gives your bond portfolio a chance at slightly higher returns but still the relative safety from higher-rated bonds.
Buying bonds across short-term, intermediate and long-term time horizons will stagger your investment by time. This will help to balance interest rate and reinvestment risk because you’ll be able to reinvest your shorter-term bonds fairly soon while still benefiting from higher current rates on your long-term bonds.
As an example:
A relatively low-risk portfolio might hold 60% in government and municipal bonds, 30% in corporate bonds and 10% in high-yield and peer loans. This allocation benefits from tax advantages and stability in government bonds while still providing higher returns from corporate and higher-risk bonds.
Investing equal amounts across short-term, intermediate and long-term bonds makes the strategy a little simpler and helps spread your investments out further.
A higher-risk portfolio might hold 20% in government/municipal bonds, 60% in corporate bonds and 30% in high-yield and peer loans. This allocation will still provide some safety in government bonds while increasing the overall return through corporate and higher-risk bonds.
There’s no “perfect” allocation for any investor and don’t worry too much about picking exact percentages in each bond type. The idea is to target a rough proportion within each bond class to help see what kind of return you can expect. While corporate and high-yield bonds may involve more risk compared to government bonds, most are still lower risk than stocks.
Step 3: How to choose and buy bonds for your portfolio
Picking individual bonds can actually be fairly easy because the credit rating agencies do the analysis legwork for you. The credit rating agencies rate bonds across four primary measures called the four C’s of credit.
- Character is the history of the company, management’s experience and any history of bond payments.
- Capacity is the financial ability of the company to make the bond payments. It includes the current amount of debt and payments as well as if the company has more credit available from banks or other companies.
- Capital is the assets and other resources owned by the company that can be used to repay debt or generate sales.
- Condition includes external factors that might affect the company’s ability to repay debt like industry growth, currency fluctuations and the economy.
You could spend hours and even days studying individual bond offers and companies, comparing the bond against others in the same rating category, but it generally won’t make much difference in your returns. It’s a lot like trying to pick individual stocks and hoping to “beat” the rest of the market by finding something nobody else sees.
Bonds within each rating category tend to be fairly similar as far as risk and return so don’t spend your time worrying about which individual bonds to choose within each rating category. Focus more on choosing a mix of bonds across risk categories, issuer types and maturities.
Climbing the Bond Ladder, My Favorite Bond Investing Strategy
Buying bonds of different maturities isn’t only a good idea to balance interest rate and reinvestment risk but it’s also a great way to plan the flow of cash from your investments.
The technique is called bond laddering and involves buying bonds that mature at different dates to coincide with your cash flow needs and expenses.
While your semi-annual interest payments might cover a good portion of your living expenses in retirement, they might not cover everything. Laddering your bonds means you can use the maturing bonds to cover additional expenses instead of having to sell bonds.
The idea is pretty simple and works while you are reinvesting your bonds as well as when you start using proceeds for expenses.
When buying bonds for your portfolio, spread your investment across many different maturity years.
If you’re planning on reinvesting the money when bonds mature, spread your maturities out every few years.
Buy bonds that mature within equal intervals from five years to 20 or 30 years. Every five years, when some bonds mature, reinvest the proceeds in a new group of bonds that mature five years from the longest-maturity bonds.
If you are planning on using maturing bonds to help pay for living expenses, you will want to buy bonds that mature every year or two. This will mean a more frequent stream of bonds maturing for a consistent cash flow.
Using Bond Funds with Your Portfolio
Because of the fees involved in buying individual bonds, most investors choose to invest exclusively in bond funds. It’s generally accepted that unless you have $150,000 or more to invest in bonds, it’s cheaper to just buy bond funds.
Exchange traded bond funds trade just like stocks and are already diversified with bonds of different maturities and risk ratings.
If you are investing exclusively in bond funds, choose a mix of bond funds that give you exposure to different issuer types, maturities and risk levels. It’s pretty easy to build a diversified mix of bond funds and really cost-effective. Buy these funds through your online stock investing platform just as you would a share of stock.
Some good bond ETFs to consider for your portfolio:
iShares 20+ Year Treasury Bond (TLT) holds long-term U.S. government bonds with maturities of twenty years and longer.
iShares Core U.S. Aggregate Bond (AGG) attempts to track the performance of the U.S. bond market. It holds investment-grade corporate bonds, Treasuries, mortgage-backed bonds and other fixed bonds.
iShares Investment Grade Corporate Bond (LQD) provides exposure to the broad U.S. investment-grade corporate bond market. Bond maturities are spread out from three years through 20+ years.
Vanguard Total International Bond ETF (BNDX) invests in bonds issued outside the United States including governments and corporations. Most of the bonds are from Europe (57%) or Asia/Pacific (28%) with varying credit qualities and maturities.
SPDR Barclays High Yield Bond ETF (JNK) invests in non-investment grade corporate bonds. Most of the bonds are rated B or BB with a small percentage rated CCC or lower. Since most investment grade bonds are issued at shorter maturities, most of the bonds in the fund mature between three to ten years.
If you plan on investing more than $150,000 in bonds, you might be able to take advantage of a combined investing strategy. Invest the entire amount in individual bonds and then use bond funds to reinvest the interest payments every six months. Waiting six months to reinvest interest payments helps to reduce commissions paid on bond funds. When individual bonds mature, the money can be reinvested in other bonds to maintain your overall exposure.
Don’t forget that you can buy U.S. Treasury bonds with no markup or fee on the TreasuryDirect website. Along with the tax advantage on state and local taxes, this can help to make the yield on government bonds much more persuasive against those on other bonds.
Step 4: When to sell your bonds
The best answer as to when to sell your bonds is never. Selling your bonds will mean extra broker fees and possibly capital gains taxes. You are not likely to consistently find cheaper bonds so there is little point to trading in and out of your fixed income investments.
There are only two scenarios that I would consider selling my bonds before maturity.
- If the stock market has fallen 25% or more and I need to rebalance my overall portfolio on the change in values. If you have 50% of your total wealth in stocks and the stock market falls by 25%, you would now have about 43% of your wealth in stocks (assuming other asset classes didn’t change). You might then want to move some money from bonds to stocks to get your percentages back on target.
- Older investors depending on their investments for living expenses may find that regular interest payments don’t cover all their needs. This problem can be minimized by laddering your bonds, using regular bond maturities to help pay for expenses, but you may still need to sell bonds from time to time.
Fixed-income investments are a mystery for many investors but should be a critical part of your wealth strategy. Don’t worry too much about the details of how interest rates affect bond yields or when to buy bonds. Invest a portion of your nest egg in bonds depending on your age and tolerance for overall investment risk. Hold your bonds until maturity and reinvest them in new bonds or use them in an income strategy to pay retirement expenses.
Wow, your explanation of bonds was detailed and thorough. Thank you for helping me better understand bonds. Now, I think I might look at investing in a bond myself.