When you want to earn passive income or save for your retirement, bonds may be a great alternative to stocks or real estate purchases. It’s a low-risk way of generating income that will give you peace of mind for as long as you want to hold them. If the idea of risky investments doesn’t sound good to you then bonds may just be the way to go. They’re easy once you understand them and won’t fluctuate like stocks or real estate. There is little risk involved and usually a good payout once you decide that it’s time to cash them in.
Be A Creditor
Buying bonds essentially makes you a creditor to the companies that you deal with. This puts you in a very safe position if the company is ever facing liquidation. When a company is forced to liquidate its assets, it’s the creditors that get paid first. This is before the stockholders.
You will be treated as a supplier or employee and that means that you get your money long before the stockholders get their share. That pretty much guarantees that you’ll get the full amount that’s owed to you in the event of liquidation.
The Market Is Massive
What’s even better about bonds is the fact that the market is huge and well varied. That means you’ll have your choice of how you go about getting your bonds. There are many variations of risk, yield, duration, issuers, and price.
It lets you really get the deal that’s perfect for you and your situation. If you put in the time to fully study the market, then you’ll be able to build a portfolio that hits all of the marks that you set for it. It’s one of the best ways to tailor fit your portfolio to you.
What Exactly Are Bonds?
A bond is essentially a lending transaction. When you buy a bond, you are lending money to the bond issuer in exchange for interest payments, also known as yield, and more money when the bond comes to full maturity.
Bonds are a financial instrument used to pay for a variety of projects, such as construction, infrastructure improvements, capital expenses, and expansion.
Investors buy bonds in order to supplement their income, build wealth, save for retirement, or live off of the interest payments. It’s one of the best and most solid ways of generating passive income or saving for your retirement.
Different Types Of Bonds
- US Savings bonds
- Treasury bonds
- Municipal bonds
- Corporate bonds
- Convertible bonds
- Bonds owned by foreign governments
- Bonds owned by foreign companies
U.S. Savings Bonds
These are a form of managing federal government debt. They’re sold at a discount, which is always well below face value. They mature over a specified timeframe. For instance, Series EE bonds are sold at half their face value and mature in 20 years.
They are an extremely safe investment. You will never lose your money after buying them. However, you will receive no interest payments. Monetary inflation that may build at compounded interest over the years before maturity may eat away at your investment. You will never receive a high return on your investment with savings bonds. That makes them safe but not very lucrative.
Treasury Bonds
These are also known as T-bonds. They are debt securities issued by the U.S. government. Unlike savings bonds, they issue periodic payments of interest.
At maturity, the bearer will sell the bond and receive par value. The money is used to finance the federal government’s debt in a similar manner as savings bonds.
Municipal Bonds
These bonds aren’t just issued by cities. Libraries, schools, hospitals, counties, and states also issue them to fund local projects, such as the construction of buildings and infrastructure improvements.
They pay relatively low interest. But, depending on your tax bracket, they offer one appealing advantage. They are generally tax-free. That makes them very appealing to buy as tax shelters.
Corporate Bonds
As the name implies, corporations issue these bonds. They are generally used to finance capital improvements, construction projects, and business expansion. They offer higher yields than government bonds but are more expensive to purchase.
You can buy them in the form of Rollover IRAs for your retirement. The investor receives a fixed or variable series of interest payment rates at preset intervals until the bond matures. At that time the investor receives the value of the bond.
Convertible Bonds
This is a form of corporate bond that allows the investor to choose to receive interest payments for a time and then convert the bond into a specified amount of the company’s common stock. That’s a great option to have if you ever wish to try out a higher-risk investment scheme.
While the possibility of losing money will always exist, the payout will be much higher for you. It’s always best to carefully study the market before you get into it. A stable market will always be a safer bet than a volatile one.
Foreign Government Bonds
These offer high risks and high opportunities to investors willing to take a flyer. If the government does well, the investor stands to reap large rewards. This, of course, is going to be a problem in volatile countries. Your investment may be subject to wild swings of value, even nationalization.
In the latter case, the investor has no recourse for recovering the investment. This means that the safest bet is always going to be buying foreign bonds from a stable nation.
As always, the higher the risk you take, the higher the potential reward is going to be. It’s always a great idea to understand the country of the bond before you decide to buy it.
Foreign Company Bonds
Just like buying bonds from foreign countries, buying them from foreign companies will offer you similar risks and rewards. You’ll want to learn how the company operates as well as how the country is faring.
The big danger here is that the company will get nationalized by its home country. This is something that will never benefit you, although foreign companies may offer higher yields. This is done in order to compensate for the higher risk of foreign investors.
Tenure
Tenure is the length of time until the bond matures. It will give you more options when deciding to buy your bonds. Each one will come with its own tenure. The longer you wait, the higher your payoff will be. Whether or not that amount of time is worth it is up to you. It’s just one more thing to consider and the following terms will help you to understand it more fully.
- Yield to Maturity means how much money the investor receives when the bond matures.
- Term to Maturity means how much time is left until the bond in question reaches maturity.
- Yield to Interest means how much money the investor receives from interest payments before maturity.
- Maturity means that the bond pays back its full value to the investor on a specified date.
- Effective duration is the most common form of measurement. This means how quickly the bond will pay back the initial investment made in terms of interest payments: the bond’s cash flow.
- Inflation-linked bonds: The rates are adjusted as inflation rates change.
- Perpetual bonds: These bonds never mature. The bondholder receives regularly scheduled interest payments in perpetuity.
- Duration measures the bond’s sensitivity to interest changes.
- Fixed-interest bonds: The rates of interest payments are known ahead of time and stay the same until maturity. These bonds offer a secure, predictable return on investment.
- Floating-interest bonds: The rates change due to market fluctuations. Returns are unpredictable and inconsistent.
- Short-term bonds: These bonds experience a low response to interest rate changes and are offered at a lower cost. They mature in one to four years. They offer you lower risk and lower returns on investment.
- Ultra-short-term bonds: These mature in as little as 90 days and are considered cash equivalents by financial experts, including me. If you want to invest and want your investment to be liquid in a short time, these are a great alternative.
- Medium-term or intermediate bonds: These mature in 2 to 10 years. Their yields fall between short-term and long-term bonds. If you prefer a medium level of risk, these may be the bonds for you. Fewer issuers are offering long-term bonds for sale these days. To illustrate the point, brokers have nicknamed the latest 10-year Treasury bond “the new 30-year bond.”
- Long-term bonds: These mature in 10 to 30 years. Since the investor is essentially lending money to the issuer for a much longer time when buying these bonds, the issuer generally offers higher interest payments for them.
There are calculators available to help you determine the mix that works the best for you. If you’re not planning on retiring in the next 20 years, then long-term bonds will be the most effective. Alternatively, if you plan on retiring soon, short-term bonds may be what you need to meet your financial goals.
Bond Ratings
Bond ratings show you the stability and growth of your bond issuers. You can find ratings for all kinds of bonds and issuers. The more you know about them, the better off you’ll be as you build your portfolio. These ratings are given to you in the form of letters.
It’s an easy-to-understand system that will let you know everything you need at a glance. The highest, strongest rating in the system is the triple-A bond or AAA. From there on, the letters change in this fashion: AA+, AA, AA-, A+, A, A-, BBB+, and so on down to CC, and D, which stand for the weakest ratings.
There are several different ratings that you can check before you buy into your bonds. The two biggest raters are Standard and Poor and Moody and Fitch. It’s always best to check with both before you make any decisions.
The ratings are not perfect and can’t be used alone to predict how your bonds will do. The best course of action is to use the ratings in conjunction with other indicators of the company’s future performance. That will be your safest strategy.
How Bonds Get Rated
Raters base their judgments on the issuer’s financial situation, growth, and ability to repay. U.S. government bonds are rated as extremely safe. In exchange for safety, they offer lower interest rates. There are two main categories of bonds, based on credit ratings:
Investment-grade bonds – These are deemed safer for investors and are given high credit ratings. In exchange for greater perceived safety, issuers offer lower yields on their bonds. If you desire safety over risk, these bonds are golden. The trade-off is low yield.
Junk bonds – These are also known as high-yield bonds. They are deemed by the raters to be high risk and so are given lower credit ratings. To offset these factors, issuers offer higher yields. Junk bonds are generally issued by start-up companies or companies dealing with high debt ratios.
Some junk bonds are issued by what brokers call “fallen angels,” which are companies that have lost their high credit ratings for various reasons. The dangers of junk bonds are obvious. These companies are often in trouble and may default. Their bonds suffer from more price volatility.
The opportunities are also obvious. The investor may wind up with a huge windfall if the start-up company grows rapidly or the fallen angel improves its finances dramatically. It’s up to you if the risk is ever worth the potential reward in these instances.
How To Purchase Bonds
When it comes time to actually purchase your bonds, there are many traditional brokerage firms that can help you out. You can also open an account with an online brokerage. It’s always best to choose one that doesn’t require a minimum purchase. That will allow you to buy as little, or as much as you want with no repercussions. You can also check over-the-counter markets.
This is where traders trade directly with no middleman. They have no physical home, though. It’s all done online but will end up saving you time and money. It’s also possible to buy your bonds directly from the United States treasury. These are traded widely and the easiest bonds to get your hands on.
You can also get them through a broker. No matter how you go about buying your bonds, it’s always a good idea to make sure that you’re using a reputable source. It’s very easy to come across scams as you try to buy anything digitally.
Bond ETFs
Bond ETFs are a new and useful way to buy bonds. The letters that you see stand for Exchange-Trade Funds and these funds are similar to mutual funds for shares of stock. The bond ETF fund manager selects bonds and pulls together a portfolio for investors, saving the investor a lot of work. Each ETF is based on a particular investment strategy devised by the fund manager and mathematicians.
When calculations are performed on bond funds, such as ETFs, to estimate future yields, a mathematically weighted calculation must be performed. There are too many bonds involved to calculate all of them separately with any certainty of accuracy for ETFs. Online analytics allow these experts to choose between a bewildering variety of bond ETFs. 430 of them are ranked highly and are available for purchase in the United States.
These experts are no doubt experimenting with an even larger number of combinations of bonds. The average investor can’t hope to select the one best suited to any investment strategy. If you’re worried about your ability to choose the best bonds for your own portfolio, your best bet is to invest with the experts through an ETF.
The latest in bond investing are Robo-Advisors. These automated systems will build and manage a bond ETF for you based on your investment needs for a low annual fee. This means the potential number of different bond ETFs will soon explode. It might very well be the future of bonds and it’s always in your best interests to accept new technology as it comes along. There’s no way to stop it and you can benefit from it if you’re willing to understand it. It’s just one more thing to learn about and will make sense once you get the basics of how it operates down.
Conclusion
Bonds are a very safe investment and more than worth your time to discover. The best investment strategy in bonds is the one that you set up with three things in mind: How many years you want to invest until you receive your payout, your comfort level with risk, and how much money you want to earn.
If you fear risk then government-issued bonds are your safest route. If you want to get a high return on your investment, you’ll have to accept the risk. Pay attention to inflation and economic growth to get the most out of it and you’ll be well on your way to a financially comfortable life.